Unpacking longevity risk in retirement
When investing for retirement there are various risks that investors and their advisers need to consider. The most obvious is market risk as this is not only visible on a day-to-day basis, but also forms a direct part of the financial planning process when a risk analysis is conducted by the adviser. There are, however, other risks that can be detrimental to the retirement journey, namely inflation and longevity risk.
Inflation risk is easy to understand, but scary when experienced first-hand. Consider an amount of R1 million today and assume a 6% inflation. In five years, with zero growth, fee or drawdown, your purchasing power will already have diminished to R733 904. After 10 years it will have been reduced to R538 615. Add an income on to this and the picture starts to look bleak.
Let’s consider an example –
Neal (aged 60) has R5 million available to provide a retirement income.
1. Living annuity drawdown 5%
2. Inflation 6%
3. Growth 10%
Let’s look at the impact on the capital amount in real terms, i.e. his purchasing power in the future, but in today’s terms.
Viewed differently, one could also see this as the value of the potential inheritance from this investment in the future. Now consider the income stream, as shown below. As illustrated below, Neal will have an adequate income stream up to the age of 84. This, however, still assumes a linear growth of 10% and does not account for any form of volatility and sequence of return risk. Adding a 5% volatility factor can reduce the odds of the income stream lasting until age 84 by as much as 50%.
Factors for Neal to consider:
1. Is the lower income after the age of 84 sustainable for Neal?
2. How will Neal mitigate the longevity risk after age 84?
3. Is 6% assumed inflation realistic? Based on CPI data per decile group of wealth distribution, the 6% number is potentially an understatement.
4. How will Neal provide for medical expenses or the increased living costs if inflation is even higher than 6%?
Source: Stats SA
This brings us to the next risk that needs attention, namely longevity risk. In essence, this refers to you outliving your money. The impact of this is dramatic as it becomes a contributing factor to what is known as the “sandwich generation” - where a financial earner is wedged between two dependant generations. This ultimately creates a knock-on effect that spirals from generation to generation. The second pressure point has the potential to hit all earners, as the state needs to then increase its social grant bill that is ultimately funded by the taxpayer.
The big question is then, for how long do you need to provide an income to ensure you have adequate income longevity? Let’s consider average age expectancy, as shown in the below table.
In our example above, there is a 50% chance that Neal would no longer need income after age 84, when the projection shows his income to significantly start to decrease, but that means there are many potential clients who would live longer and still need a sustainable income. Therefore, the above cash flow example would potentially cover only 50% of clients, which is not acceptable. Assume you need to leave an income for a spouse, would like to leave a legacy or assume you live to 100. Measures need to be taken to ensure there is some form of income at that stage.
Addressing longevity risk
There are three ways we could address this:
1. Fix the retirement longevity dilemma by ultimately fixing the c