Longevity risk, simply put, is the risk that you will outlive your retirement savings. Longevity risk is a worry for many people. After all, none of us wants to think of reaching 75, 85, 95 or more and facing $0 in either our bank accounts or our investments.
At Financial Freedom Fee-Only Wealth Management, we believe it’s never too early to begin retirement planning. Based on your unique situation, we can provide practical advice to help make your financial dreams a reality. We hope this article will help you to understand what is meant by ‘longevity risk’.
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Financial advisors use several different methods for assessing likely longevity. Some like to plan for a scenario in which their clients live to 95, or even to 100 or more. Why? Because planning for the high side manages the risk most effectively.
Even if you think you’ll live to 85, and your own estimates are based on the history of your parents and grandparents (one of the best methods of assessing your likely longevity), planning for a scenario in which you’ll live longer than that lessens the risk that you’ll outlive your own estimates.
Plus, advances in medicine and living conditions have resulted in steadily increasing life expectancy for the overall U.S. population. In 1933, the average man had a life expectancy of nearly 62 years and the average woman a life expectancy of roughly 65 years. In 2016, the average man’s life expectancy had risen to nearly 76, and the average woman’s to nearly 81.
Making a Plan I: Estimate Your Retirement Expense Budget…
It can be daunting to think of your life expectancy. But it can also be a relief to have a firm plan for managing longevity risk. The best plan is to manage your retirement savings to cover you comfortably throughout a long retirement – 30 years or more.
You also need to factor in your estimated expenses in retirement, your estimated income in retirement, the estimated length of your retirement (ie, when you plan to retire), your goals in retirement, market risk and asset allocation and likely inflation scenarios.
One method of estimating retirement expenses is to extrapolate from your current expenses and forecast forward by factoring in your plans and likely scenarios. Many observers believe that retirees generally need about 80 percent of their pre-retirement income once they retire. With the above said, some retirees want to spend 100 percent or more of their pre-retirement income given how hard they worked for so many years. It’s important to consider your own situation to determine what the best retirement income estimate might look like for you.
Your current expense budget likely includes common categories such as housing expenses, healthcare, food, transportation, travel, utilities and so forth. Make a preliminary expense retirement budget by picking relevant categories and revising them in light of what you expect from retirement.
Are you likely to have your mortgage paid off, for example, or to still be making payments? Do you expect to still live in the same home, or might you downsize? Healthcare costs have been rising steadily over the past several decades, so it’s prudent to estimate an increase. If you don’t expect to be working, you may pay less in commute costs. What are your goals? Do you want to travel? Launch a business? Gift to family or charity?
Unless you’re relatively close to retirement, this expense budget will require progressive revision as time goes on. The important point is that it gives you an estimate to work with – and factors to think about.
Then, estimate how much you’ll need for retirement income. One method of forecasting this is to estimate your Social Security retirement benefits and subtract them from the amount you project you’ll need in expenditures. The remainder is what you need in retirement income.
If your expenses indicate you’ll need an income of $60,000 annually in retirement, for instance, and you expect to receive $24,000 annually in Social Security benefits once retired, you subtract the benefits from the estimated amount you’ll need to arrive at what you’ll need to withdraw from your retirement nest egg. In this example, $60,000 – $24,000 = $36,000, so you’ll need a retirement nest egg that can yield you $36,000 per year to achieve a $60,000 yearly income.
One of the best features of working with plans is that you will be able to adjust them as needed. If you estimate you’ll need to save more, retire at a different time or work longer, you can accommodate all these elements as circumstances change.
Making a Plan II: Estimate Your Retirement Nest Egg Needs and Withdrawals
Once you know the figure you’ll need each year from your retirement nest egg, you can make a plan for retirement savings.
A helpful method is to multiply your estimated annual nest egg withdrawals by 25 to give you the amount you’ll need as a retirement nest egg. In the example above, $36,000 x 25 = $900,000, so $900,000 is the figure to save for.
Then, you’ll need to plan for one of the most crucial elements to protect you against longevity risk: how much can you withdraw from your retirement nest egg without running out in retirement?
Many financial advisors use the 4 percent rule as a guide to withdrawals in retirement. The 4 percent rule simply states that, if retirees withdraw 4 percent annually from a portfolio divided roughly equally between bonds and equities, their retirement savings will likely last 30 years. If, as illustrated in our ongoing example, you have a $900,000 portfolio at retirement, withdrawing 4 percent each year will provide $36,000 for 30 years.
The 4 percent rule, however, may need to be modified to plan for longevity risk. If you retire at 66 and expect to live to no longer than 30 years (the age of 96), the 4 percent rule will likely cover you. But if you want your retirement savings to last longer than that, the 4 percent rule needs to be modified. You may need to withdraw less, save more or a combination of the two.
Similarly, a number of factors can change the 4 percent rule for you. If your portfolio allocation is different than the roughly 50 percent in bonds and equities, the 4 percent rule may need to be modified. If you want to leave a considerable amount of money to your heirs, a business or a charity, your withdrawals will need to be modified to include that goal.
Given the complexities and importance of retirement planning, at Financial Freedom, we look at financial plans individually rather than relying on a one-size-fits-all 4 percent rule. We conduct models using Monte Carlo simulation to help create and assess your retirement plans. Our approach to financial planning is comprehensive and creates a roadmap to help you realize your financial goals.
In short, longevity risk can be planned for comfortably. But there’s no substitute for working with a financial advisor to do so. A financial advisor can advise you on retirement planning, goals, savings strategies and more. Contact Financial Freedom Fee-Only Wealth Management for a complimentary conversation to see if our services might be a fit for your needs.