What is Longevity Risk? How to Avoid Running Out of Money in Retirement

Planning for a “perpetual” retirement doesn’t require too much more than a “normal” retirement length.

A few days ago, I read this interesting article by Mel Schlesinger titled “More Terrible Retirement Advice in the Headlines.”

In the article he writes (among many other interesting and helpful nuggets), “Whether it is your family health history or the life expectancy at a given age, planning for anything less than age 100 can get you in trouble.”

That reminded me of how I noticed a long time ago that planning for a “perpetual” retirement (i.e., one where you’d expect to have enough no matter how long you live) doesn’t require as much more than a “normal” retirement length.

I left a comment to that effect.

Then, it occurred to me I have a lot more to say about that, so here goes…

Retirement Planning Needs to Deal with Longevity Risk and Beyond

There are 7 major risks when crafting your retirement plan. One of these is the so-called “longevity risk.”

In plain English, longevity risk is the risk you’ll outlive your money and fall into poverty in your old age. If you plan on retiring early, this risk is even greater since your portfolio has to cover your expenses for potentially decades longer.

Christopher J. Berry, JD, CFP®, CELA®, founder of Castle Wealth Group, says, “Longevity risk is one of the biggest risks for retirees these days because it amplifies all other risks, such as market volatility and most importantly, long-term-care risk. People live longer than ever — we even call retirement planning “Planning for the Second Half of Life.” That’s why we advise clients to plan for a longer retirement than normal, and that means a larger nest egg and additional protections from the risks of retirement, such as market risk, tax risk, and long-term care risk.”

Kevin Lao, CFP®, Founder and Director of Financial Strategies, Imagine Financial Security, agrees, saying “Three risks increase due to longevity: (1) inflation risk — the cost of goods rise over time, and longevity increases how many years inflation will impact your spending; (2) long-term care risk — the longer you live, the more likely you’ll need care later in life; and (3) market risk — the longer you live, the more time the markets have to impact your portfolio, both positively and negatively.”

Is It a Risk or an Issue?

In simple terms, something negative is a risk if it may or may not happen, while an issue is a negative thing you know will happen.

In most cases, financial planners treat a longer lifetime as a risk from a financial perspective (most people would consider living longer a positive thing from other perspectives).

This leads to planners estimating the likelihood of success (you die before running out of money) using, e.g., Monte Carlo simulations for different lengths of retirement. 

It also leads them to decry people not realizing how much longer life expectancy is today than it was decades ago because the risk of failure increases as the expected length of retirement grows longer.

But what if we choose to assume that retirement will be longer than at all possible?

We could base our plan on the assumption that retirement will last forever. This changes it from a risk to an issue we need to address.

But That Just Makes Things Worse, Doesn’t It?

Yes, it does, in terms of how much you need to save and invest.

But since uncertainty leads to fear, if we can bound the problem, knowing it absolutely cannot be any worse than our assumption (as long as we can find a workable solution), it makes things simpler and less scary.

Jon McCardle, AIF, President Summit Financial Group of Indiana, says, “About three years ago, after doing the math on how long clients’ money would last before running out, we shifted our ‘income in retirement’ goal from 4 percent to 3 percent, because if you run out of money it’s usually at an age where going back to work is no longer an option, making you a burden on relatives or on the state (aside from the fact that suddenly becoming inescapably poor is no fun).

“Having more gives you more options during retirement, such as helping grandkids with education, giving to your faith or a favorite charity, or just living in more comfort.”

Zack Swad, CFP®, CWS®, BFA™, AWMA®, AAMS®, President & Wealth Manager, Swad Wealth Management, says, “I always plan for longer than an individual’s life expectancy. 

“When working with a couple, the odds of one of them living into their 90s is about 50 percent. For someone with average health and family longevity, I typically plan for a retirement lasting to age 92 for men and 94 for women currently in their 60s. Of course, these are averages, and I make adjustments dependent on my clients’ situation.

“It may make sense to guide clients to target a larger nest egg to overcome longevity risk if they aren’t willing to adjust their spending down if the markets perform worse than expected, inflation is higher than expected, or unexpected costs such as long-term care come up. 

“Also, for those seeking early retirement and financial independence, say in their 30s, 40s, or even 50s, having a larger nest egg could help prevent them from having to go back to work.”

Nathan Mueller, MBA, Financial Planner, and Financial Coach at Blackbird Financial Planning, agrees with recommending a larger savings goal, but for different reasons, “I often recommend clients save more for retirement. However, it’s more to address the possibility of Social Security benefits getting reduced and healthcare costs increasing rather than for longevity reasons.

“With my clients, I do bring up family history and discuss longevity, but for most people, it won’t be too impactful — UN projections say a 30-year-old is only expected to have a 4-year life expectancy increase compared to someone today. Younger generations, say 20 and younger, should consider saving more for retirement for longevity reasons, but they aren’t yet at the point of seeking financial planners.”

How Bad Do Things Get If We Assume Perpetual Retirement?

Interestingly, you don’t need as much more to fund a “perpetual” retirement than, say, a 35-year one.

Let’s make some (over-)simplified assumptions:

• Annual portfolio returns are 6 percent
• Annual inflation is 3 percent
• Initial withdrawal is $50,000, with each subsequent draw increased to counter that inflation

Using these, we find that we need an initial portfolio of about $1.12 million to last precisely 35 years (say, from age 55 to 90 or 65 to 100) — as shown by the blue curve in the plot below.

