Wednesday, December 6, 2017

Life Expectancy vs. Lifetime Planning Period

We provide recommended assumptions that you can use to calculate what we call your “Actuarial Budget Benchmark (ABB).”  Your ABB is a “market value” calculation of your current spending budget using assumptions approximately consistent with current insurance company pricing of life annuities and provides you with a relatively low-investment risk “data-point” to be used in your financial planning and budget setting process.  You don’t have to use these recommended assumptions to develop your spending budget, but we encourage you to do the calculations with the recommended assumptions annually to compare your spending budget (however you develop it) with the ABB.

In this post, we will focus on one of the assumptions you need to make to calculate your spending budget:  your lifetime planning period (LPP).   LPP is a nice way of saying how many more years of life you plan to fund with your assets.   Notice that we did not say that this is the number of years of life you expect to live.   We purposely want to make a distinction between your life expectancy and your LPP.

For ABB calculation purposes, we recommend that you use the LPP (or LPPs for couples) based on the 25% chance of survival for a non-smoking male or female (as appropriate) with “excellent health” from the “Planning Horizon” section of the Actuaries Longevity Illustrator.  So, for a 65-year old male in excellent health, this would be an LPP of 29 years, implying an age of death, for planning purposes, of 94.   By comparison, the 75% probability of survival is 15 years (age at death of 80) and the 50% probability of survival is 23 years (age at death 88).   While this male’s life expectancy (the 50% survival probability) is 23 years, there is still a relatively large range of when death is more likely to occur than not (ages 80 to 94). 

If you are not fully insuring your retirement through the use of annuity contracts, it is just prudent to plan for a longer-than-average lifetime.  We view this as part of the extra cost associated with self-insuring one’s retirement.  The insurance companies, of course, argue that the risk-pooling associated with their lifetime income products avoids this extra cost (i.e., where individuals who die early can subsidize those who live longer). They sometimes refer to this risk-pooling survival benefit as a “mortality credit.”

In addition to being more prudent to use the 25% probability of survival LPP rather than the 50% probability (life expectancy), using this LPP avoids future actuarial losses and declining spending budgets as you age if all other assumptions are realized (until about your late 80s).  This potential decline in spending budget is illustrated in the graph below originally from our post of December 3, 2014.

click to enlarge

Using Other LPP Assumptions to Develop Your Spending Budget

As discussed above, you should feel free to develop your spending budget using assumptions you believe are more appropriate than the ones we recommend to determine your ABB.  Not everyone is in “excellent” health.  Your current health or family history may cause you to believe that your LPP is shorter than the LPP we recommend for ABB purposes.   You should be aware, however, that most individuals tend to underestimate their life expectancy.  So, feel free to use the “average” or “poor” general health choices from the Actuaries Longevity Illustrator if you believe these choices would be more appropriate for your personal situation.  However, for the reasons noted above, we recommend that you still use the resulting 25% probability of survival LPP for budget setting purposes.

Assumptions for Evaluating Alternative Investment or Spending Strategies

You can use the Basic Actuarial Equation and our workbooks to give you additional “data points” in your evaluations of alternative investment or spending strategies by running possible scenarios and seeing which ones produce a larger current spending budget.   When evaluating immediate or deferred annuity purchases, lump sum or annuity options from defined benefit plans or Social Security deferral strategies, we recommend that you also use the 25% probability of survival LPPs rather than your life expectancy for your calculations.   Since these types of strategies generally favor the long-lived, we find that your ABB (which uses an LPP based on “excellent health”) will generally increase if you should decide to use some of your accumulated savings to purchase an annuity or defer commencement of your Social Security, but if your budget calculation is based on an LPP for someone in “poor” health, this may not be the case.

In addition, we recommend that you use a low-investment-risk discount rate for purposes of making these types of comparisons.  See our post of July 23, 2017 entitled “What is an Appropriate Discount Rate for Personal Financial Planning” for discussion of why we believe it is important to properly consider expected risks when comparing alternative strategies.   In general, investment in risky assets will carry higher risks than investment in annuities.   And while stochastic modeling can provide a measure of this risk (in the form of a probability of success), the comparisons are highly dependent on the reasonableness of the assumptions selected for modeling investment returns and variances.  Therefore, we recommend that if stochastic modeling is used to make such comparisons, they be supplemented by comparisons, based on the basic principles of financial economics, using a low-investment-risk discount rate.