Editorial note: this post is part of the Cornerstone Foundations series that explains our firm’s philosophical thinking on matters of critical importance to retirement savers and retirees alike.
At Cornerstone we often talk about various risks and how to mitigate them. We also ask clients and prospects, many of whom are retired or close to it, what they think the most important risks are when it comes to their financial lives. We often hear answers about the stock market, inflation, the cost of health care, and so on.
From an analytical standpoint, the correct answer is none of the above.
The biggest risk to the success of a retirement plan is longevity. Not to sound too morbid, longevity risk is the danger of exhausting your resources before your life ends. And for too many savers, it is one of the least understood aspects of retirement planning.
Many people confuse longevity risk with life expectancy. But there is an important distinction between the two. Life expectancy refers to the average number of years someone will live, while longevity refers to how long someone may live if things go well. Without proper planning, this misunderstanding can put pressure on retirement income.
In our experience, not many people think about living too long, they think about dying too soon. Well, the good news is many Americans live much longer than expected. But the bad news is many Americans live much longer than their money expected. For example, while they may not plan for it, women in excellent health born in 1990 have a 20% chance of living to be 100:
Historically, the risk of outliving your money hasn’t been focused on enough from a planning perspective because most people have merely looked at life expectancy actuarial tables. These tables provide expectancy values that are based on someone who was born that day. What they don’t account for is the fact that, once you’ve aged to say 65 years old, you’ve surpassed many mortality risks already.
This disconnect between life expectancy and longevity is most significant when planners use basic retirement calculators that only provide information on average life expectancy. Thus, the people who have “planned appropriately for life expectancy” run a high risk of missing how likely they are to live longer than the average. As this chart shows, life continues beyond expectancy for many Americans:
Cornerstone is different in this regard. Our core philosophy aims to mitigate or even eliminate longevity risk by attacking retirement via a goals-based planning analysis. This work is fundamentally anchored by cash flow realities, not calculating probabilities.
Wondering how this could affect you? Get a sense using this online calculator. You may be surprised, especially by the chances of one individual in a couple living significantly longer than the other. A recent Wall Street Journal piece summarized it well:
In other words, there’s a nearly coin flip’s chance that one member of a 65-year-old couple will live to age 95. If you think about the people in your own life, you can probably recall friends or family who have experienced such a situation.
Now, let’s compare that to current actuarial life expectancy. For men, it’s 73.5 years old and for women it’s 79.3. Obviously, there’s a big difference between living until your 70s and living two decades longer. Remember, once you make it to age 65 or so, many mortality risks have already been eliminated. So, using life expectancy as a basis for retirement planning means, despite “assurances” to the contrary, you might be building a plan that doesn’t cover how long you’ll actually live.
Understanding this context, the following stat is less surprising. According to the Society of Actuaries, one out of three men and half of women who currently are in their mid-50s will live to age 90 or beyond. In a nutshell, that is longevity risk.
The potential pain of this risk is exacerbated by the fact that today fewer retirees have the guaranteed lifetime income and protection of a pension plan. That’s why we think “base withdrawal rates” or retirement rules of thumb are inadequate for dealing with longevity risk in any meaningful way.
As such, we use goals-based planning and income realities for our clients. Anchoring your plan around goals you want to achieve and solid household cash flow analysis effectively eliminates longevity risk over the long term because significant variables that come into play are reduced.
Is this topic important? We certainly think so, and we’re not alone. The TIAA Institute studies this topic and found that only 37% of U.S. adults have a strong understanding of longevity and how it could affect them.
Instead, most people think stock market risk poses the biggest threat to retirement success. However, if you eliminate sequence of returns risk and market volatility risk with a goals-based plan focusing on cash flow, you simultaneously mitigate or eliminate three potentially dangerous, intertwined risks that can sink a retirement plan: sequence of returns, market volatility, and longevity.
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