Retirement Planning - Accounting for underlying Longevity Risk

Retirement Planning - Accounting for underlying Longevity Risk  Posted By - Mr. Lalatendu Raju- On-04/10/10

Retirement calculations are geared towards estimation and planning for the money one needs in the post retirement years. However, while estimating through static analysis the longevity risk may still remain unplanned. Here is an understanding on a more realisticestimation of life expectancies. In an era of economic uncertainty and volatility, coupled with lack of social security mechanisms, one requires to plan for securing a financial independence in retirement.   Longevity risk is one of the critical areas that an individual may be exposed to and that can affect him both as individual and as a member of society. Managing the retirement fund assuming that you will live a certain age based on average life expectancy is risky. It must be recognized that life expectancy is based on law of large numbers. In the case of personal life expectancy for any one individual, average life expectancy cannot be a precise evaluation. About fifty percent individuals live longer compared to average life expectancy. Wives outlive husbands in most cases. Further, there are other risks too, like inflation risks, market risk, interest rate risk that the retirees may be exposed to and which need to be addressed. In this paper we have limited the discussions only to longevity risk.   A new challenge for Financial Planning Professionals It's time for a new challenge for financial planning professionals. They need to provide a better advice by using dynamic methods of analysis, rather than static methods of analysis. Compared to static methods, dynamic methods of analysis provide more realistic picture for enabling a better decision making. Using static method of analysis, i.e. planning to live to a certain age may be risky or inadequate for most of the individuals. Application of dynamic methods of analysis also requires careful planning because unreasonable assumptions may give misleading results. We have applied the dynamic method in determining life expectancy for individual life and joint life using probability of death, on the basis of actuarial data.   Financial Planners thus need to consider all factors and account for longevity risks that individuals may face in their retirement years.   Understanding Life Expectancy Life expectancy at a particular age measures the average number of years that you can expect to live. This estimation is based on the mortality rates of the population in a given year. With the improved medical technology along with healthier lifestyles, life expectancy for Indians has increased significantly during the past half century and appears to be improving further. Therefore, one can expect to live longer. In the context of retirement care for life, it also means that an investment portfolio needs to last for 20 years or more if one plans to retire at the age of 60 years. When it comes to retirement care for life, there is a lot at stake. Longevity risk is one of the major concerns while planning for retirement. Based on IRDA 2004-2006 mortality table the average life expectancies formen and women are shown below (Table 1):   Average Life Expectancies Average Life Expectancies For Men For Women Current Age Expected Additional Years Expected Age at Death Current Age Expected Additional Years Expected Age at Death 40 37 77 40 39 79 45 32 77 45 34 79 50 27 77 50 29 79 55 23 78 55 25 80 60 18 78 60 20 80 65 14 79 65 16 81 70 10 80 70 12 82 * Data Source: IRDA   The above table (Table 1) just shows the average life expectancy. The average life expectancy means there is a 50-50 chance that one can live longer. But how much longer? Let's understand this from technical perspective.   Probability of Survival – A Technical Perspective Most Financial Planning professionals choose a certain life expectancy age (may be 80, 85 or 90) as an input while constructing afinancial plan across for clients in all age groups to plan for the payout period in the retirement. Further, planners fail to interpret these numbers. There is major gap that exists in understanding these risks and in the techniques dealing with it. Using probability of survival, let's interpret the life expectancy numbers used by most of the planners.   The table below (Table 2) which is based on mortality table defines separate mortality rates for males and females of different age group. Caution must be observed in interpreting these probabilities. For example, if the couple both aged 50, there's a 68% chance at least one of you will live to age 80.   