People are living longer today than ever before, which is music to some people’s ears, as it provides more time with loved ones and the ability to have more and varied experiences. However, living longer poses an unanticipated risk — the possibility of outliving your money.
According to the World Bank, the average life expectancy for a person born in the U.S. in 2015 was nearly 79 years, compared with 75 years in 1995. In 2015, there were 72,000 centenarians living in the U.S., and this figure is expected to surpass 370,000 by 2050.
In addition to more Americans living longer, the population growth is slowing, resulting in an older America. This shift in demographics will have ripple effects for financial advisors and the U.S. economy.
Confronting potentially tepid economic growth and preserving retirement savings will be future obstacles for financial advisors. According to the Economic Policy Institute, the current level of retirement savings is alarmingly low, with the average retirement savings for all U.S. families just north of $95,000, and half of working-age families having nothing saved for retirement.
It is imperative that clients have clear goals and priorities in place, so financial advisors have solid targets to aim for. Once the goals are in place, investment portfolios can be constructed to achieve the income requirements, which is easier said than done, as key decisions lie ahead.
For example, a retired couple in their early 70s has saved $1 million. They strive to enjoy their lives to the fullest, but wish to pass at least $500,000 in today’s terms (inflated at 2.25%) to their heirs. With these requirements in hand, we now can formulate a portfolio to achieve these goals.
In Figure 1, we show a moderately conservative portfolio (40/60) that includes real estate investment trusts. Based on the index returns and standard deviations from the past 15 years, this portfolio has an expected annualized return of 6.2% and standard deviation of 7.4%.
Using this return distribution, we can determine if the goals are attainable.
In order to maintain their desired living standard, an annual withdrawal rate of 5% inflated at 2.25% is required. Due to increased longevity, goal number one is in jeopardy, as some of the Monte Carlo simulations show the couple could start going broke in year 24 (Figure 2). Their second goal of leaving money to their heirs is also in question. There is a 36% chance that $974,697 ($500,000 inflated at 2.25%) will be available in 30 years.
For these goals to be more achievable in the face of increased longevity, the couple can either scale back their annual withdrawals to 4% or adjust the portfolio allocation to increase the return distribution. To increase the likelihood of achieving goal No. 2 to 85%, the return requirement increases to 10% while the standard deviation jumps to 14%.
At the end of the day, investors with goals in place shouldn’t worry so much about the path taken to achieve the goals, and just focus on getting there. Standard deviation is nice, but should an investor worry about how far portfolio returns deviate from their mean if they are on track to reaching their goals?
Hedging drawdown risks and black swan events should be emphasized to provide more capital appreciation potential for longer time periods.
Capital preservation statistics such as the pain index, pain ratio and maximum drawdown should be part of every advisor’s key statistics, as well as tail-risk metrics like value at risk, omega, skewness and kurtosis. These statistics provide insight into how a portfolio performs during down markets or rare events.
In Figure 3, we take a closer look at the capital preservation characteristics of the enhanced 40/60 portfolio, a basic 40/60 portfolio and the S&P 500 and Barclays U.S. Aggregate indexes. As you can see, the basic 40/60 portfolio consisting of 40% S&P 500 and 60% Barclays U.S. Aggregate does a better job of preserving capital across the board; however, the return is 80 basis points lower. One must determine if a higher return is worth the additional drawdown risk and which portfolio provides the greatest probability of achieving the long-term goals. Using mean variance optimization tools are critical when trying to determine the return-risk tradeoff.
Obviously, no two portfolios are made the same, and decisions need to be made about which portfolio is best suited for the investment goals and objectives of the client so they can enjoy their extended years. Longevity plays a significant role in this decision-making process, as financial practitioners must understand their clients’ time horizons and what risks might inhibit achieving a goal that is 30 years into the future.