longevity risk and retirement planning

Longevity Risk and Retirement Planning – Strategies for Longevity

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 and product allocation 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, you must consider your specific risks when thinking about longevity planning. For instance, the risk of long-term care increases with age and is a significant concern for many. Long-Term Care planning is an important consideration and may or may not include Long-Term Care insurance.

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.

 

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.

 

Longevity Annuities

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?

 

DIAs

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.

 

QLACs

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.

 

Long Term Care Insurance

The great unknown, of course, is the expense of Long Term Care. While Long Term Care Insurance is available, it leaves much to be desired. So even if you have oversaved for retirement, you still need an LTCI plan.

Because Long Term Care Insurance is such an important topic, I’m going to cover it in detail now.

 

Long Term Care Insurance

If you build wealth and self-pay for Long-Term Care insurance, you have the best of both worlds. There are, after all, two possibilities: either you do, or you don’t use the insurance. And, it is not as simple as the statistics would have you believe. You see, the number “70% of people” will need care at some point. Yes, as we get older, many of us will need care. But how many need and qualify for reimbursable care? The answer is much lower, perhaps 9% of those with a policy.

longevity long term care risk

Look above at your total out-of-pocket expenses for long-term care services—almost 63% pay zero. You see, healthcare, for the most part, is a mitigated longevity risk because of insurance.

Next, note that just 8.6% (round up to 9%) pay more than $250k out of pocket over their lifetime.

So, finding an alternative to traditional or hybrid Long-Term care is the right answer 91% of the time.

How Much do you Need to Self-Pay For Long-Term Care 

So, how much do you need to self-pay for Long-Term Care expenses?

Morningstar recently put the self-insure number above $2.5M. The title of this piece, however, is “There is no magic number for self-funding long term care insurance.” Instead, they suggest you:

  1. Gage the likelihood of needing long term care
  2. Ballpark the cost of care (with this document)
  3. Customize based upon your situation and preferences
  4. Think through the backup plan
  5. See if you can afford it
  6. Segregate assets set aside for long term care from other assets

For those who don’t want to self-insure and are considering Long-Term Care Insurance, should you consider traditional insurance or a hybrid product? To answer that question, let’s review what is available and think a little about the pitfalls of both.

Pitfalls of Traditional Long-Term Care Insurance

Let’s start with the pitfalls of traditional Long-Term Care policies. These policies underwrite morbidity risk. They are less common now than in years prior because of premium increase horror stories. Traditional policies may be expensive given chronically low-interest rates, longer life spans, and increasing medical costs. Premiums are subject to increase over time.

Premiums paid to traditional Long-Term Care Insurance are tax-deductible for individual taxpayers. There is, of course, a 10% floor in 2019 that must be met to itemize these as deductions. The 10% floor is difficult to get above given the large current standard deduction. The amount of the premium that is deductible depends on your age. That is, someone in their 70’s can deduct $5270 a year, whereas someone in their 40’s can only deduct $420.

Some States have tax deductions as well. Partnership Plans are important to consider if you think you may eventually qualify for Medicaid.

A business owner can often deduct the full amount, but this is a complex topic and depends on type of business entity. See Kitces for general reference on business deductions.

What about the tax treatment of reimbursements? As with health insurance, you can exclude payments for personal injury or illness from LTCI. There is a limit of about $370 a day in qualified expenses. Payments above this are fully taxable unless actually used for long-term care.

Paying Premiums from a Health Savings Account

Usually, only medical expenses (rather than insurance expenses) qualify for reimbursement from health savings accounts (HSAs). LTCI premium payments, however, are, in fact, HSA eligible.  The same age-based limits above apply. Any amount above the limits requires after-tax payment. Obviously, if you use the HSA to fund premium payments, you can’t turn around and deduct the payments as this would be double-dipping.

Pitfalls of Hybrid Long-Term Care Insurance Policies

Let’s move on to Hybrid LTC/Life Insurance policies.

