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Value, CFA, dividend growth investing, research analyst
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I spend a lot of time helping people understand how much money they will need to meet their retirement goals. Many people rack their brains and do a lot of research trying to come up with assumptions for inflation, rates of return on investments, and many other items that go into a retirement plan. But too many of these same people only spend a few minutes thinking about their life expectancy. This is unfortunate because a person's life expectancy can be the biggest factor changing the outcome of a plan.

Today I want to look at how changes in life expectancy can impact whether or not a retirement plan is successful. I will then analyze how owning a basket of solid dividend-paying stocks can help retirees build in a buffer in terms of how long they will live.

Like any retirement calculations, this one involves many assumptions. But as long as our assumptions are reasonable, say 6% for equity returns rather than the 10% figure that many people used to use, we can come up with a workable, conservative plan.

Let's start with the assumptions I used for the couple we will look at:

Inflation (NYSEARCA:CPI)

3.00%

Current Age of Both People

55

Age Of Retirement

65

Age When Both People Have Passed Away

80

Social Security at age 67 (combined)

$35,000 per year

Average Savings Rate

$10,000 per year

Total Investment Balance Today

$500,000 (50% in Taxable, 50% in IRAs)

Recurring Annual Expenses in Retirement

$50,000

Investment Mix Before Retirement

70% U.S. Value Stock Index Fund,
30% Medium Term Treasuries

Return Assumption Value Stocks

6% per year

Standard Deviation Value Stocks

16.20%

Return Assumption Treasuries

2.0% per year

Standard Deviation Treasuries

7.20%

Before generating a retirement plan for this couple the first thing we need to clear up is, what constitutes success? We live in a dynamic world, especially when it comes to investing. So I like to look at the probability of never running out of money in retirement using Monte Carlo analysis, where thousands of scenarios are run, shocking investment returns in every scenario in every year. In this example I will define success as having a probability of at least 80% that funds never run out in retirement.

Using Monte Carlo analysis in our retirement planner I calculated that the probability they never run out of money is 98%. This easily meets our definition of success. However, we have used a typical life expectancy of 80 years. One problem with using life expectancy numbers is the fact that these numbers take into account all people, young and old. So today the typical person has a life expectancy at birth of 78 years. But this is a very misleading number. The average baby boomer actually can expect to live to age 83. Why the difference? Because the average baby boomer has survived over 60 years already! In statistics we call this survivorship bias, and it's a very important bias indeed. To further show this bias, a person who survives to age 75 today sees his or her life expectancy rise to age 87.

There is also the issue of the probability of surviving to a ripe old age. Today a 65-year old man has a one in four chance of living to age 92. Married couples that are 65 have a one in four chance of at least one spouse surviving to age 97. A 25% chance is way too large to ignore.

So let's see what happens if we extend both of their life expectancies to age 95. If we do this then the probability of plan success drops significantly to 50%. This is a drastic change and one that should not be overlooked.

So how can this couple make sure that they will be able to meet all of their spending goals, whether they live to 80 or even age 95? Assuming they don't want to work longer, there are really only two ways to do this: They can find higher returning investments with the same level of volatility they currently have or they can find investments that have the same returns, but less volatility.

My favorite way to reduce volatility while maintaining reasonable levels of return is to buy high quality dividend-paying stocks that have a history of rising dividends over time. As dividends build over time, the volatility of the overall portfolio returns drop dramatically. So let's see what happens if this couple replaces their value stock index fund with a basket of dividend payers that I like for their combination of dividend yields and dividend growth stability.

A few of my favorite dividend payers for retirement portfolios that have consistently raised their dividends over the years are Johnson & Johnson (NYSE:JNJ), Sysco (NYSE:SYY), AT&T (NYSE:T), Wal-Mart (NYSE:WMT), Coca-Cola (NYSE:KO), and Eli Lilly (NYSE:LLY).

Company

Div Yield

1 Yr Div Growth Rate

5 Yr Div Growth Annual Rate

JNJ

3.0%

6.7%

8.2%

SYY

3.5%

3.7%

5.5%

T

5.2%

2.3%

3.80%

WMT

2.6%

9.0%

12.6%

KO

2.9%

8.5%

8.4%

LLY

3.7%

0%

2.3%

I replaced their Equity Value fund with the stocks listed above, equally weighted. I used the 5-year growth rate for their dividend growth rates over time and lowered the level of volatility to the historical levels of these stocks. That is, I reduced the volatility level from about 16% to 13% per year. Also, the volatility naturally decreases due to the increased dividend payments over time.

Using the scenario where they live to age 95, the probability that this couple never runs out of money now jumps from 50% to 88%. This is a large jump, solely due to the fact that they are now invested in more stable, solid dividend-paying stocks instead of an equity index fund.

To test this even further I changed their life expectancy to age 100. Even in this long-lived scenario the couple has an 80% chance of meeting all of their spending needs thanks to the income being thrown off by their dividend payers.

Each person and couple has a different situation and might need to change a variety of things in order to meet retirement goals. But it is usually impossible to tell whether or not you can retire when you want until you sit down and actually run through the numbers. At that point you can begin running interesting scenarios that will tell you what you need to do to get to your goals.

Source: The Problem Of (And Solution To) Life Expectancy In Retirement Plans