Longevity Risk: An Old Problem

Longevity Risk:

When thinking about your retirement and the lives of those who financially depend on you, two of the biggest risks we have to manage are the risks of dying too young or living too long.

The risk of living too long, as awkward as that sounds, is the more difficult of these two risks to deal with. Furthermore, the risk of living too long is a rapidly growing problem because the U.S. population is steadily aging and life expectancy has increased dramatically. 

To underscore the degree to which we are living longer, consider this fact: white Americans have seen their life expectancy at birth increase over 60% from the years 1900 to 2000. You can see how this requires all of us today to have substantially more assets to support our future retirement than were needed in years prior. In the remainder of this discussion, we will call the risk of living too long “Longevity Risk.”

You may have noticed we used the word “white” in the paragraph above. To more fully appreciate the complexity of Longevity Risk, and the need for insightful financial planning around this issue, consider for a moment the fact that life span materially varies based on whether you are a man or woman, your race, your health and your level of wealth.

For example, there is a 12-year life expectancy difference when comparing the life expectancy for a white American woman vs. a black American man born in 2000 – nearly 18% difference! Likewise, black American women have a 10% longer life expectancy than black men – a huge difference (6.5% difference between white American men and women, in favor of women).[1]

As you can see, Longevity Risk does not affect everyone equally. In practice, what does this mean? In short, it means “one size fits nobody” and personalized financial planning is key. In the context of managing longevity risk, it means that among other things, we need to take gender and race into account, instead of treating everyone the same.

Treating everyone the same would mean some clients will be saving too little for retirement and others will unnecessarily be forgoing important purchases and experiences – not acceptable!

Another factor that can impact Longevity Risk is wealth. Wealthy people are not healthier but they have access to more resources that can be used to extend one’s lifespan. In addition, some have such high levels of wealth that there is no chance of their outliving their wealth. 

Likewise, at the opposite end of the spectrum, there are those who have insufficient assets to meet their retirement needs and depend on social security and other such subsidized forms of retirement assistance; their investment portfolios no matter how invested will not materially impact their retirement nor will their lifespan.

Longevity Risk affects everyone in between the two extremes outlined above: retirees with enough money to make choices but not so much money that longevity risk does not apply. As a result, Longevity Risk is an issue that affects a lot of people.

Traditional financial planning starts by quantifying future cash flows needs and then determining how best to source the needed cash flow using the investment and retirement assets of the client. Naturally, cash flow needs depend on how long you live. Therefore, to produce a financial plan both advisor and client typically agree on a lifespan which serves as one of the most important assumptions underpinning the analysis. Often, the U.S. Census derived lifespan average statistics are used as the basis for the lifespan estimate.

However, we need to acknowledge that the lifespan estimate can be wrong – and that many of us will live longer than the “average” lifespan, hence the importance of managing Longevity Risk. According to the Associated Press[2], America's population of centenarians (a person who lives to or beyond the age of 100 years) has roughly doubled in the past 20 years to around 72,000 and is projected to at least double again by 2020. So much for averages!

So how does one manage Longevity Risk?

Essentially, there are three basic strategies depending on what matters most to you.

The first path is for those who want extreme reduction of uncertainty, even if it means substantially downsizing lifestyle so that they can live on a fixed but relatively guaranteed level of income. A recognized solution for this path is “immediate annuities.” The second path is at the opposite end of the spectrum: self-insuring Longevity Risk. The third path is a hybrid path, whereby a specific portion of Longevity Risk is annuitized and the majority of the portfolio assets are invested in a more conventional manner that preserves some of the upside.

The following overview of immediate annuities will help us understand the First Path:

Immediate annuities are long-term, tax-deferred contracts that provide immediate regular payments in exchange for an upfront lump-sum investment.

In essence, you irrevocably hand an insurer, bank, or mutual fund company a chunk of money upfront known as the premium and then the company invests the cash in bonds and securities and immediately starts paying you a set monthly stipend based on your life expectancy and interest rates at the time of purchase. Depending on the annuity you choose, the payments you receive can last for life or a specified period of time.