More salespeople are pushing hybrid policies, where you get permanent life insurance with a long-term care or chronic illness rider. The riders vary in their cost. Another example is an accelerated death benefit rider. Many allow access to the cash value or death benefit if needed for LTC expenses. For example, you could get 2% of the death benefit a month in advance to pay for long-term care. Or you can get, for example, 25% of your death benefit a year for qualifying costs.

For (often) a lump-sum premium payment, your heirs may get a death benefit. In addition, these policies have a small amount of cash value and a defined dollar amount of LTC benefits. Obviously, you can use only one of these three benefits. So, if you use the LTC rider or access the cash value, the death benefit either shrinks or goes away entirely.

Hybrid Long-Term Care Policies are Not READY for Prime Time

Hybrid policies are relatively expensive and, in reality, don’t do anything well. The death benefit is small and may decrease with age. The cash value is low for the cost. As for paying long-term care costs, traditional LTCI policies are more effective and pay more.

An advantage: premium is paid up in advance, so not subject to increases.

Folks like these policies, however, because if they don’t “use” the LTC benefit (say they die in their sleep), they still get something for their money (the death benefit). All is not “lost.” Or, they can use the cash value instead, if needed.

This is a similar argument for Variable or Equity Indexed Annuities rather than single premium immediate annuities (SPIAs). With the expensive fancy annuities, you still get “something” if you die early. Of course, there are massive downsides to these annuities compared to straightforward, traditional annuities like SPIAs. Hybrid policies are like an expensive swiss army knife when all you may need is a good old-fashioned steak knife for your dinner.

Tax Implications of a Hybrid Policy- The Largest Pitfall

Hybrid policies have significant tax shortcomings. They are not tax-efficient; this is a downside most folks don’t think about. The salesmen won’t necessarily say anything about the inefficiencies: “consult with your tax advisor” is what you are likely to hear.   

Premiums are never deductible.

As for reimbursement of expenses, hybrid policies payout basis (the after-tax money you paid for the policy) first, leaving the fully taxable excess behind.

Neither of these are good features. No deduction going in, and your after-tax money coming out first.

So, in general, traditional LTC policies are more effective and tax-efficient than hybrid policies.

But we haven’t yet even discussed the most problematic feature of hybrid policies.

Should You Use your Hybrid Policy or an IRA to Pay for Long-Term Care?

Think about this for a second: if you have an IRA and a hybrid policy, which would you rather use for long-term care expenses? You would rather use your IRA. Really? But you bought the hybrid policy just in case you needed long-term care…

So, you have long-term care insurance, but you shouldn’t use it?

Exactly. See the numbers in detail below.

If your goal is to leave money to your heirs, use the Always Taxable money in the IRA to fund health care costs. Then, if healthcare-related spending is above the 10% AGI floor—as is common in years where you have massive LTC bills—you might get a tax deduction. When you spend from the hybrid policy, there is no possibility of a tax deduction.

In addition, spending down your IRA on health care means less fully taxable income for your heirs. Thus, you save the tax-free death benefit in the hybrid life insurance policy. Your heirs would rather receive a tax-free death benefit from the hybrid policy than pre-tax income from the IRA.

So, hybrid policies are less effective, not tax-efficient, and even if you have one (and an IRA), you shouldn’t use it.

When might a hybrid policy be a good idea?

Using 1035 Exchanges – The Advantage of Hybrid Policies

In general, if you have old annuities or permanent life insurance, consider a 1035 exchange if you decide you want LTCI.

The advantage here: take tax-deferred growth in these products and use them for another purpose without paying the taxes.

This is especially true for an annuity that is otherwise fully taxable as a death benefit. Or, if you have tax-deferred growth in a life insurance policy, use this money tax-free to pay qualified LTCI claims after a 1035 exchange to an appropriate hybrid policy.

Again, Kitces has a great review on the topic.

Yes, 1035 exchanges are complicated. They can make sense if you have an old annuity or life insurance policy not otherwise of use. Especially consider a 1035 exchange if there is a lot of tax-deferred growth and you have a high probability of needing long-term care.

The long and the short: leverage an old product into something you might have a better use for. If you do, in fact, have the need.

Annuities with Long-Term Care Riders?

Yup. There are “hybrid annuities” as well.

