Longevity Risk and Retirement Planning
Longevity Risk and Retirement Planning go hand in hand. Longevity is the great risk multiplier in retirement!
We all know the greatest fear in retirement is running out of money. Obviously, the longer you live, the greater the chance you run out of money. In fact, longevity risk is the leading risk in retirement planning, as longevity is the great multiplier of risk: all risks are worse with longevity.
We all need to plan for longevity! Unfortunately, the alternative is not as much fun.
Longevity planning is not a product. Instead, longevity planning encompasses wellness, accessible housing, planning for cognitive decline, healthcare, and many other non-financial considerations. I like to focus on financial strategies, so that we will discuss the financial aspects of longevity planning.
What is longevity risk and retirement planning? Let’s start with a definition.
What is Longevity Risk in Retirement Planning?
Longevity planning is not about the product. It acknowledges that all other retirement risks increase when you live a long time! From a purely financial standpoint, the longer you live, the more assets are required to take on those risks.
Longevity planning begins with social security planning. Social security is the most straightforward first step to ensure adequate resources if you should live a long life. Nowhere else do you find a cost-of-living adjusted annuity with a government guarantee.
Social security optimization should be considered before any withdrawal strategy or insurance product. Delaying social security is the most cost-effective way to guarantee an ongoing, cost of living adjusted stream of income that lasts as long as you do.
Beyond social security, withdrawal rate must also be optimized for longevity. Here, you need to understand how withdrawal rate, sequence of return risk, asset allocation, and other products (such as life insurance and annuities) interact over decades of de-accumulation.
Next, Long-Term Care Insurance. We won’t even mention that.
However, the bread and butter of longevity planning are, in fact, annuities, which are insurance products. Don’t fear annuities when you retire! Just fear the complicated, expensive, advisor-sold annuities where you are not sure about the purpose of the money. We will discuss these annuities below.
So, in summary, what is longevity planning? Using longevity risk and retirement planning, longevity planning involves organizing your assets to have money for the rest of your life! Even if you should live a long life.
When Should You Consider Longevity Risk in Retirement Planning?
If you have a family history of longevity, now is an excellent time to consider what you would do if you lived to be 100. Actually, the younger you are now, the earlier you should start to plan for longevity. Who knows what medical advances we might see in the following decades?
Whenever you consider retirement, the time is right to consider longevity planning. Specifically, longevity planning is an essential aspect of every retirement plan.
In addition, it is wise to mitigate every retirement-specific risk you can, including longevity!
Longevity Risk Example
This is the most important consideration: why do you need retirement planning for longevity risk?
Let’s think about this with an example.
First, if you are liability matching (also called bucketing or time segmentation), it may be nice to plan to fund your retirement, say, before 85 and after 85. That is, you will assign your money different tasks: to fund your lifestyle before 85 and then after 85.
There are, of course, sources of income that will continue before and after this point, like social security, pensions, and annuities. But perhaps you have a bucket of money that will fund your needs before 85.
Then, when you turn 85, a DIA and a QLAC kick in that fund the rest of your life. How nice is it to know you have a pot of money to blow before you turn 85? And then income turns on when you are 85 to provide an additional life-long stream.
Conversely, you could plan on the retirement spending smile. Here, you know that spending decreases over time until it increases again (due to medical and frailty expenses) later in life. If you are worried about affording risks later in life, you could add on some retirement income that kicks on later in life or Long-Term Care Insurance to cover those expected expenses as they increase.
This is an example of longevity risk in retirement planning. We have considered the various assets and their timeframe and our income needs.
How to Mitigate Longevity Risk
Again, the risk of longevity is multiplied by all your other retirement risks. Let’s look at some ways to mitigate longevity risk.
Some products (longevity annuities) are explicitly aimed at the risk that you live a long life. However, I like to think of income annuities (SPIAs and the like), not as longevity annuities, as they are not focused on long-term (inflation-adjusted) income. Rather, longevity annuities provide money at a certain point in the future and plan to meet inflation-linked targets.
There are many ways to address longevity risk. First, let’s look at some products.
In 2016, Kitces predicted that longevity annuity would become a standard planning tool. While this is yet to happen, more and more academic research points out that annuities do better for most folks than bonds do. That is, you can use annuities as a bond replacement for a portion of the bonds in your asset allocation, and because of mortality credits, you have increased odds of success and may even leave more to your heirs. You need to invest in stocks and decrease your allocation to bonds due to the annuity.
Which annuities are longevity annuities?
Deferred income annuities are good annuities! They are simple (not complex), inexpensive (not fee laden), and easy to shop for. But unfortunately, all of this means that insurance salespeople don’t like to offer them because they don’t make much money off them.
With a DIA, you take a lump sum of money and give it to the insurance company in exchange for a future income stream. The longer you defer the payments, the more you get back in return.
Qualified Longevity Annuity Contracts are good annuities too! These are like DIAs in your 401k or IRA. However, they come with some extra whistles. Please read more about these products to understand them.
How to Manage Longevity Risk without Products
If you don’t want to manage longevity risk with products, you have to think outside of the box.
Make sure you have some wiggle room in your retirement plan! What is Wiggle Room, and how does it apply to Longevity Risk?
