One phenomenon I find most fascinating about retirement income planning is the sizable gap between how the average Joe thinks about retirement income planning and the views of the experts. While this gap includes different approaches to investing, what I will speak to in this article is the investor's view on and response to longevity risk, compared to the view of an actuary.
Layperson's View of Longevity Risk through Annuitization Attitudes
As a financial advisor, I have witnessed investor's attitudes toward longevity risk first hand when suggesting immediate annuities or longevity insurance in a retirement income plan. Common responses that I often encounter include:
- I want to leave something for my kids; with an immediate annuity, the insurance company keeps my money, so forget it.
- Immediate annuities are a bet against the insurance company; they are betting that I will die before I recoup my premium, and I am betting that I will live beyond this "break even" point and get the better of the insurance company. So, no thanks - I don't feel like making a bet because you never beat the house.
- I like the idea of an annuity, but they are just too expensive.
The Actuarial View of Longevity Risk
While there is some element of truth in these comments, the actuary in me still cringes when I hear them. You see, when actuaries think about longevity risk they view retirees as a group of individuals (or a "pool of risk"). Actuaries gather historical mortality data on these groups, and use this data to create mortality tables that are, in turn, used to estimate the probability of survivorship over different time periods - a critical input when calculating the cost of an annuity. If the pool is sufficiently large, these mortality tables can be remarkably accurate (you may recall this from the "Law of Large Numbers" from statistics); that is, actuaries can pretty accurately predict the number of people that will survive from one year to the next. You see, unlike investment returns, past experience is indicative of future experience when it comes to human mortality. But, here's the kicker: you just don't know exactly who will die when.
To illustrate, let's assume that the group of retirees consists of 65 year old individuals of identical health. While these individuals may share a common life expectancy (let's say 30 years), actuaries observe that each will most certainly have different periods of actual survivorship. Some will survive less than a year while others will survive 50+ years, and there is no way to know with certainty how long a given person will live. Actuaries know that roughly 50% of the group will not make it to their current life expectancy, and 50% will live beyond their current life expectancy, so there is a 50/50 chance that a given person will survive beyond his or her life expectancy. This is longevity risk from the eyes of an actuary.
Revisiting the Annuity
With this actuarial view of longevity risk, let's revisit the annuity solution and its antithesis - systematic withdrawals to life expectancy. If none within the group of retirees purchased an annuity, and instead drew down their savings to their life expectancy (30 years), an actuary will observe that:
- Approximately 50% will not reach their life expectancy, and leave some amount of money to his/her heirs.
- Approximately 50% will, tragically, live beyond their life expectancy and run out of money.
So, by forgoing an annuity, each person (knowingly or unknowingly) is assuming a risk (or "making a bet") regarding his or her own survivorship period, with potentially dire consequences.
Can this risk be mitigated through some kind of pooling mechanism?
The answer to this question is an emphatic "yes." The way that such a pooling mechanism works is to capture the estate that would have been left by those that did not reach their life expectancy, and use these funds to provide an income benefit to those that live beyond their life expectancy. Is this fair? Actuarially, yes - remember, everyone in the pool has the same life expectancy and is bearing the same risk; with hindsight, it may appear that some will have benefited while others will lose, but what has really happened (as seen through the eyes of the actuary) is that everyone has been protected and their longevity risk mitigated. To make this point clearer, let's look at fire insurance on your home: everyone pays the same premiums - is it "fair" that some will "benefit" from their fire insurance policy because of a fire while others paid an insurance premium without receiving a "benefit?" Of course it is; it is a fair and equitable exchange that reduces risk.
And this pooling mechanism is what is called an immediate annuity.
Revisiting the Layperson's Views
Now, let's go back to the common reactions that a layperson has to an immediate annuity, and provide a response that they would likely receive from an actuary:
"I want to leave something for my kids; with an immediate annuity, the insurance company keeps my money, so forget it."
- Actuary's Response: Not buying an immediate annuity does not assure that you will be able to leave an estate to your heirs. In fact, what you are really doing is imposing a 50/50 "bet" on your kids, with one side of the bet being that they get an estate (if you do not live to life expectancy) and the other side of the bet being that they will have to provide you with financial support (if you live beyond life expectancy and run out of money). Do you really want to do this? And, if you want to transfer wealth to your children, why not gift a portion of your income to them instead?
"Immediate annuities are a bet that I am making against the insurance company; they are betting that I will die before I recoup my premium, and I am betting that I will live beyond this "break even" point and get the better of the insurance company. So, no thanks - I don't feel like making a bet because you never beat the house."
- Actuary's Response: First, the insurance company does not "win" if you do not survive beyond your life expectancy. The bulk of any excess of premium received over benefits paid is used to provide income to other annuitants that live beyond their life expectancy. Second, the insurance company is eliminating the risk of you outliving your assets, so what you perceive as a "bet" is really an offsetting hedge against a risk that you are not fully recognizing. You are really making a bet by not buying an annuity.
"I like the idea of an immediate annuity, but they are just too expensive."
- Actuary's Response: The price of an annuity reflects several factors, including the amount of periodic benefits, the probability of survivorship, the investment returns that the insurance company believes it can recognize on your premium, and operating costs. Immediate annuities are relatively expensive because (1) people are generally living a long time and (2) interest rates are low, so insurance companies cannot get as much investment return on your premium. However, whether you choose to purchase an annuity or not, the price of an annuity reflects the actuarial cost of your retirement, so if you are concerned that an annuity is too expensive, be careful that you are not planning on spending more than you should. In fact, buying an annuity is actually cheaper than self-insuring; if you self-insure, you will need to curtail your spending to earmark funds to provide income in the event that you live beyond your life expectancy. Under an immediate annuity, you are protected against this risk through longevity pooling, so you will have a higher level of income. This is why payout rates from immediate annuities are typically well in excess of the 4% recommended payout rate under a conventional systematic withdrawal strategy.
Is the actuary right? Well, in a perfect world, we would have a crystal ball and know exactly how long our money would need to last, which would eliminate longevity risk (on second thought, I'm not so sure if we would really want to go there). But the actuary is right in that, if no one purchased an annuity, many, many people will run out of money or live off of a much lower income benefit under a responsible withdrawal program than what they could have received from an immediate annuity. Certainly, from a societal perspective such an outcome is not good (which is why many countries require individuals to annuitize a portion of their retirement savings).
What the actuary does not know is whether you will be among the victims.