Longevity risk is the risk that the amount of money you save for retirement is not enough to sustain you throughout your life, due to your increased life expectancy. Ok, that sounds scary. But the fact is that most people save far too little for their retirement ambitions. Therefore, it is essential that they take calculated risks. Investment risks are relatively higher when savings are low and relatively lower when savings are high. The trick is to sensibly spread your risk in the years you are contributing to your retirement. (But never, ever sit back and let your investments run themselves. That is like being asleep at the wheel.)
If you are already retired or getting near retirement, you may think that risk is not for you. Retirees are risk averse because they no longer have the chance to build more wealth. The idea is to balance your longevity risk and your investment risk. In doing this, there are three competing goals.
Are you an average person?
Recently I had the good fortune to attend an interesting presentation on these concepts by Don Ezra, co-chairman of Global Consulting for Russell Investments worldwide, member of the Editorial Advisory board of the Financial Analysts Journal as well as many other impressive appointments. Mr. Ezra first defined the average person or couple as having assets and/or income sufficient to cover basics and more, but not for an indefinite period. Therefore, choices must be made. Many of us fall into the “average” category. The “top wealth” level people have assets and/or income so large that money will not run out in their lifetime and the “bottom wealth” level have assets and/or income so small that even basic necessities are uncertain.
Three competing goals
Mr. Ezra reveals that in balancing our longevity risk and our investment risk, we in the “average” category have three competing goals and each goal has a feasible solution. You will notice that each solution competes with the other solutions because each goal competes with the other goals.
Goal #1: To have longevity protection – We do not want to out last our money.
For this goal, Mr. Ezra suggests having a deferred lifetime income annuity that will kick in if you survive past your 85th birthday. If you are a couple, it should kick in past the older one’s 85th birthday.
A deferred income annuity (“DIA” and sometimes called a longevity annuity) is a contract between you and an insurance company. You pay a lump sum to the insurance company in exchange for a lifetime of income that starts at a future date. DIAs are sort of like pensions for those people who don’t have a pension. The fluctuations in the stock market do not affect the amount of future payments you will receive from the insurance company. Deferred income annuities are not liquid investments. Once you pay your initial premium lump sum, you cannot get it back as a lump sum. You have to get it back as monthly payments. DIAs offer significantly higher payouts than do immediate annuities. I recommend that you consult with a fee-only planner before buying a DIA. Choose a planner who does not sell or otherwise get compensation when you buy any annuity.
Goal #2: To grow and thrive – Our lifestyle is richer than we are. Also called champagne taste on a beer budget.
Mr. Ezra’s advice here is to invest in equity type assets, also known as “stocks” and represent ownership in a company. This is in an effort to grow your wealth but includes the risk of the ups and downs of the stock market. Stocks can be divided into two main categories: growth stock and value stock. They are also sorted into large cap versus small cap and foreign versus domestic. We can include real estate investment trusts (REITs) as a special type of stock. There isn’t enough room in this column to explain these assets and go deeper in this area, so I will simply warn you that choosing investments can be an emotionally draining experience for most investors. If I have just described you, I strongly recommend that you consult a fee-only financial planner before diving into an investment program. Yes, this type of investment is very different from a DIA, which avoids the stock market. But then, since Goals #1 and #2 are competing goals, different advice is appropriate.
Goal #3: To be safe and survive– We don’t want to be shocked with sudden financial advice like “it’s time to turn the spending dial down.”
For this goal, Mr. Ezra recommends having five years of total spending invested in short term fixed income assets (possibly more than five years of spending for essentials). Since Goal #3 competes with Goals #1 and #2, we have yet a different investment.
Fixed income investments give you a return of fixed periodic payments with the eventual return on your principal at the maturity date. You will know the amount of these periodic payments in advance. An example is a short-term bond fund. Not all short-term fixed income investments are the same. As with my advice on choosing stocks, I recommend that you consult with a fee-only financial planner before investing in any fixed income securities or mutual funds.
To balance longevity risk and investment risk, you would allocate the three competing goals in proportions that reflect their relative importance to you. Risk is always with us. Try to identify in advance where and when you can turn down your spending dial in the event that some risk does not result in reward.