A key to any plan is knowing how long the plan is needed. For retirement, the plan is often based on life expectancy, which has been steadily increasing over the past 100 years. While the concept of life expectancy appears simple enough, some common misunderstandings can create problems for financial advisers and their clients.
Today’s retirees are now typically living into their late 80s; 10 years longer than they did in the 1990s. In 2020, the most common age of death in Australia was 89. When compulsory super started in 1992, it was only 78.
Until very recently, the age of 85 was a convenient estimation of a typical lifespan. Many financial models just assumed that everyone lived to 85. Not only was this factually wrong, but it was based on only a 50% probability of being correct. How many retirees would be happy to learn that their retirement plan only had a 50% chance of success?
The Australian Bureau of Statistics (ABS) estimates that the life expectancy of an Australian male is 81.2 years and 85.3 years for a female. While correct, these figures are estimates of life expectancies from birth, so they include the deaths of people who die young from accidents or illness. For that reason, they are misleading to use for retiree life expectancy. Having reached 65 or 66, you have a higher life expectancy because you are already a survivor.
The life expectancy of a 66-year-old female today, for example, is currently another 24 years to age 90. In practice, this means that around two-thirds of females of that age will live to somewhere between 81 and 99.
Based on the improvements in the mortality trend over the past 25 years tabulated by the Australian Government Actuary, half of today’s 66-year-olds will live to at least 88 for males and at least 90 for females. Surviving longer also increases a person’s life expectancy. A male alive at age 90 can, on average, expect to live to 94 while a female can expect to live to 95.
UNDERSTANDING LONGEVITY UNCERTAINTY
Most investors are aware that equity markets can be volatile. This volatility is clear even in rolling 10-year annual average real returns as shown in Chart 1.
Why is this relevant to life expectancies you might ask? While most of us are well aware of the risk posed by market uncertainty, many are not aware that a client’s longevity is just as uncertain. And while markets can recover, there is not an equivalent ‘rescue’ for a longer than expected life.
Using a measure based on completed actual lives (with no mortality improvement), the potential variability of lifespan for a new retiree is about the same as long-term equity returns. The average age at death in 2020, for those over 66, was 83.6. The standard deviation of this was 8.6 years, meaning that roughly two-thirds of people died between 75.0 and 92.2. The uncertainty surrounding longevity is as large a risk as the equity market.
WHO NEEDS PROTECTING FROM LONGEVITY?
Not all retirees will need a specific plan to manage longevity risk and not all income needs to be protected. Retirees with little wealth will have access to the Age Pension and the very wealthy will have enough money to never fear running out. Those in between are more likely to seek financial advice, and these are the retirees who need help to manage their longevity risks.
It can be expensive to protect everything, so a targeted approach which manages the risks to retiree clients and ensures their needs will be met for life can provide the peace of mind they look for.
Retirees’ spending tends to change over retirement with total levels of spending usually declining as they age, therefore longevity risk protection might only be needed for the spending in the later stages of retirement.
As with any risk, there is a cost to managing longevity risk and retirees effectively have three ways to manage longevity risk.
Firstly, self-insurance is a strategy to try and protect a retiree against running out of money in case they live too long. The approach is to spend less, creating a buffer, so that their accumulated savings can last longer. This increases the probability that income will be available at later ages, but it means a diminished lifestyle for the retiree.
This approach also needs to consider market risk. If investment returns fall below expectations, then retirees will run out of money earlier. At the other end of the spectrum is a fully insured retirement through a solution that provides guaranteed income, such as a lifetime annuity. For example, using a Challenger enhanced liquid lifetime annuity a 66-year-old male would be able to get $46,507 a year indexed to inflation from a $1,000,000 investment (as at 8 November, 2021). This payment would be fully guaranteed and would be higher than many of the buffers that are needed in the self-insurance strategy.
A recent alternative to insuring longevity has been the idea of pooling the risk, which pools the exposure across a group of retirees. This can take various forms, depending on the underlying investments and payment structure, but they usually have a common element.
Using the law of large numbers allows an accurate gauge of mortality and a large enough pool enables idiosyncratic longevity risk to be diversified away. By pooling, retirees can achieve an average result and agree to pass their capital on to the survivors to fund their longer lives.
However, just as an annuity provider must inject further capital when the pool lives longer than expected, surviving participants in the pool would have to ‘contribute’ to the shortfall by reducing their income entitlements. This has happened in the Netherlands where both the indexation of pensions, and then pension payments themselves, were cut to maintain the sustainability of their (pooled) pensions .
An income layering approach to retirement income portfolio construction, as shown in Chart 2, seeks to provide cashflow to meet retiree goals. This approach ensures that a retiree is at least able to meet a certain level of spending needs, including required lifestyle expenditures, for as long as they live.
The first layer is provided by the Age Pension (to the extent that a retiree meets the criteria) and pays for basic necessities. A second layer of lifetime income can be used to fill the gap between potential Age Pension payments and the level of spending required to meet their personal retirement needs. The rest of their retirement savings are then available for investing or added spending.
Layered retirement cashflows can be constructed using a range of different retirement products. A lifetime income stream, such as a lifetime annuity, can be used to provide the ’required lifestyle’ layer of cashflows, with the remaining funds invested in growth assets to provide for more spending or a bequest. Non-guaranteed options can also be used in the second layer, but the retiree will have the risk that their needs won’t always be met.
A LONGEVITY CHECKLIST FOR ADVISERS
- Use up-to-date life tables – currently 2015-17
- at aga.gov.au;
- Use an appropriate mortality improvement table – 25-year improvements (explained in 2015-17 life tables) which are the ‘most optimistic’ and hence safest to use;
- Never use a ‘from birth’ life expectancy. They are not relevant to retirees;
- What confidence interval are your plans based on? Build in a margin of error such as a longer plan horizon – don’t let 50% of your clients down because, on average, that’s how many will live longer;
- Use a range when talking to clients about how long they might live;
- Consider gender differences and plan for them;
- Beware the ‘joint lives’ issue – the age of the second death is potentially longer than each single life expectancy;
- Research shows that pre-retirees materially underestimate their own life expectancies. Communicate the real numbers effectively;
- Identify those clients who don’t need a longevity risk plan:
- a. the ultra-wealthy who can’t stop growing their capital; and
- b. modest clients whose needs would be met on the Age Pension alone.Work with your client to figure out their essential spending requirements.
- This is what needs protecting from longevity risks; and
- Consider a guaranteed solution for clients who want peace of mind.
Aaron Minney is head of retirement income research at Challenger.