What is longevity risk and how can you mitigate it?
What happens when your clients outlive their savings? Social trends point to longer life expectancies but also to depleting number of households in the US that have retirement savings. Faisal Khan, Senior Trading Analyst at TradeAlike, explores this current socioeconomic situation and social attitudes, and suggests several strategies to mitigate longevity risk.
Most of us are aware of the financial risks associated with investment portfolios, businesses, or retirement plans. Some of these risks are controllable while others are not – market risk is an example of the prior, while financial risk or credit risk falls in the latter category. Managing these risks is an important part of managing your business, investments or savings plan. One such risk which has emerged in a big way is longevity risk – which describes what would happen if you were to outlive your savings.
This is a real worry in today’s world as lifespans continue to get longer with drastic improvements in healthcare technology, lifestyle changes, and socioeconomic status. The graph below from World Bank shows that the global life expectancy has jumped almost 40% between 1960 (52 years) and 2010 (72 years). As evident, people are living longer today, so they need bigger investment portfolios to sustain themselves after retirement.
Despite the data, people still underestimate their life expectancy for two reasons. First, they compare themselves to older relatives and second, they quote life expectancy at birth statistic, both of which are misleading, and here’s why.
According to the US Library of National Medicine, only 25% of the variation in lifespan is based on ancestry, but it’s certainly not the only factor. Gender, lifestyle, and diet are some of the other factors that contribute towards your lifespan. For the second metric, people fail to realise that while their expected lifespan might be shorter at the time of their birth, it continues to increase during their lifetime. An OECD study found that as of 2016, the expected age of death in the US climbed from 72 to 86 for men and 82 to 89 for women during their lifetime.
Couple the longer lifespans and an inaccurate life expectancy prediction with the lack of retirement savings in US households (figure below) and we have a bigger problem at our hands. According to the data, 35% of US households don’t even have any retirement savings whatsoever. This is where longevity risk enters into the picture.
Combining all these factors, many people are facing a real problem of outliving their savings. To combat this situation, the simplest and most common solution that is emerging is that older individuals (over 65) work longer to make up for the difference. This is evident from the labour force participation rate for seniors that has been steadily trending upwards for in the past decade in the US (figure below). But this alone can’t combat longevity risk. And to top all of this, the problem is not restricted to seniors alone. According to Federal Reserve, 41% of US millennials (aged 18-29) have no retirement savings and prefer to keep cash.
How do you solve this problem? One solution lies in the right mix of asset allocation in the investors’ portfolio. The “100-age” rule provides a guideline on the kind of asset allocation mix one should have as their age progresses. Basically, your client’s age should match the proportion of stocks (high risk-high return) and bonds (low risk-low return) that they should have in their investment portfolio to manage risk exposure effectively. For example, a person aged 25 who has just started working and looking at a long career in front of themselves would opt for 25% of bonds and 75% of stocks, because they are not risk averse at this stage of life and are also looking for growth. On the other hand, a 65-year-old who is looking to retire soon would look at a 65% asset allocation to be in safe but low-risk investments because their aim at this age is the preservation of their retirement capital. With the rise in life expectancies and stretching time horizons, financial advisers are even suggesting a 110 or 120-age rule to their clients.
Simple rules of thumb as discussed above provide an easy understanding of the investment criterion, but they shouldn’t be treated as the only policy tool. Every person has a unique situation, risk profile, investment objective, lifestyle and net worth, which eventually dictate the overall make of their portfolio. Here are some of the things which can help reduce longevity risk.
- Historically speaking, equities have provided a much higher rate of return than other asset classes. The comparable returns between US treasury bills, bonds, and stocks have a huge difference as you can see in the chart above. But also, stocks provide added value with investment returns in the form of dividends for the reinvested capital.
- Small yearly withdrawals can reduce the risk of downside in equities. Let’s assume a retired 65-year-old has a retirement account $1M and last year, the market took a hit of 20% reducing his savings to $800K. If he withdraws 4% of his original portfolio ($40K), his net loss would only be $8,000 (4% of $800K). Over time, his withdrawal with the fluctuating market would average out his returns.
- Working beyond the retirement age can increase the potential of earnings and also reduce the effect of market downside on the retirement portfolio. In this case, seniors are better equipped to recoup any losses they incur in the short-term while maximising the returns from continued investment in equities.
- According to PwC, baby boomers are forecasted to transfer $30 trillion to younger generations over the next 30 years. Many well-off individuals want to leave the next of kin in a financially secure position. For this, their retirement portfolio withdrawals will only occur after their passing away. The longer investment time horizon ensures that the portfolio weathers the short-term market risks by maximising returns in the long run.
Holding equities is an effective way to battle the longevity risk since stocks deliver desired results in the long-term. Having said that, this requires a lot of psychological discipline – investors need to control their emotions in ups and downs of the market while eyeing the long-term perspective.
