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One of the biggest variables that confront people when planning retirement is their life expectancy. Some folks like to use the life expectancy of their age group or the life expectancy numbers that exist for a person born today. But this can be very misleading and can result in retirees running out of money in retirement.

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 what can we do to incorporate survivorship bias and figure out what happens if we live way longer than expected?

I believe it is vitally important to view multiple outcomes for a retirement plan if a person or couple lives to various ages. We should look at the probability of never running out of money in retirement at various ending ages (when each person passes away).

I ran an analysis to see what kind of impact changes in the couple's ending ages might have. I used a plan for a couple that is 60 years old and plans on retiring at age 65. Here were my starting assumptions:

Inflation (CPI)

3.00%

Current Age of Both People

60

Age Of Retirement

65

Age When Both People Have Passed Away

Various- 80, 83, 86, 89, 92, 95, 98

Social Security at age 67 (combined)

$40,000 per year

Average Savings Rate

6% on Income of $100,000

Total Investment Balance Today (all in IRAs)

$900,000

Recurring Annual Expenses in Retirement

$65,000

Investment Mix

50% U.S. Value Stocks, 15% Emerging
Market Stocks, 35% Treasuries

Investment Location

50% in taxable accounts, 50% in IRAs

Average Return Assumption Value Stocks

6% per year

Standard Deviation Value Stocks

16.20%

Average Return Assumption Emerging Mkt Stocks

9% per year

Standard Deviation Emerging Mkt Stocks

25.80%

Average Return Assumption Treasuries

1.5% per year

Standard Deviation Treasuries

7.20%

After generating their plan using the various ending ages I found the following results:

Ending Age

Probability Of Meeting All Retirement Goals

80

100%

83

100%

86

98%

89

91%

92

81%

95

70%

98

61%

It becomes obvious pretty quickly that the life expectancy of this couple has a huge impact on what they can expect in retirement. By adjusting how long they live from age 89 to 98 they see a significant drop-off of 30 percentage points in the probability of funding all of their goals in retirement.

It is also important to point out that if people are underestimating how long they might live they also might dump most or all of their money into low yielding Treasuries too soon. I believe it is prudent to build a basket of solid dividend paying stocks that will provide a steady stream of income in retirement, which will help reduce the risk of running out of money even if you live longer than you expect.

I always look for companies that have a strong history of increasing their dividends even in recessions. Companies that fit this bill are Johnson & Johnson (NYSE:JNJ), Coca-Cola (NYSE:KO), Wal-Mart (NYSE:WMT), and Procter & Gamble (NYSE:PG).

Company

Div. Yield

5 Year Div Growth
Rate (Annualized)

JNJ

3.6%

9.4%

KO

2.7%

10.0%

WMT

2.2%

16.2%

PG

3.3%

12.1%

Source: Watch Out For This Retirement Pitfall