Lesson 6: Longevity Risk

One often reads that at the end of the 20th century, life expectancy in the U.S. hit a record high of approximately 73.6 years for males and 79.2 years for females. These statistics come from the Social Security Administration (SSA) and apply to the U.S. population in its entirety. And, although these numbers have been steadily increasing over time — in the year 1950 the respective values were 65.6 for males and 71.1 for females — one can’t help but wonder why there is all this fuss about financing a long period of retirement. Yes, people are living longer compared to 50 years ago. But, can saving enough money to generate an average of 10 to 15 years of income be that onerous?

Of course, most financial professionals will see through my straw man fallacy and know that these numbers do not apply to their healthier and wealthier clients. More critically, these numbers only apply at birth, not at retirement. Likewise, they do not account for any possible improvements or reductions in future mortality. They are based on today’s death and survival rates.

Either way, if you are a 75-year-old male or female, your life expectancy is much higher than at age zero. In this case, using the same SSA statistics, the numbers are now 84.6 and 86.9, respectively. The headline values — 73.6 and 79.2 — only apply to newborns. As you age and hence survive hazards like infant mortality, teenage accidents, child-bearing years, etc., your conditional life expectancy increases. All this is pretty clear to professionals.

Yet, when talking to individuals who are outside the financial services (or medical) profession, I find that there is pervasive confusion in the public at large regarding what these life expectancy numbers actually mean. If these misunderstandings are left to fester in your clients’ minds, they can lead to behavioral biases that result in underestimates of their retirement income needs, and, consequently, insufficient savings.

Either way, I think that life expectancies and averages are not the best way to explain these ideas. Averages can be deceiving. In fact, there is a silly joke about a statistician who immerses one hand in scalding hot water and the other in freezing ice water, who then declares that the temperature is fine “on average.”

I believe that a better way to think about and explain longevity risk and uncertainty is via actuarial probability tables (such as the one displayed on the next page), as opposed to life expectancy tables.

Here is how to read and interpret the table. If you are a 65-year-old male there is a greater than 45 percent chance that you will live to the age of 85. That would obviously require 20 years of retirement income, if you decide to retire exactly at the age of 65. Likewise, the same 65-year-old male has a 24 percent chance of living to the age of 90, which necessitates 25 years of income. For females the numbers are even higher. A female who is 65 years of age has roughly a 35 percent chance of living to 90. Compare this number to the 24 percent probability for a male and you can see the relative impact and magnitude of female longevity.

And, for those of you struggling with the notion that people have an actuarial mortality rate tattooed into their DNA — which dictates their longevity — a more general way to think about these probabilities is by focusing on ratios and proportions. If you have a large group of male clients who are all 65-years-old, then slightly less than a quarter of them will live to the age of 90. Of course, you can’t know in advance who will be included in that lucky quarter, so to be prudent you want to make sure they all plan for the possibility of 25 years of retirement income.