Wiggle Room to Mitigate Longevity Risk
I came across the idea of room for error when reading Morgan Housel’s book The Psychology of Money (affiliate link). While Morgan is an accumulation-focused guy, it struck me that room for error is even more important in retirement than it is during accumulation. After all, usually, you don’t get to un-do the retirement decision—you’d better make sure you get it right the first time!
If you have to get a decision correct the first time (like the risk of living too long), you’d best build in some latitude—some room for error or wiggle room in your retirement plan.
Let’s see how Morgan first introduced Room for Error:
Many bets fail not because they were wrong, but because they were mostly right in a situation that required things to be exactly right. Room for error—often called margin of safety—is one of the most underappreciated forces in finance. It comes in many forms: A frugal budget, flexible thinking and a loose timeline—anything that lets you live happily with a range of outcomes.
The Psychology of Money Morgan Housel (emphasis mine)
Anything That Lets You Live Happily with a Range of Outcomes
Let’s define wiggle room. Is it “anything that legs you live with a range of outcomes?”
While that definition is excellent for accumulation, it is less accurate in retirement!
Sure, having the ability to be flexible in your thinking can be important in retirement. But defining room for error as the ability to decrease spending is not ideal. Nor can you have such a loose timeline in retirement. Sure, you can gradually cut back on work, but at some point, you pull the plug on “work income” and start living off your nest egg.
Living in Retirement with “a range of outcomes” is not a safe bet. The risks in retirement are just different than those you face during accumulation. While you should not plan on being “exactly right” when facing known retirement risks, you need to address them.
When you plan for longevity risk when retirement planning, you need wiggle room.
Longevity Risk and Taxes
As taxes become a more significant problem with age (RMDs increase year after year, and there is the risk of the Widow Tax), longevity risk increasingly becomes tied to taxation. So, yes, there is legislative risk that taxes might go up in the future, and almost certainly they will, but how much do you think taxes will go up?
Don’t get me wrong: you need to plan for taxes, but that is the whole point of the Tax Planning Window!
As taxes are not infrequently a retiree’s most significant expense, you don’t build in wiggle room for taxes; you just assume the worst!
How bad can it get? First, let’s look at this graph of past effective tax rates.
Above, you can see the top federal marginal tax bracket in Blue. See how it changes over time?
But more importantly, look at the average effective tax rates for the top 1% (green) and all earners (yellow). Despite massive changes in the top marginal tax rate, the effective tax rate (how much you actually pay in taxes per year) is relatively stable. Make sure you understand the difference between marginal and effective tax rates.
If you are a top 1%er, just assume you will pay 30-40% effective taxes and move on. It would help if you planned for taxes when thinking about Longevity Risk.
Longevity Risk vs. Being Conservative.
Let’s get back to Morgan and his writing. His quote goes on:
It’s different from being conservative. Conservative is avoiding a certain level of risk. Margin of safety is raising the odds of success at a given level of risk by increasing your chances of survival. Its magic is that the higher your margin of safety the smaller your edge needs to be to have a favorable outcome.
The Psychology of Money Morgan Housel
Planning on your Longevity Plan not Going According to Plan
Morgan says you stay rich by being guided by “some combination of frugality and paranoia.” However, his book is not about financial knowledge; it is about behavior.
To get rich: “save like a pessimist and invest like an optimist.” He suggests you have enough pessimism to be optimistic about the future. Have room for error in the short run because you need to plan on your plan not going according to plan.
To stay rich, you need to have both short-term pessimism and long-term optimism. Unknown risk will be there in the long haul, but if you plan to be flexible through the short term, you live another day to fight. Remember, never interrupt compounding growth. You do that by having the ability to stay invested. Mitigating longevity risk and retirement planning mean having short-term pessimism and long-term optimism.
“Worship room for error. A gap between what could happen in the future and what you need to happen in the future to do well is what gives you endurance, and endurance is what makes compounding magic over time.”
How Do you Manage Longevity Risk?
“The wisdom in having room for error is acknowledging that uncertainty, randomness, and chance—’unknowns’—are an ever-present part of life. The only way to deal with them is by increasing the gap between what you think will happen and what can happen while still leaving you capable of fighting another day.”
So, how do you manage longevity risk in retirement planning? Morgan suggests that you need to be ok not knowing what the future will be like and stop listening to folks who claim they know for sure how things will turn out.
Next, avoid ruin. Not infrequently, this means being careful with leverage. Don’t get caught in an (even implausible) scenario where if it goes south, you will be ruined.
His solution to longevity risk in retirement planning: use lower future return expectations. He suggests 1/3rd lower.
I suggest you over save. Same difference, just a different time perspective!
Finally: “few financial plans that only prepared for the known risks have enough margin of safety to survive the real world.” Build in wiggle room in your longevity plan by having some room for error.
Summary- What is Longevity Risk in Retirement Planning?
Don’t forget that delaying social security is the cheapest longevity insurance. No other form should be considered until after you have optimized social security.
Most folks need to consider what will happen if they should live a long life. Longevity is the great risk multiplier. Think of every other retirement risk you have and double it because you live a few extra years.
It may be expensive to live a long life, but it is better than the alternative. Remember there are often better ways to use your money than to buy insurance, but few ways to sleep better at night.
Finally, remember to consider how to mitigate all of your retirement-specific risks!