Despite narrative to the contrary, a significant proportion of retirees are underspending in retirement out of fear of running out of money. However, there still remains the risk of overspending and running out of funds, not being able to meet costs later in life. Both these scenarios are not ideal and they’re a key driver of why people seek financial advice in preparation and throughout their retirement.
Longevity risk is influenced mainly by three different factors: mortality risk, investment risk and expenditure. How these three factors interact through retirement generally determine whether they will have sufficient funds to see them through their later years or are forced to make do with government aged pensions, regardless of whether this is sufficient to their lifestyle needs or not.
Looking at some of these components of Longevity Risk in more detail, we start with mortality risk. Mortality risk is the chance of death in a given period of time. It can be broken down into two underlying components: Idiosyncratic mortality risk and Systematic mortality risk. Similar to the way that we think of company risk in investing, idiosyncratic risk is the specific risk that a person may die as an individual. Every individual faces the risk of death on any given day that is specific to their own personal situation regardless of how the rest of the population is faring. In the same way that any given company, depending on its specific circumstances, may be exposed to more or less risk than investment markets as a whole. For example, the risk of investing in a tobacco company are quite different to the risks of investing in a bank. So too are the risks of an individual different for a lifetime smoker compared to a vegetarian yoga instructor.
Systematic mortality risk is your life expectancy within the overall population, and it tends to be the greater focus in financial planning when trying to make judgements around longevity. Life expectancy of the whole population changes over time; with advancements in medical technology and a greater understanding of the impact of lifestyle; things like diet and exercise, mental activity, etc. are reflected in continuously changing life expectancies. It manifests in facts like that someone at the age of sixty-five today can expect, based on population trends, to live much longer than just ten or twenty years ago. So, when trying to estimate how long people will live for in retirement, we need to not just take into consideration current life expectancies of populations, but potentially over shooting from advancements in life expectancy as we move into the future.
This can be further complicated when trying to plan for retirement with things like the male/female life expectancy differential, though this difference has been narrowing over time to now being within just a couple of years for individuals at aged sixty-five. But probability still states that roughly one individual in every two couples, is likely to live to age one hundred, despite individual life expectancy only somewhere in the mid to late eighties.
Our next major factor in Longevity Risk, as it relates to retirement planning, is investment risk. However here we are primarily concerned with sequencing of returns, in addition to the actual long-term investment return, as the sequence of future returns, particularly in the early part of retirement, is critical to how long our funds last. The basic premise is that the order of returns that you experience (strong returns or weak returns early on, positive returns up front, or negative) in your retirement years can be more important to the overall result of whether your or not your funds last for your retirement than the actual average rate of return over say a given thirty year period.
An average return of just six or seven percent can be more than ample for requirements where the first ten years of investing are largely positive, as opposed to the dramatic impact where, with the same thirty -year average return, we experience a high frequency of negative or poor returns in the first ten years.
Under both these scenarios, the long-term, average return can be the same, but the sequence of a poorer first ten years of returns can have a dramatic impact when funding retirement through regular systematic withdrawals from your investment base. Dynamic Asset Allocation can help manage this particular risk, but it can also be impacted and managed somewhat through the use of a Dynamic Expenditure plan, which brings us to the last component of the Longevity Risk; Expenditure.
Expenditure in retirement is not simply a reflection of available funds but can be impacted also from likely lifestyle requirement of retirees. In the past, Safe Withdrawal Rates popularized by William Bengen1 where a withdrawal or expenditure rate generally of four percent (of your retirement savings) has been considered to be a safe maximum. New research, in particular that from the New Zealand Commission for Financial Capability, considers that there are actually three different stages in retirement with different expenditure requirements; an Active, then Passive, then Supported phase.2
The Active stage is the early years of retirement, approximately the first decade, when lifestyle is the main driver of spending, as retirees have the energy and desire to be active. This can reflect itself in additional expenditure on things like travel, hobbies and other types of active endeavors. The following decade can be categorized as more Passive, where there is generally less appetite for activity and spending can commensurately drop. Then for those find themselves in the later stage of retirement; roughly eighty-five plus years of age; support increasingly is required with higher medical and health care costs and potentially aged care needs. Marking an increase again in expenditure needs.
Consequently, the interacting requirements in Financial Planning for Longevity Risk in Retirement necessitate an ongoing adaptive approach to plans, where the interaction of life expectancy, investment markets, expected returns and sequencing of returns as well as the changing needs of retirees depending on their stage of retirement, can result in the need for continuous adaptation of an investment strategy.
Other influences that can complicate Longevity Risk in Retirement Planning can be retiree’s desire to leave (or not) a substantial estate to surviving children and whether or the not the spending down of financial capital is allowable part of the strategy (i.e. spending the kids’ inheritance). Does a principal residence form part of accessible funds for the retirement strategy, specifically in later years such as funding aged care needs? The continuing play of these risks, and how we prepare for them, form the basis of Longevity Risk and Retirement Planning for financial planning clients.
1. Bengen W 1994, Determining withdrawal rates using historical data, <http://www.retailinvestor.org/pdf/Bengen1.pdf>
2. Commission for Financial Capability , n.d., The three stages of retirement, Commission for Financial capability, Auckland, viewed 30 January 2018 from <https://www.cffc.org.nz/retirement/thethree-stages-of-retirement/>