This post is a follow-up to our post of September 14, 2021 entitled; “How Long Should You Plan to Live?” In that post, we advocated using our “default” assumption of the 25% probability of survival from the Actuaries Longevity Illustrator for non-smokers in excellent health when planning for your retirement. In this post, we look at the planning implications of using shorter or longer Lifetime Planning Periods (LPPs) than our default assumptions in your retirement planning. Based on our brief analysis, we believe that, for most reasonable LPP assumptions, it still makes sense for you to use the Safety-First InvestmentStrategy to build a robust Floor Portfolio comprised primarily of non-risky investments like Social Security, pensions and life annuities to fund your future expected Essential Expenses. Using this strategy and these types of investments will better enable you to match your non-risky investments with your essential expenses over your remaining lifetime, however long that period may turn out to be.
In the sections that follow, we will discuss:
- Factors that are generally known to affect your estimated longevity and planning problems presented by the wide range of expected lifetimes, and
- Using the Safety-First Investment Strategy to “immunize” your retirement plan against longevity risk
We will also illustrate how longevity risk is immunized for a hypothetical individual named John.
Factors Generally Affecting Longevity and Planning Problems Presented by the Wide Range of Possible Remaining Lifetime Periods
As noted in the fourth FAQ of the Actuaries Longevity Illustrator (ALI), What about other factors thataffect longevity?
In addition to those considered in the ALI, longevity depends on many factors. These include: availability and access to health care, current medical conditions, exposure to environmental toxins, family history, geography, income, lifestyle and occupation. While these all affect longevity, many of them are reflected in your health status. The four factors chosen for the ALI (age, gender, smoking and health) have been shown to account for a significant amount of the individual variations in longevity. While these four pieces of information have been shown to produce reasonable approximations of an individual’s longevity*, you or your spouse/partner’s actual lifetime can differ significantly from these estimates, either above or below.
The table below shows remaining lifetime (in years) for a 65-year-old male for various smoker/health statuses and probabilities of survival from the ALI. Similar probabilities for an age 65-year-old female are generally two years longer than years shown in the male chart. The chart shows a wide range of possible remaining lifetime periods. This wide range of possible lifetimes can make it difficult to financially plan for retirement. If the LPP is underestimated, spending may have to be reduced late in life, but if the LPP is overestimated, too much unspent assets may remain at death. And while “longevity risk” generally refers to living longer than expected, in personal financial planning it can also apply to living shorter than expected.
Remaining Lifetime for a 65-year-old Male (in years) Based on Smoker/Health Status*
Smoker/Health Status | 75% Probability of Survival | 50% Probability of Survival (life expectancy) | 25% Probability | 10% Probability |
Non-Smoker/Excellent | 16 | 23 | 29 | 33 |
Non-Smoker/Average | 13 | 20 | 26 | 31 |
Non-Smoker/Poor | 10 | 17 | 23 | 28 |
Smoker/Poor | 4 | 9 | 14 | 19 |
*From Actuaries Longevity Illustrator
The chart shows that approximately half of non-smoking age 65-year-old males in excellent health (the top row results) are expected to die either before age 81 (65 + 16 years) or after age 94 (age 65 + 29 years), while the other half of this group can expect to die within the 13-year period from 81 to 94. Even wider age at death variations can be achieved by varying the smoker/health status.
Some argue that income and education levels are perhaps not fully captured in current health status and may also be significant drivers of longevity. For example, the recent article “From Longevity Leader to Longevity Laggard” argues
What makes all of this even more worrisome is that morbidity and mortality in America are increasingly skewed by income and educational attainment. Life expectancy is still rising for those Americans who are more affluent and better educated, while it is falling for those who are not.
It is also important to note that while mortality tables can show us probabilities of living a certain number of years in the future, “pieces” of us based on mortality table probabilities of death do not actually die each year. In any given future year, we will either be 100% alive or we will be 100% dead. What we do learn from looking at probabilities, however, is that there is considerable uncertainty involved in selecting how long we can expect to live in retirement, and this can make retirement planning challenging.
Side note. We have not seen data that compares expected longevity of those individuals who are vaccinated for Covid-19 vs. those who are not, and while the impact of the pandemic on mortality will hopefully be transitory, we encourage our readers to get the shot, stop smoking and take other actions to improve their general health if they want to increase their odds of making it to the 25% or 10% probabilities illustrated above.
Using the Safety-First Investment Strategy to “Immunize” Your Essential Spending Against Longevity Risk
What if you are convinced that your family history, income level or some other factor significantly increases or decreases your Lifetime Planning Period as compared with the default 25% probability of survival for a non-smoker in excellent health default assumption used in our Actuarial Budget Calculator (ABC) workbooks? The good news is our workbooks permit you to “override” the default LPP assumption(s) and use your best estimate (or test the impact of using alternative LPP assumptions). The even better news is that if you are using the Safety-First Investment Strategy and building a Floor Portfolio by matching lifetime income assets with lifetime essential expenses, your Floor Portfolio funded status (the ratio of the present value of your Floor Portfolio assets to the present value of your future expected Essential Expenses) is not expected to vary significantly under different LPP assumptions. Thus, employing the Safety-First strategy can immunize the funding of your Essential Expenses for longevity risk.