If you think about it, immediate annuities are the mirror opposite of a life insurance policy. 

Instead of paying the insurance company annual premiums and then receiving a lump sum payment upon your death, in the case of annuities you pay the insurance company a lump sum payment upfront and they then pay you a set annual amount as long as you are alive.

Using immediate annuities in retirement portfolios, retirees can trade the possibility of larger accumulated wealth levels for a greater degree of certainty that their portfolios can generate income throughout their entire lifetime.

Another major benefit of immediate annuities is the fact that as an individual, you are benefitting from the pooling of Longevity Risk across the entire insurance portfolio, which means that you can much more cost effectively insure against Longevity Risk.

However, immediate annuities have some drawbacks including: low absolute payouts given the near-zero-interest-rate environment right now, fees and credit risk since as the old adage goes, nothing is 100% guaranteed in life except death and taxes.[3]

Another downside to a standard immediate annuity is the fact that the payments are fixed, which leaves you exposed to the damage inflation can inflict on your buying power. Some firms offer ‘Inflation Protected Annuities’ whose payments increase over time based on CPI but not all firms offer this feature and some of them cap the increased payout, thereby reducing the effectiveness of this kind of feature.

As you might expect, there is a cost for the ‘inflation protection’ feature and the imbedded cost makes this feature less attractive than appears at first glance. The break-even point for this kind of feature can be as long as 15 years, but the exact break-even depends on the terms of the annuity and the options you select. The insight here is that this inflation protection feature pays off only when there are periods of significant inflation or when retirees have sufficient resources to compensate for modest rates of inflation over longer periods of time (not immaterial) until the break-even point is reached; after which one starts to actually benefit.

The biggest problem with immediate annuities is the simple fact that you pay dearly for certainty (especially in a low interest rate environment) and doing so may leave you with a payment stream that is too low or a lifestyle that feels unattractive since there is no upside and no possibility of funding future aspirational purchases or experiences.

The second way to address Longevity Risk is to self-insure. In this scenario, one might hold an investment portfolio comprised of equities and fixed income securities starting with a substantial allocation to equities and shifting over time to fixed income securities as one ages. This strategy is the mirror opposite of the first strategy in that it provides no certainty with regards to Longevity Risk but it does retain the potential for upside in retirement spending.

The third strategy one can take to address Longevity Risk is a hybrid that combines the strengths of path one and path two, where the retiree allocates the majority of their assets to traditional investment strategies, in effect self-insuring the period of their theoretical lifespan and purchasing insurance to protect them thereafter (Longevity Risk). For good reason, this third path has been gaining traction. More insurance companies now offer deferred annuity contracts, demand for them is increasing, deferred annuity contracts continue to evolve with the addition of new features and the academic community has also embraced the usefulness of deferred annuity contracts with at least three academic papers having been published in the Financial Analysts Journal on this subject since 2012.[4]

A brief discussion of insurance pricing will help us understand the third path. For this purpose, consider a fictional retiree: Mr. Smith who is 65 and whose estimated life span is 20 years.[5] 

If Mr. Smith wanted to self-insure the ability to spend $1 in 20 years, one smart way to do that would be to buy a zero-coupon bond. Assuming interest rates are 2.5% at all maturities as a simplifying assumption, then that would cost Mr. Smith $0.61 [1/(1.025^20)].

Now, by contrast, consider the first path – using annuities. A multi-year annuity is merely the sum of each single-year annuity in the time period which is specified in the contract. Pricing a one-year annuity yields important insights into the pricing of annuities and insurance generally.

What would a one-year annuity that pays $1 in 20 years cost the retiree?[6] Remembering that the $1 payment is paid only if the retiree is still alive so therefore, using a 52% survival probability the cost is $0.61 x 52% -- almost a 50% reduction in cost! As you can see, the reduction in cost is directly impacted by the low survival probability (52%) in this example.

