Retirement: Betting against longevity risk
By Samukelo Zwane
The most important requirement when you reach retirement is to ensure that you don’t run out of your retirement savings before you die.
Longevity risk is the risk of outliving your retirement savings and having to rely on your children or the state to make ends meet. This risk has also been made worse by an improvement in medical technology resulting in longer life expectancy than before.
The easiest way to curb longevity risk is to save sufficiently leading up to your retirement. However, only 10% of people save sufficiently for retirement and most people fall prey to several behaviours which result in insufficient retirement savings. Some of these behaviours are withdrawing pension when changing jobs, taking up one third lump sum to service debt when you get to retirement age, not increasing your retirement contributions on an annual basis.
In planning for retirement, it is important to understand that it is a journey which happens throughout your economically active life. It does not happen in isolation in your life, it must remain a constant factor as you go through different life stages, young adult, family formation, family development, family maturity and retirement. Therefore, you need to start thinking about ways of reducing longevity risk way before you reach retirement age.
Even though the easiest way to avoid longevity risk is to save sufficiently for retirement there are still financial planning strategies that will enable you to reduce the effect of longevity risk. This is done through some asset-liability matching exercise. Actuaries and investment professionals apply these strategies on a regular basis when managing investments for corporates and individuals.
In retirement your liability will be the regular expenses that you will have to cover daily.
Your asset will be the retirement income that you will get from your retirement income product
Your expenses can be divided into two; none-negotiable basic expenses and nice-to-have expenses. None-negotiable expenses include food, medical care, accommodation, transport costs etc. Nice-to-have expenses include annual vacation with grandchildren, eating out on a regular basis, leaving a legacy for your dependants etc.
Basically, you will have two financial products that you can use to purchase income when you get to retirement. These two products are guaranteed life annuity and living annuity. They produce different income profiles for you. A guaranteed life annuity will provide income which is guaranteed for life. In the event of your death your spouse may continue receiving income if you have selected a joint life option. With a living annuity, you can drawdown income between 2.5% and 17.5% of your retirement savings. On an annual basis you can change the income that you would like to drawdown from your lump sum. Unlike the guaranteed life annuity, income from a living annuity is not guaranteed, if you drawdown more income than the investment returns you will deplete your capital.
To do our asset liability we follow two steps. Firstly, we need to match none-negotiable expenses with guaranteed life annuity income. You do this by getting a quotation from your life insurance company on the lump sum required for you to get an income which will cover your none-negotiable expenses. Its important that quotation caters for income that will increases with inflation because your none-negotiable expenses will have inflationary increases on an annual basis. In this way, even if you leave longer than expected you are assured that your none-negotiable expenses will be met.
Secondly, you take balance of your retirement lump sum and use it to purchase a living annuity. Decide on the drawdown rate, between 2.5% and 17.5%, that you will cover the nice-to-have expenses. If your required contribution rate is above 17.5% you need to adjust your nice-to-have expenses down. A rule of thumb is that you need to ensure that your annual drawdown rate is lower than the investment return and expenses of your living annuity. In this way, your living annuity will not run out before you die.
Questions around passing on earlier than expected always come up? What happens to my lump sum that I have used to purchase a guaranteed life annuity? If you and your spouse die earlier than expected your beneficiaries will not receive a lump sum pay out. A guaranteed life annuity is like insurance, it provides you with a peace of mind that your basic needs will be taken care of if you leave longer than expected. In this way, you don’t have to bet against longevity risk instead you put measures in place to protect you in case you live longer than expected. Similarly, when you purchase vehicle insurance you are not guaranteed that you will have an accident in the future. However, through purchasing a car insurance you get a peace of mind that when you crash into a Ferrari your third-party insurance cover will pay your damage costs.
Samukelo Zwane is the Head of Product at FNB Wealth and Investments