How to deal with longevity risk
Longevity risk is one of the biggest risks facing retirees. Recent research has been highlighting how life expectancy of individuals is increasing. What does that mean and how can this affect your retirement savings?
Longevity risk refers to the risk of outliving your savings, meaning there is a chance that your life expectancy may exceed the years you have savings available to draw an income from.
At the beginning of this year the USA elected its oldest president in history at 78 years of age. Though there are undeniable gaps in life expectancy among different socioeconomic groups and the Covid-19 pandemic will make a temporary dent on this hypothesis: many people are living longer thanks to a greater focus on healthy living together with the advancement of medical technology.
How can you make the most of your retirement savings?
Ideally, you should set your retirement goals, and subsequently start saving to meet those goals, from the moment you start earning your first income. You need to follow an investment strategy that encapsulates your risk tolerance and risk capacity together with the actual risk required to reach your goal. This can be achieved with the help of a financial adviser, who can on an ongoing basis help you to set goals and review your progress towards those goals. Should you start working at the age of 25, you typically have a timespan of between 30 to 40 years to work and save towards your retirement. Taking the increase in life expectancy into consideration, you need to have a plan to provide for a potentially longer period in retirement than you may have previously expected
Understanding investment risk and the importance of diversification
To achieve your goals, you typically need to be comfortable with a degree of investment risk to attain a targeted investment return. This means that you will in most cases need to invest in a combination of asset classes, each with their own implied investment risk characteristics. For example, a higher equity exposure in a portfolio will introduce higher levels of risk, as equities are more volatile in the shorter term. However, over the longer term it can give greater returns. Cash and bonds on the other hand are less risky in nature and offer steady returns linked to interest rates, however the risk of being overly exposed to cash or bonds is that your portfolio may not keep up with inflation. With increased longevity it becomes imperative to invest in assets classes that can offer substantial growth and outperform inflation. The effects of being overly cautious and taking a more conservative risk approach to investing can be illustrated as follows:
Investor 1: Carol
Carol is a very risk-averse person. While she was growing up her parents made bad investment decisions and she took the stance to rather “play it safe” by always investing in asset classes that produce a steady investment return with minimum market volatility.
Investor 2: Khethiwe
Khethiwe made the decision to consult a financial adviser to help her identify her goals. The adviser explained the different investment options and the risk approach she would need to take to achieve her goals. She now understands that she needs to take a certain level of investment risk to achieve her retirement goal and to make sure she does not outlive her savings due to longevity.
For purposes of this illustration, we are making some assumptions:
• Carol and Khethiwe both started work at the age of 25, earning a salary of R25 000 per month and saved 15%. The salary and savings will increase yearly by the rate of inflation.
• Inflation assumed at 5%.
• Carol saves more cautiously with an assumed investment return of 7.5% and Khethiwe accepts more risk with an assumed investment return of 10%. No fees were taken into consideration for this illustration.
• Should they plan to retire with 75% of their monthly income (adjusted by inflation of 5%) at the age of 65 and draw income until age 95 (which also increases with inflation), they will have the following outlook. The illustration also assumes they both continue with their risk approach after retirement:
As is evident from Graph 1, it is necessary to take a certain level of investment risk to achieve your goals. Longevity and the quality of living is becoming more relevant of late and the risk of running out of funds in your retirement years is a reality. With the help of a financial adviser, you can identify your goals and consider different investment options in line with the risk approach you need to take.
Gerhardt Meyer, Strategic Technical Manager, PSG Distribution