Usually, these are Fixed or Equity Indexed Annuities with income riders used for LTC expenses. Often, with fees and expenses, returns are zero or negative.  However, they build up 2-3x the initial investment (in a fictional separate account) for LTC expenses.  Of course, your premium is utilized initially, and the fictional money only tapped if there are still LTC needs after your money is gone.

In reality, only consider an LTC annuity if you are in poor health. Annuities with income riders require minimal underwriting to purchase. If you die before you use the rider, your heirs get the annuity value. Of course, the death benefits of annuities are fully taxable. If you die while taking income, heirs usually get the initial premium minus any paid income.

 

Should you Use the IRA or Hybrid Insurance?

Hybrid long-term care insurance is a less effective way to pay for long-term care costs than an IRA.

Even though you pay more in taxes with the IRA, you pay taxes in the face of usually massive healthcare-related deductions, which offset most of the taxes!

Use the ten and even 12% brackets to take money out of the IRA and save the tax-free death benefit of the life insurance for heirs. They are usually at the peak of their earnings and will pay much more than 12% taxes on your tax-deferred money!

Alternatives to Long-Term Care Insurance

In retirement income planning, the decision about long-term care insurance is tough. Single folks and those without legacy or charitable goals are less likely to want it.

If you don’t have much, consider a partnership plan or plan to spend down for Medicaid.

If you have “enough” to self-fund or self-insure, likely more than $2.5M, the decision is more based on your individual health and personal risk preferences.

In the un-sweet spot in the middle, the choice is most difficult.

If you have an annuity or permanent life insurance policy you don’t need, a 1035 exchange to a hybrid policy is something to think about. But if you can afford one, a traditional LTC policy is better.

Most of the time, Long-Term Care Insurance is a waste of money.

Celebrate when you waste money on term life or auto insurance and don’t use it. If you have long-term care insurance and don’t use it, great!

Sometimes, especially with insurance, wasting money is good.

Next, let’s look at how to mitigate longevity risk without insurance products.

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!

You might have some Tax Diversification built-in, and you should have a 20-30-year tax projection in your mind when you retire. Consider Roth Optimization Early in your career!

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.

longevity risk and retirement planning

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

So, when considering longevity risk and retirement planning, mitigating longevity risk does not mean avoiding a certain level of risk. Instead, it would be best to increase the odds of success at a given level of risk. How can you increase your odds of success over longevity risk? By thinking probabilistically in a deterministic world.

 

Probabilistic Thinking in a Deterministic World

We are actually quite good at this in medicine.

We understand that not everyone we treat will have benefits. For example, though it is only a 20% chance that your breast cancer is metastatic, you will get chemotherapy. By definition, 80% of folks will have no benefit from this treatment (and only side effects), but if you are one of the 20% that might have metastatic disease, you just may have your life saved.

A priori, it is “known” if you will have metastatic disease in the future (maybe only be the cancer cells themselves). Still, currently we human doctors only have a probability estimate. Nevertheless, there is a chance you might be affected, so you get treated as if you are.

So, too, with living a long life and longevity risk. It is “known” now what will happen in the future (see my bit on Chaos Theory and Investing), but you cannot know it personally. That is, you are going to live to a certain age, but you just don’t know right now what that age is. So you have to plan for the known risks and the known unknown risks, but you cannot plan for the unknown unknown risks.

You just have to assume there are unknown unknown risks and plan for them by building in wiggle room to your longevity plan. Plan for your plan to fail!

It will probably happen. If it doesn’t, you overplanned, but you will be just fine either way.

 

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.

Ok.

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.

Next, consider all of your assets and figure out your withdrawal strategy in retirement and how to create income in retirement.

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.

Finally, remember to consider how to mitigate all of your retirement-specific risks!

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One Comment

  1. I must be missing something, because it seems to me that if you die right after you buy a Life-only SPIA you will leave less behind than if you didn’t buy the SPIA. I agree that if you invest more aggressively (because you have the SPIA), then you could eventually leave more to your beneficiaries because of the higher expected growth rate (you showed this in a previous blog post), but it takes awhile to grow back the money that is put into the SPIA. I think the charts in your previous blog showed that.

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