There are two insights here: first, insurance is particularly useful when the risk is big and the probability of payout is small and second, the value of purchasing the insurance to a retiree is maximized when the probability of an insurance payout is small. “Value” in this context means the ability of the retiree to free up cash today that they can spend or invest in other ways while still receiving the protection of being insured. This can be directly measured using the Spending Improvement Ratio, which measures the dollars freed up to spend as a result of using insurance and is defined as: (1 – P) / P – where “P” is the probability of an insurance payout. 

Therefore, applying the logic of the Spending Improvement Ratio to the retiree we can generalize that the relative value of the insurance benefit of insuring the next one year of cash flow is not nearly as valuable as insuring cash flow decades into the future. Retirees who purchase annuities at 65 will almost always live to collect the payment at 66, so the insurance benefit is limited. By contrast, as the example above illustrates, the value for insuring a payment 20 years in the future is material – and even more so past one’s life expectancy. Said differently, the further out one insures the cash flow, the retiree maximizes spending improvement per premium dollar invested in the annuity.

Therefore, insuring Longevity Risk is best accomplished using what is known as a “Longevity Annuity” or sometimes called a “Deferred Annuity”. These are annuities that start at some point in the future that is defined by the buyer. The further one pushes out the date when cash flow starts being received, the more compelling the ratio of benefits to premium paid and the lower the premium due to increased mortality rates the further out. 

It is also worth mentioning, from a planning perspective, that healthier than average clients benefit more from Deferred Annuities and unhealthier than average clients less so. As uncomfortable as it makes some planners to directly incorporate health status, it cannot be ignored when looking at life contingent options like annuities and life insurance.

In short, using Longevity Annuities maximizes spending for retirees and reduces risk.

This then begs the question of which years of cash flow one should annuitize.   

Because client preference, between the trade-off of certainty vs. growth is subjective, there is not a formulaic answer that fits all clients. 

For the clients pursuing the first path, where the goal is to maximize certainty, not spending, another option beyond using an immediate annuity might be to use a bond ladder of TIPS for the first 20 years of retirement (consuming approximately 88% of available capital) and a longevity annuity purchased with the remaining 12% of capital.[7]

This TIPS / Longevity Annuity combination would address inflation risk for the great proportion of one’s statistically probable lifespan, it would allow the retiree to keep control of their assets (instead of irrevocably handing them over to an insurance company), which in turn creates the option of re-allocating the bonds to a more traditional portfolio (should one tire of certainty and want to take risk to grow the investment portfolio to accommodate retirement aspirations). As a practical matter, one can also reduce counterparty risk by spreading the longevity annuity exposure across several different providers.

Another study found that allocating 10-15% of wealth to a longevity annuity creates spending benefits comparable to an allocation to an immediate annuity of 60% or more,[8] thereby reaching a similar suggested overall allocation of assets to a Longevity Annuity.

In absence of a client preference or need that drives the overall allocation, one methodological starting point for a plan might be to use self-insurance strategies for the full period of one’s probable lifespan and then insure against Longevity Risk using Longevity Annuities. One benefit of this approach is the consistency of allocation that can be achieved, while still, if not explicitly, taking gender, race and health into account.

In conclusion, Longevity Risk is a big and growing issue. The good news is that individually tailored and insightful financial planning can help mitigate this risk. However, in order to spark a continued sense of urgency, and to encourage you to speak with your advisor about this issue sooner than later, consider the one fact about Longevity Risk that we have intentionally withheld from you until now: the longer you live, the more Longevity Risk you face! 

What – my expected lifespan changes? Yes. Why is that?

The lifespan statistics quoted in the beginning of this paper were all based “at birth” (when age = zero) but the insurance analysts responsible for helping insurance companies quantify their Longevity Risk have long known that life expectancy is “age contingent” and gets longer as you age. For example, a white American woman at birth is expected to live to 80, but if she lives to 65 she is expected to live another 19 years to the age of 84 (a 5% increase from her expectancy at birth) and if she lives to 85, she is then expected to live another 7 years to the age of 92, a 15% increase over the initial expectancy! The fact that Longevity Risk is age contingent should cause you to pick up the phone and call your financial planner.