However, if we increase that initial portfolio size by just 58 percent to $1.77 million, the red curve shows us the inflation-adjusted portfolio size stays constant “forever.”

In 1994, financial advisor William Bengen published research showing that by investing 25 times your Year-1 draw in a 50/50 portfolio of large-cap US stocks and US bonds and adjusting your subsequent years’ draws to address inflation, you’d never have run out of money within 30 years, all the way back to the Great Depression.

He called it the 4-percent rule since the initial draw would be 4 percent of the initial nest egg size.

That initial nest egg size for a $50,000 initial draw is $1.25 million, as indicated by the green arrow below.

Caveats

Clearly, in real life, we don’t have stable returns of 6 percent a year nor inflation of 3 percent a year over decades (or even just a couple of years).

That’s why I put “perpetual” in quotation marks — since the portfolio size won’t really stay constant across all time when you have real-life fluctuations in both returns and inflation.

However, it is instructive to see that you don’t even need to double your nest egg size to have it last far longer than 35 years (under idealized conditions).

The Drawbacks of This Approach (and a Silver Lining)

Targeting a larger nest egg is more challenging and isn’t without drawbacks. 

As Swad says, “Targeting a larger nest egg comes with its own risk that shouldn’t be taken lightly. Doing so may require people to work longer than they want, giving up some of their precious years when they‘re younger and in better physical shape, able to do things they love with the people they love.

“I’ve never heard anyone say they wished they’d worked longer and died with more money, which is the most likely outcome for those who ‘over-target’ their needed nest egg.

“Rules like the 4-percent rule provided great information for the financial planning world; however, they’re too rigid and were never meant to be used in practice for retirees. I believe a flexible spending plan like the guardrails approach provides people with the best chance of living their most fulfilled life in retirement while making sure their money lasts the rest of their lives.”

However, saving and investing more makes it more likely you’ll leave a larger bequest for your kids, which some people (like me) see as a big plus.

Other Options for Addressing Longevity Risk

Targeting larger nest eggs isn’t the only approach that can work.

Daryoosh Khalilollahi, CFP, MBA, MSEE, Principal and Financial Planner at DABK Financial Planning Services, says, “One way to reduce longevity risk is to have at least a portion of your monthly retirement expenses paid by a lifetime annuity. That’s why most retirees who’re concerned about longevity risk should consider waiting until age 70 to claim Social Security benefits. Every year delay after full retirement age (67 for those born in 1960 or later) gives an 8-percent increase in benefits for life. That’s 24 percent more for waiting three years.

“This will likely be true even if benefits are reduced in the future due to insufficient funds in the Social Security trust fund. For married couples, there’s another advantage — Increased benefits to the surviving spouse.

“Beyond that, you can allocate 20–30 percent of retirement funds for the later stage of retirement (after age 85) to purchase a low-cost fixed annuity from a highly rated insurance company.

“The advantage of a lifetime annuity over self-funding via withdrawals from your retirement portfolio is that some annuitants die early so, everything else being equal, if you’re one of those who live, your income from a given investment paid toward a fixed annuity will be higher than your safe withdrawal from adding the same size investment to your portfolio.

“In general, I’m not a fan of annuities because of inflation risk, loss of liquidity, surrender charges, and sometimes hidden costs, but for this specific case, it is a viable option.”

Kevin Lao agrees and adds some other ideas, “I wouldn’t necessarily recommend targeting a larger portfolio. If you have longevity on your side, it’s still not a guarantee you’ll live to that ‘expected’ age. So, it can do you a disservice to simply plan for longevity. I prefer to look at other ways of protecting against longevity risk.

“STRONGLY consider long-term-care insurance. If you outlive your spouse, there’s a good chance your children will have to care for you, and 100 percent of my clients say they don’t want to burden their children.

“STRONGLY consider delaying Social security to age 70 to maximize your benefit amount, as well as your spouse’s survivor benefit (in case your spouse outlives you).

“Consider an annuity. That way, in addition to Social Security, you have another income stream you can’t outlive! This is the purest form of longevity protection!

“Consider a higher stock allocation in your portfolio. Bill Bengen’s research advocated a stock exposure of 50 percent at a minimum and up to 75 percent. For someone with higher likely longevity, increasing stock exposure up to 75 percent helps protect against inflation risk and maintain dignity in your later years.”

How Will You Address Longevity Risk?

The 4 percent rule has just an 87 percent likelihood of success for a 30-year retirement. That likelihood shrinks as you increase the length of retirement, but increasing the initial nest egg size by just under 42 percent (relative to the 4 percent rule) will increase your likelihood of success even for much longer periods than even 30 or 35 years.

If you want to set aside the uncertainty and fear of outliving your money, you can try targeting a perpetual retirement by, e.g., assuming a 2.8 percent initial draw. That way, even if you fall short of the idealized “perpetual retirement” target, you’re almost certain not to fall into poverty in your old age.

This means you’ll probably need to work longer and live more frugally, which we don’t like to hear. It also means you’ll probably leave a lot more money behind. For some people, that’s a negative, while for others (like me), leaving a larger bequest for your kids is a positive.

Alternatively, you could delay claiming Social Security, purchase an annuity with part of your portfolio, buy long-term-care insurance, and consider a more aggressive stock allocation in your portfolio.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

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