Table 2: Probability of Survival Probability of Survival   Male Female One only To age 80 39% 47% 68% To age 85 20% 27% 41% To age 90 7% 11% 17% To age 95 1% 3% 5%     Male Female One only To age 80 40% 48% 69% To age 85 20% 28% 42% To age 90 7% 11% 18% To age 95 2% 3% 5%     Male Female One only To age 80 43% 50% 71% To age 85 22% 29% 44% To age 90 8% 12% 19% To age 95 2% 3% 5%     Male Female One only To age 80 46% 54% 75% To age 85 23% 31% 47% To age 90 8% 13% 20% To age 95 2% 4% 6% It is important to interpret longevity risk correctly. Suppose you are constructing a plan for a 60 years old man and use the life expectancy that described under average life expectancy (50 percentile life expectancy) to plan for pay out period for the investment portfolio. You'd see that your average life expectancy is 18 years i.e. age at death is 78 years. Suppose you then decide your withdrawal rate for retirement corpus so that it will be exhausted after 18 years. This would be a bad move, since there's 50-50 chance that he can live beyond 18 years. In fact there is 25 percent chance (one out of four) that he could live additional 6 years upto the age of 84 and a 5 percent chance (one out of twenty) that he could live additional 14 years upto the age of 92.   Let's look at another example. Suppose you are planning for a 60 years old woman. Her average life expectancy is 20 For example: If it is a 40 years old man, there's a 25% chance that he will live another 43 years   For example: If it is a 40 years old woman, there's a 25% chance that she will live another 45 years.   Years i.e. the age at death is 80 years. But there's a 25 percent chance that she can live additional 6 years upto the age of 86 and a 5 percent chance that she can live additional 14 years upto the age of 94.   If you are planning for a married couple it is advisable to use the joint life expectancy, i.e. life expectancy of last survivor. Suppose you are constructing a plan for a 60 years old man with 55 years old spouse. There is 50-50 chance that at least one of the partnerswill live for an additional 27 years. There is 25 percent chance that the money needs to last for the period of 32 years and at the same time there is 5 percent chance that the money needs to last for the period of 39 years.   Now that's longevity risk!   The tables below (Table 6, 7 & 8) plot the joint life expectancies for probabilities with "50th percentile","75th percentile" and "95th percentile". This will help you out while selecting your drawdown period for determining withdrawal rate in retirement. Table 5: Joint Life Expectancy for "50th percentile" (50% chance last survivor will live longer for remaining years) Current age of Female     Current Age Of Male Age 40 45 50 55 60 65 70 40 43 41 39 38 37 37 37 45 41 38 36 34 33 32 32 50 40 36 33 31 29 28 28 55 39 35 31 29 26 25 23 60 39 34 30 27 24 22 20 65 39 34 29 25 22 19 17 70 39 34 29 25 21 18 15 Table 6: Joint Life Expectancy for "75th percenti le" (25% chance last survivor will live longer for remaining years) Current age of Female     Current Age Of Male Age 40 45 50 55 60 65 70 40 48 46 44 44 43 43 43 45 46 43 41 39 39 38 38 50 46 41 38 36 34 34 34 55 45 41 37 33 31 30 29 60 45 40 36 32 29 26 25 65 45 40 36 31 27 24 22 70 45 40 35 31 26 22 19 Table 7: Joint Life expectancy for "95th percenti le" (5% chance last survivor will live longer for remaining years) Current age of Female     Current Age Of Male Age 40 45 50 55 60 65 70 40 55 52 51 51 51 51 51 45 53 50 47 46 46 46 46 50 53 49 45 42 42 41 41 55 53 48 44 40 38 37 36 60 53 48 43 39 35 33 32 65 53 48 43 38 34 30 28 70 53 48 43 38 34 29 26 Consequences of living longer than expected It is evident if individuals outlive five years longer than expected, in the absence of proper Financial Planning, the situation can be disastrous. Following are the likely strategies that one may have to adapt to in such a situation. Reduce expenses significantly Utilize the money otherwise earmarked for children and other family members Take assistance from children and other family members Use the value of your home to help fund your remaining retirement years (like reverse mortgage) In actual practice, many retirees are forced to adopt these practices well before they reach average life expectancy.   The bottom line While planning for pay out period for determining withdrawal rate of the investment portfolio in retirement, it would be wise to use 25 percent likelihoods and may be even 5 percent likelihoods. This will allow for a factor of safety in the financial plan to ensure that the money lasts for life. Apart from longevity risk, other risks also have to be accounted for securing financial well-being in retirement. Some common ones are: Inflation risks, Market risk, Interest rate risk, unforeseen needs of family members, and unexpected health care costs. Let's assist our clients in planning for a rewarding retirement.