There is a problem in the retirement planning profession that isn’t being discussed – but is essential knowledge for every prospective retiree…
Life expectancy is constantly increasing. In the last 100 years, average life expectancy has increased by 30 years stretching the amount of time most people spend in retirement. When Social Security was first created in 1935 most people lived just a few years in retirement – now they can expect to live for decades.
While this is good news for retirees the sad truth is few people recognize the dramatic impact it has on financial planning for retirement. Having enough money to support 15 years of retirement is completely different from financing 30 years or more of retirement. In the first case you can spend investment principal, but in the second case spending principal is tantamount to financial suicide. The two situations are as financially different as night and day.
Planning for long retirements would be less of a problem if there was a way to know how long you will live. Unfortunately, your personal life expectancy is unknowable and cannot be predicted with any confidence no matter how many actuarial tables and research studies are consulted.
What this means is you must determine how much money you need to fund an ever-growing but unknown length of retirement. If you guess wrong then your money may die before you do. Below we will explore several solutions to this serious problem…
Why Longer Life Expectancy Is A Critical Retirement Planning Issue
Most people intuitively grasp that the longer you live, the more money it takes to pay for those additional years. That much is obvious.
What isn’t obvious to many retirees, however, is that a time threshold exists where principal cannot safely be spent without jeopardizing financial security. As the number of years spent in retirement increases the amount of investment principal that can be spent to support living expenses decreases. As retirement duration extends to 30 years and beyond prudent retirement planning necessitates a perpetual income stream where investment principal isn’t touched at all.
This is a very big deal because it requires a lot more money to fund a perpetual income stream for retirement than it does if you are allowed to spend principal. Intuitively, this situation is clear to anyone who has paid off a home mortgage. The initial payments on a 30 year mortgage pay down very little of the principal balance owed; whereas, the initial payments on a 15 year mortgage pays much more of the principal owed. The difference is because of the amortization periods, and it is the identical situation in retirement planning only in reverse. Rather than paying down a debt you are spending down an asset. The longer the duration the less principal that can be spent.
This is a big problem for future retirees. Their life expectancy is reaching the point where it is reasonable to expect to cross that threshold where little or no investment principal can be spent to support living expenses.
Why You Must Plan For A Very Long Retirement
Life expectancy is growing and expected to rapidly advance in the next 30 years. Improvements in healthcare and medicine combined with recent developments in biotechnology, nanotechnology, and DNA research are consistently increasing the average human lifespan.
Life expectancy at the beginning of the 20th century was a mere 47 years and had grown to 63 years when Social Security was enacted in 1935. By the end of the 20th century average life expectancy had grown to 77 years creating a 30 year increase in just 100 years – this equates to an amazing 108 days of increased life expectancy for every one year of living in the past century.
This is a profound development that can’t be overstated. Estimates from the United Nations indicate that by 2050 there will be six times as many people over age 85 and 16 times as many over age 100. These figures strongly contradict even the most conservative actuarial tables. Already there is a 60 percent chance that one member of a couple age 60 will make it to 90 or beyond. Continuing medical developments will only push that boundary out further.
The key point to realize is you must plan on a very long retirement. If you are part of a couple retiring at age 60 it does not take any stretch of the imagination to realize you may need enough money to support 30 years – or maybe much more – of retirement living. And as we saw above, a retirement lasting that long means you need a nearly perpetual income stream because you can’t risk spending much investment principal – particularly in the early years.
How Traditional Financial Planning Handles The Problem
The way traditional financial planners deal with longevity is to use standard life expectancy tables to guesstimate how long you should live. Conservative planners might add five to ten years to those figures if your family health history indicates above average lifespan or they might subtract a few years if your personal health issues indicate a shorter than expected lifespan. The implied assumption is your personal lifespan can be meaningfully predicted using actuarial tables. Unfortunately, that assumption is false.
