Health, happiness and a long, long life

The main objective of a financial retirement plan must be to provide an inflation-protected, after tax income that will last until death. There are two important risks to the achievement of that objective: investment risk and longevity risk.

There has been plenty of debate about the former but not too much about the latter. Not much science has been brought to bear on establishing how tolerant clients are likely to be of outliving their money.

In some ways this is surprising in an industry so populated with actuaries, whose main role in life is to analyse and manage long-term uncertainties.

Their skills, however, have mainly been applied for the benefit of life offices and superannuation funds, and not many have taken an interest in how things look to the punter on the receiving end.

A couple of notable exceptions are Andrew Wakeling and Andy Yang, who presented an excellent paper on the subject to the Institute of Actuaries some years ago. This paper can still be found in the research papers section of the Invesco web site.

The way for a retiree to reduce longevity risk to as close as possible to zero, is to spend no more than the after tax, after inflation returns from the investment portfolio. Arguably, the inflation adjustment should be for wage inflation (AWOTE) rather than price inflation (CPI).

This approach means that an income stream will be produced that can be maintained into perpetuity. Any higher spending means that it will not be possible to maintain the purchasing power of the income indefinitely, and that at some point the money may run out.

Retirees may understandably take the view that they are not prepared to accept any risk. This means that they must invest in cash to remove the investment risk, and spend only the after tax, after inflation return to eliminate the longevity risk.

If we assume that price inflation falls midway within the Reserve Bank’s target range of two to three per cent and that cash returns remain around 4.25 per cent, this means spendable income available to the no-risk investor will be 1.75 per cent of invested assets. This will be lower if any tax has to be paid, and lower again for those wanting their income to keep pace generally with other incomes rather than prices.

So, if someone with a $500,000 lump sum to invest is happy with an income stream of $8,750 per annum, well and good. Otherwise, some risk will need to be taken. The next question is: what kind of risk?

Assuming that the reward for taking on some investment risk is an increase in return of three per cent per annum, someone taking on a lot of investment risk, but no longevity risk, could expect to be able to spend the risk free rate (4.25 per cent) plus the risk premium (three per cent), less inflation (2.5 per cent), less tax.

For the rest of this article I’ll assume tax to be zero. That means that a $500,000 investment will generate an inflation adjusted income of $23,750. The expected reward, then, for taking on a significant amount of investment uncertainty is an increase in income from $8,750 per annum to $23,750. Adverse markets may, of course, torpedo these expectations.

What is the payback for taking on longevity risk?

Life expectancy for a 65 year old male is now 17 years. If a cash investment of $500,000 earning 4.25 per cent per annum is spent down over that period, the income available would start at $34,000 and grow with inflation to $50,473 by the 17th year, when the money would run out.

Very close to 50 per cent of people outlive their life expectancies, so in this case, the client would be electing to run a 50/50 chance of running out of money, or taking on a longevity risk of 50 per cent. So a high longevity risk and low investment risk profile means an expected increase in spendable income from $8,750 per annum to $34,000.

High investment risk and low longevity risk means the probability of a large estate. Conversely, low investment risk, high longevity risk may mean no estate.

Mortality rates can be expected to continue to improve, but the current life tables show that 10 per cent of 65 year old males live for 27 years. A male wanting to take no investment risk but accepting a 10 per cent longevity risk will therefore plan to run down his money over that 27 year period.

On the assumptions previously used, that will result in a starting income of $23,000 per annum. This is close to the income that is available from equities. The proposition for 65-year-old male retirees in these circumstances, therefore, is this:

If an income of $23,000 to $24,000 is the minimum acceptable indexed income from an investment of $500,000, some risk must be taken. Which is preferred: the investment risks of equity markets with the expectation that the income will last forever, or the certainty of cash with a 10 per cent risk of out-living the money beyond age 92?

In many cases, a combination will be the preferred option. For example, expected returns from a 50/50 mix of cash and equities would be 5.75 per cent. That should provide an indexed income of $26,000 per annum for 31 years, reducing the longevity risk to below five per cent.

The reality over the past 30 years has been that longevity risk has been a much larger problem than investment risk. No doubt, many retirees have lost money on stock markets, but hordes have become poor by avoiding investment risk in their asset selection and then spending the total return, without making the necessary re-investment to cover inflation.

In other words, they have too often adopted a spending pattern that means that the low returns from ‘low risk’ investments will not last for their lifetimes.

Like many risks, pooling longevity risk would seem to be the way to go. Unfortunately, the only pooling mechanism at the moment is the lifetime annuity, which also necessarily removes investment risk.

Growth annuities, invested in diversified asset classes with income streams payable for life and with the early casualties funding those who outlive the averages, would be desirable products to have in the toolbox.

Pooling through the tax and social security system would be another option, which would mean substantially increasing both the level of the age pension, and the commencement age.

Under this scenario, superannuation assets built up with tax advantaged monies would be spent down in the first period of retirement, and a generous pension would then kick in as a protection against living too long.

These initiatives would need legislation, but clients who are retiring now obviously can’t wait for the possibility that some Australian government might give attention to a coherent retirement policy.

If both types of risk are properly explained, many retirees will doubtless elect to take some investment risk by including a prudent proportion of equities. They may also take some longevity risk by planning for a bit less than full provision for inflation in the latter years of retirement.

They should prudently place some funds outside of allocated products, which are going to leave many investors in trouble in their old age. Finally, they will give careful consideration to including lifetime annuities in the mix.

A wish-list for the immediate future

* Actuaries start taking an interest in longevity risk and provide information and tools that will help advisers and their clients to make the trade-offs between investment and longevity risks.

* Lifetime annuities are recognised as having a role in retirement portfolios, even where social security is not involved. One of the reasons lifetime annuities have seemingly poor returns is that the life office is accepting substantial longevity risks. Avoiding these products means that the client assumes these same risks. While lifetime annuities may have low yielding assets backing them, they also avoid the need to build up a reserve of money to protect against old age, which will, in most cases, be passed on as an inheritance. These factors should be compared. Retirees should be offered choices.

* It becomes common practice for some investment funds to be placed outside allocated pensions for retirees. If a 62-year-old female retiree has no funds other than $500,000 in an allocated pension and spends only the minimum draw in year one and indexes that to inflation, even if a six per cent real return is achieved over the period of her retirement, she runs an even chance of running out of money.

* We stop referring to the interest bearing investments that have devastated the lives of so many retirees as ‘low risk’, and start talking about how to balance different kinds of risk. The unfortunate reality is that there are no free lunches. The investments that reduce the chances of running out of money early due to adverse market movements are the same ones that increase the chances of running out in very old age. Reducing investment risk means increasing longevity risk, for any given lump sum and income flow.

John Prowse is general manager atIntegraTec.