Thursday, June 9, 2011

How Long Will Retirement Last?

Perhaps the biggest challenge in planning retirement is dealing with the uncertainty of how long we will live.  Economists and financial planners refer to this as longevity and the possibility that we will outlive our savings as longevity risk.

We could spend more every year of retirement if we knew we would only live to age 75 than we could spend if we knew we would live to age 95.  Of course, we don't know.  In fact, most of us literally have no earthly idea when we will die, so we need to choose a way to plan for that uncertainty.

It's a very important decision.  No one wants to find themselves bankrupt in old age after it's too late to reenter the workforce.
There are two basic ways to fund retirement: with annuities or with rationing.

Annuities are contracts an insurance company will sell you that promise to pay you a certain amount monthly or annually for the rest of your life, no matter how long you live.  Social Security benefits are an annuity, too, except they are "sold" by the U.S. government instead of an insurance company.

Here is an example from A 65-year old man living in North Carolina with his 65-year old wife could pay $100,000 today to an insurance company for a fixed annuity that would pay them in return about $538 a month for the rest of their lives, no matter how long that might be.

Annuities insure against longevity risk. They eliminate the risk of outliving your wealth. If all your retirement income came from annuities, your annual income would be the same no matter how long you lived. Of course, the people who buy these annuities and live to 95 will get much more for their $100,000 than people who buy the same annuity and only live to 70.  Those who live to 95 will get 360 monthly payments of $538 instead of just 60 payments.

A lot of people can't seem to get past that. They think, ". . . but what if I die before I get really old and the insurance company doesn't have to pay back that entire $100,000?" On the other hand, people who buy these annuities don't have to worry about outliving their savings.

The alternative to annuities is rationing. We can save money and instead of paying it to an insurance company for an annuity, we can invest it and ration it to ourselves.

Rationing, unlike annuitizing, is totally dependent on how long we believe we will live.  Imagine you were stuck on a desert island waiting for rescue and only had the food you brought with you. You would eat less each day if you expected to be marooned for a week than you would eat if you knew you might be stranded for a month.

Here's a point, though, that many of us miss when we think about retirement.  We have to ration for the longest time we believe we might be marooned on that island, not the average.

Suppose we knew that people marooned on islands are rescued  in one week on average, but some people have been stranded as long as a month.  We would want to ration our food to last 30 days, not 7.  If people rationed for the average duration, half of them would run out of food before being rescued.

Similarly, planning for retirement based on life expectancy— the average age people like us will attain— is too risky.  It leaves a 50% chance that we will outlive our savings.

Which leads us to the crux of the matter. We need to plan to live to a ripe old age, say 90 or 95, just like we would need to ration food on that island for the worst case, 30 days, because running out of money in old age and running out of food are both intolerable outcomes.

The Key Points
  • If we buy fixed annuities, we are guaranteed a paycheck for life.  The risk is that we might die not long after purchasing the annuity and not receive many payments from the insurance company.
  • If we don't purchase fixed annuities, we can invest our savings and ration them.  The problem with this approach is that we don't know how long we will live.  
  • To avoid the possibility of outliving our savings with the rationing approach, we have to plan on a very long life, 95 years for example, and that means spending a lot less each year than we could spend if we assumed we would only reach our life expectancy.
  • Annuities generally provide more annual income than the rationing approach, but the rationing approach improves the odds that we will leave an inheritance.
  • And most important of all, a retirement plan has to assume that we will live much longer than our actual life expectancy, because we just might.

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