Note that the same immunization effect will not be true with respect to spending on discretionary expenses from your Upside Portfolio. If you underestimate your remaining lifetime or you over-estimate investment returns on your risky assets, you may have to reduce your future discretionary spending. As we have mentioned many times, however, you can presumably be more aggressive with your planning assumptions when it comes to determining how much you can afford to spend from your Upside Portfolio as, theoretically, you are more comfortable reducing discretionary expenses funded by this portfolio if it becomes necessary to do so.
Also, while the Safety-First Investment Strategy may immunize essential spending against longevity (and possibly investment) risk, it does not immunize essential spending against other possible risks, such as greater than assumed inflation.
We will use the following example to illustrate how building a Floor Portfolio of non-risky investments can “immunize” your retirement plan from significant differences between expected and actual longevity.
Example
John is a 65-year-old single male who is considering retirement. His age 65 Social Security benefit is $18,000 per annum and he is eligible to receive an immediate pension benefit of $10,000 per annum. He has $400,000 of accumulated savings. John expects to use his home equity to pay for his long-term care, if needed, so he excludes this amount from both his assets and liabilities.
John determines that his essential non-health expenses (including taxes) will be $25,000 per annum, which he assumes will increase with inflation. He also estimates his essential health related expenses at $7,000 per annum increasing at inflation + 1% per annum. He estimates his recurring discretionary expenses at $5,000 per year with no future increases. He also enters other expected and unexpected non-recurring expenses and classifies these expenses as either essential or discretionary.
The following screen shot shows John’s Actuarial Balance Sheet based on default assumptions and the data he enters. He also determines that 50% of his accumulated savings ($200,000) will be invested in non-risky assets and the rest will be invested in equities.
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| (click to enlarge) |
John sees that, with $200,000 of his accumulated savings invested in low-risk investments, the present value of his Floor Portfolio assets is expected to fund about 96% of the present value of his future expected essential expenses based on the default assumptions and the data he inputs into the workbook. He is pleased with this funding percentage.
At this point, he would like to see how his Actuarial Balance Sheet is affected if instead of planning to live 29 years, he lives somewhat longer (34 years) or somewhat shorter (23 years or 18 years). He uses the override feature of the workbook in the Input & Results tab to input different LPPs. He is surprised to see that while the PV of his floor assets decreases with decreased shorter LPPs, the present value of his future expected Essential Expenses also decreases and the ratio between the two items remains relatively constant. He determines that the funded percentage would remain even more constant with changes in LPP if his pension were indexed with inflation and he did not assume that his medical expenses would increase by inflation plus 1% each year. John’s expected Floor Portfolio funded status under various LPP assumptions is summarized in the chart below. Based on the results of this longevity stress test, John concludes that he doesn’t have to worry about living too long (at least with respect to his essential spending).
Funded Status of John’s Floor Portfolio Under Various LPP Assumptions*
LPP in years / % of Life Expectancy of 23 years | PV Floor Portfolio Assets | PV Future Expected Essential Expenses | Funded Status |
18/78% | $640,259 | $591,262 | 108% / $48,997 |
23/100% | $742,020 | $729,113 | 102% / $12,907 |
29/126% (Default) | $854,516 | $888,092 | 96% / $(33,575) |
34/148% | $941,051 | $1,015,477 | 93% / $(74,426) |
*From Actuarial Budget Calculator for Single Retiree, based on male age 65, inputted data, default assumptions (other than LPP) and immediate commencement of age 65 Social Security benefit
John then decides to see how deferring commencement of his Social Security benefit to age 70 will affect the present value of his Floor Portfolio assets. Instead of entering $18,000 and immediate commencement, he enters $28,433 [($18,000/.8667) x 1.24 and increased by five years of 2% per year inflation increases]. The results are shown in the chart below.
PV Floor Portfolio Assets—Defer Social Security commencement to age 70 vs. immediate commencement at age 65*
LPP in years / % of Life | PV Floor Portfolio Assets (Defer Social Security until age 70) | PV Floor Portfolio Assets (Immediate Commencement at 65) | %/ Difference |
18/78% | $642,578 | $640,259 | 100% / $2,319 |
23/100% | $776,234 | $742,020 | 105% / $34,214 |
29/126% (Default) | $925,006 | $854,516 | 108% / $70,490 |
34/148% | $1,040,190 | $941,051 | 111% / $99,139 |
*From Actuarial Budget Calculator for Single Retiree, based on male age 65, inputted data and Default assumptions (other than LPP)
John sees from this chart that the value of deferring commencement of his Social Security benefit does depend on how long he plans to live. Based on his family history and other relevant factors, John decides to be conservative and use the default assumptions to determine the value of deferring his Social Security benefit. As a result, he decides to defer commencement of his Social Security benefit because the longer he lives, the more will be the financial benefit of deferring.
Conclusion
The length of your expected lifetime is an important component of your financial planning in retirement. If you use a Safety-First Investment Strategy, however, you can immunize the funding of your Floor Portfolio against longevity risk in addition to immunizing it against investment risk. The same is not true, however, with respect to determining spending from your Upside Portfolio or with respect to certain decisions like whether or not to defer commencement of your Social Security benefit, so you will potentially need to be more careful when selecting an LPP for those purposes.
