Understanding and managing longevity risk

When we reach retirement, we have a pretty good knowledge of the resources we have at our disposal.

Most of us will have a superannuation account. Many of us will be eligible for the age pension, in full or in part. Many will own our home, though more and more are entering retirement with a mortgage or are renting. Other potential resources include human capital (that is, part-time work) and savings or investments outside of superannuation.

The challenge of retirement planning is to use these resources to support us efficiently and effectively in life after full-time work, no matter how long it lasts.

Why is this a challenge? Because of the many unknowns and uncertainties that we face as we make that transition. That is, retirement planning is an exercise in risk management. The list of risks facing us in retirement is a long one.

Understanding longevity risk

One of the most important and least understood is the risk of running out of resources and relying on the age pension. This risk is known as longevity risk, and it is the mother of all retirement risks—the longer you live, the more exposed you are to all the other retirement risks.

Like most risks, there are two sides to longevity risk. The first, and the one most think of, is the risk of outliving your retirement savings. The second, less often discussed, is the risk of underspending your savings, leading to a lower income over retirement.

Many other retirement risks, such as market volatility or inflation, can be somewhat predictable and managed. In contrast, longevity risk is inherently unpredictable at the individual level. Market volatility and inflation are likely to impact all retirees in a similar way. Longevity risk is more personal. While average life expectancy provides a rough estimate, individual life spans can vary significantly.

Managing longevity risk

Once you understand the risk, you need to consider ways of managing the risk. When it comes to longevity risk, there are three broad options available:

• An annuity or other lifetime income product;
• An account-based pension; and
• Self-insurance.

In Australia, the two dominant options are the account-based pension purchased from a superannuation fund or self-insurance, taking all your money out of superannuation and managing it yourself. These options don’t completely protect against longevity risk. There is still a chance of running out of money. Consequently, many retirees adopting these approaches are overly conservative spenders rather than enjoying a higher standard of living.

Lifetime income products that guarantee an income for life are an excellent way to manage longevity risk. However, these products have been unpopular with retirees (and superannuation funds and financial planners). There are many reasons given for why Australians don’t buy annuities, from “the rates are too low” to “they are too restrictive/they lock money away” to “they are too complex”.

Several providers have recently developed lifetime income products that sit between the traditional annuity and the account-based pension. They have designed these products to offset some of the downsides of the traditional annuity and the account-based pension. These new products are sometimes called investment-linked or market-linked annuities. The common feature of these products is that while they guarantee an income for life, the amount will vary from year to year, depending on the underlying investments supporting these products.

Planning for retirement, especially managing longevity risk, is different for everyone. Given the need to plan for the possibility that you may live longer than you think, having a broader range of products available can only be a good thing.

Stephen Huppert is an independent consultant and advisor partnering with institutions committed to improving the retirement outcomes of Australians.