Standard life expectancy tables are statistically valid only when applied to large groups of people such as with insurance companies and Social Security. You are no more likely to die at your average life expectancy than any year before or after that date. The lifespan of any one person is not a probabilistic outcome and cannot be predicted with any accuracy. In other words, the whole exercise in planning retirement based on statistical life expectancy is completely meaningless.
The reality is half the people will live less than the average and half the people will live longer than the average. You certainly want to be in the second half, but if you budget your retirement based on standard life expectancy tables you could run out of money long before you run out of life.
One proposed solution is to use life expectancy calculators. They take the standard expectancy tables a step further by adding a few personal factors into the analysis. They ask for information about your lifestyle, family history, education, career, and personality type to come up with an age that you can expect to live to. While this is a slight improvement, it is still not a viable solution. Your date with destiny is not a statistical event.
The unfortunate truth is nobody can know with any confidence how long they will live. No individual’s lifespan is a probabilistic outcome. You might die tomorrow or live to age 102 – nobody knows. Traditional retirement planning might try to put a pretty face on this problem by using various forms of pseudo-science, but in the end the truth is undeniable. Your lifespan is completely unknown and unpredictable. It is not a probabilistic event because no individual’s lifespan can be probabilistically determined.
Potential Retirement Planning Solutions
If longevity is increasing and your actual lifespan is completely unknowable and unpredictable, then the only prudent solution is to plan your retirement for a very long lifespan unless health concerns or family history indicate otherwise. 100 years or more is not out of the realm of possibility. The only danger of erring to the long side is that you leave a nice inheritance to your heirs, but the risk of not planning for a long life is running out of money when you need it most – which is not acceptable.
This presents a problem. The amount of savings needed to finance very long retirements is much larger than traditional financial planning and many online retirement calculators might estimate. It takes a lot more retirement savings to fund a nearly perpetual retirement income than to fund 15-20 years where you can spend investment principal safely.
One potential solution offered by some financial planners is to recommend fixed annuities with inflation adjusted income provisions so that you have a base of financial support you can never outlive. Alternatively, it is becoming more common for advisors to increase a retiree’s investment allocation to equities in an attempt to provide long-term growth that will offset the ravages of inflation and longer life expectancy. The problem with this potential solution is it increases investment risk which may not be acceptable to some retirees.
Another strategy that helps assure you have enough money during retirement but allows you to spend a pre-determined amount of investment principal is to plan on living to a fixed age like 95 in your fully-paid-for home. Assuming your savings dies at 95 but you keep living, you can then place a reverse mortgage on your house to harvest additional funds or sell the house if needed. Either way, it provides you with an emergency source of funds if you outlive your assets.
Finally, another potential solution is to invest some portion of your retirement savings in income producing real estate financed with mortgages that are fully paid for prior to beginning retirement. This strategy should produce a secure source of income you can never outlive that will also grow with inflation over time.
Any way you look at it, planning for retirement is more challenging when the amount of principal you can spend from your savings is severely limited due to longer life expectancy. Solutions exist, but they are not the traditional investment strategies practiced by most retirees.
In Summary
Increasing life expectancy will play an increasingly important role in future retirement planning. Greater savings and non-traditional investment strategies will be required to counter-balance the long-term effects of inflation and greater life-spans. Actuarial tables are dangerously misleading tools that can cause a retiree to severely underestimate life expectancy and the amount of money needed to retire. Finally, budgeting means you can’t afford to spend principal from savings because longer life expectancy requires a nearly perpetual income stream so that you don’t outlive your savings.
You only get one life and one retirement. There is no second chance to recover from bad decisions so it is wise to build your plan using conservative assumptions that assure your financial security. It isn’t the easy path because it increases your savings burden – but it is the prudent thing to do.
About the Author:
Todd R. Tresidder wrote the book, How Much Money Do I Need to Retire? simplifying advanced concepts in retirement planning so that you can learn how to retire with financial security. He lives in Reno, Nevada with his wife and two children where he provides retirement coaching services and publishes educational articles about retirement planning.
