Longevity Risk – What it is, and how to Manage It

Longevity risk is one of the risks you face when saving for retirement. Simply put, it is the risk that your retirement savings will not last for your entire lifetime. A few other ways to refer to longevity risk include:

  • You’ll outlive your savings
  • You’ll run out of money before you run out of life
  • Your account balance will go to zero before your blood pressure does

What’s the Risk?

Longevity risk is a real problem for retirees. The risk has increased due to… well, longevity. It seems that doctors want to save our lives and replace our parts as medical technology improves. What’s more, we’re more active in retirement than previous generations might have been. We’re really living while we’re still alive. Your parents or grandparents might have spent a few years of retirement in a rocking chair on the front porch, but today’s retirees are more active. It costs money to get out and do the things you enjoy (hopefully for many years).

longevityYou may wonder if longevity risk is really an issue. Of course genetics and lifestyle play a role, but the fact is that life expectancies keep growing. If you’re 65 years old today, how likely is it that you’ll live to age 80? There’s a 71% chance if you’re a female and a 60% chance if you’re a male. Due to the wacky nature of statistics, there’s an 88% chance that at least one member of a married couple will reach age 80 (whether it’s you or your spouse). There’s a 45% chance that one of you will make it to age 90.

What if you’re nowhere near age 65? These numbers will only get larger. Medical technology will continue to improve, and the odds of reaching milestones of 90 or 100 years will increase. So take care of yourself – eat well and get plenty of exercise.

Financial Implications

You may or may not be happy to hear that you’ll live longer than previous generations. You’ll probably be in better physical condition, which is a good thing, but it’ll also cost a lot of money. If you plan for a retirement like your parents’ or grandparents’, you’re taking on a lot of longevity risk. The safest bet is to prepare for a long life, but though there are no guarantees that you’ll get one and it’s harder to save the additional money.

There are several ways to think about longevity risk. Some people ignore it and figure that they won’t live very long. Some assume that they’ll be “out of it” by age 80 or 90, and they won’t care if they run out of money and move to a lower standard of living. Others assume that somebody will provide for them (a family member or government program), which may or may not prove to be true. Finally, some people decide to plan for a long retirement, even though they may be overdoing it.

Longevity risk is hard to deal with, because you’ll put everything in motion well ahead of time, when you don’t know what is really going to happen. If you ignore the risk during your working years, you’ll have to deal with the consequences during retirement. There’s very little you can do to change things (by earning a significant income to beef up your savings, for example) if you happen to reach age 80 or 90 and you don’t appreciate your prospects for a comfortable standard of living.

Managing Longevity Risk

So, what can you do to manage longevity risk? The most important thing you can do is plan. Figure out how much you’ll need in retirement and calculate how much you’ll need to have saved to provide your desired income. Assume that you’ll live a long time. Some financial planning calculators assume that you’ll live to age 92 or 93, and that should get you in the ballpark. If you want to be more conservative, bump it up a few years.

Almost any retirement calculator can help you as long as the calculator focuses on retirement income. This one does a pretty good job. Use the information from the calculator to help you make choices. If you need to save more money, work a few extra years, or adjust your expectations, do it now before it’s too late. You can usually get better results if you combine those strategies (it’s easier to improve your situation if you both work one or two extra years and reduce your retirement budget slightly, as opposed to just trying slash your retirement budget).

You can also use certain products to control longevity risk. But before considering any product, remember that there is no free lunch. If you get something (a benefit), you’ll have to give something (pay a fee).

Annuities are products that are commonly used to deal with longevity risk. Somehow or other, an insurance company promises to pay you for the rest of your life. The amount you get depends on a lot of factors, which are beyond the scope of this article. The point is that you have a promise of lifetime income, so it doesn’t matter if you spend all of the money in your retirement accounts. As long as your insurance company is still in business and can honor their promise, you’ll keep getting payments no matter how long you live.

Is it better to use an insurance product or to manage things yourself? It really depends on you, and there’s no right or wrong answer. You can either transfer longevity risk to an insurance company, or you can keep it for yourself. There is no way of knowing which option is best until after you’ve passed away.

If you decide not to use an annuity, planning is especially important. Be sure to triple-check your math and adjust everything for inflation. In years when your retirement investments don’t earn much, you may have to live on less, but you might be able to give yourself a little bonus in especially good years.

Finally, your investment choices can help you manage longevity risk. If you’re a conservative investor, your money might not grow as fast as more aggressive investments. Remember that you might be retired for 25 years or more if you retire at age 65 and live to age 80. You’ll have to decide if it makes sense to put some of your money (not necessarily a large portion) in investments that have more growth potential (like stocks or stock mutual funds). Of course, you should only consider this if you’re willing and able to take some risks with that money, and if you can really leave it alone for a long time.