Even for those of us in the business, it is too difficult to construct a value-added financial plan on the back of a napkin. A quality planning process should include stress testing, such as Monte Carlo simulation and scenario analysis – both of which cannot be done with mere pencil and napkin. Furthermore, everyone’s fact set is unique to them and needs to be taken into consideration as much as possible to narrow the choices and help clients navigate their retirement with the fewest financial surprises possible.

Gone are the days when wealth advisors could purely focus on “financial matters” – today, a good wealth advisor cannot ignore the impact that gender, race, and health play in identifying the appropriate lifespan to use for the client’s financial plan and efficient ways to manage Longevity Risk. Relatedly and perhaps a topic deserving of its own discussion, withdrawal rate strategy is also particularly important to managing retirement cash flow. Withdrawal rate strategy is crucial when utilizing the self-insurance and hybrid strategies for managing Longevity Risk. Market returns are not homogenous, losses can and will occur and payout rates must adjust accordingly or else Longevity Risk could materially worsen. A static withdrawal rate strategy cannot ignore inflation, asset returns, changes in expected longevity et cetera, which helps explain the value behind a Dynamic Spending Strategy.[9]

Living longer is a blessing. With insightful planning you can enhance your ability to enjoy your retirement years, knowing that you have made informed choices that strike the right balance for you between certainty and your future spending power.

DISCLOSURE:

The information in this paper is intended for educational and discussion purposes only. National Wealth Partners, LLC does NOT directly offer insurance products to our clients. We do, however, have principals of our firm who are licensed insurance agents. Clients should be aware that the insurance may pay a commission or other compensation and involve a conflict of interest, as commissionable products conflict with the fiduciary duties of a registered investment adviser. National Wealth Partners, LLC always acts in the best interest of the client, including the sale of commissionable products to advisory clients. Clients are in no way required to utilize the services of any representative of National Wealth Partners, LLC in connection with such individual's insurance activities outside of National Wealth Partners, LLC.

[1] Data source: data found on Elderweb.com which in turn attributes the data to these sources: National Vital Statistics Reports, Vol. 50, No.6. Life Expectancy at Birth, by Race and Sex, Selected Years 1929-98.; National Vital Statistics Reports, Vol. 49, No.12.Deaths, Preliminary Data for 2000.;U.S. Census Bureau. P23-190 Current Population Reports: Special Studies. 65+ in the United States.

[2] Source: article titled, “Number of 100-year-olds is booming in U.S.” by Matt Sedensky of The Associated Press published April 27, 2011.

[3] In the case of annuities, one is depending on the solvency and viability of the insurance company company in order to receive ones promised payments – and while the insurance industry takes precautions to ensure its financial health, it cannot be entirely guaranteed, as is illustrated by historical instances of insurance companies going bust.

[4] “Making Retirement Income Last a Lifetime” Volume 68, Number 1 (2012); “The Longevity Annuity: An Annuity for Everyone?” Volume 71, Number 1 (2015) and “Most People Need Longevity Insurance rather than an Immediate Annuity” Volume 71, Number 2 (2016); all three available on www.cfapubs.org.

[5] Data from “The Longevity Annuity: An Annuity for Everyone?” FAJ, Volume 71, Number 1 (2015).

[6] This example ignores fees, insurance reserves and other frictions for the sake of simplicity, which is not an unreasonable assumption given that most investors incur frictions of their own, namely investment management fees and financial planning fees; therefore, this example remains reasonable in comparison.

[7] “Making Retirement Income Last a Lifetime” Financial Analysts Journal Vol. 68, No. 1 (2012).

[8] “The Longevity Annuity: An Annuity for Everyone?” Financial Analysts Journal Vol. 71, No. 1 (2015).

[9] Such as defined in the 2016 issue of Journal of Investment Consulting “Wealth Management | An Overview of Retirement Income Strategies.”