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Investors Should Add 5-8 Year ‘Cushion’ to Retirement Plan: Morningstar

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Woman's face, one side young, other side old (Photo: Shutterstock)

While people who have planned for retirement may think they’ve got their futures pretty well taken care of, a new study by Morningstar Investment Management finds that investors frequently underestimate the number of years they likely have left and may fail to plan accordingly.

While a number of variables such as gender, income, household health and smoking status factor into how long someone is likely to live, the detailed study “Estimating ‘The End’ of Retirement” finds that even those who feel they’ll be around for 20 or 30 years after retirement may be underestimating their own longevity — and thus not funding their golden years appropriately.       

The study finds that individuals would benefit by adding an extra five years to their expected lifespan, while couples — who must take into account that one partner may well survive the other — should plan for an extra eight years. 

The report also noted that financial planners, who are likely to counsel more affluent (and longer-lived) individuals, are themselves disposed to use varying means to estimate how long their clients will live and their consequent income needs.

“There is no consensus approach to estimating the length of retirement among financial planners, even if the decision is based on the same underlying mortality rates (or life tables),” the report said. “Some planners are going to use more conservative assumptions than others, for a variety of reasons.”

It noted that individuals who estimated that they had no chance of living to 75 actually had about a 50% chance of reaching that age; on the other hand, respondents who said their odds of reaching 75 were 100% actually only had about an 80% chance. 

The report also said standard retirement plans routinely estimate end of life ages at 90 — as do about 70% — or 95, as reflected in 20% of such plans.

“In theory, retirement periods should be personalized for each client in a financial plan, based on that client’s facts and circumstances, considering various attributes such as years until retirement, income, health status, smoker status, and so on,” wrote the report’s author, David Blanchett, the head of retirement research for Morningstar’s Investment Management group.

“Through simulations it is determined that adding five years to the life expectancy estimate for a single household, and eight years to the longest life expectancy of either member of a joint household (or to each member if separate end ages are used for spouses), at the assumed retirement age, is a reasonable approach to approximating the retirement period,” wrote Blanchett. 

“While more complex approaches that consider the distribution of mortality would be more robust, such as modeling survival stochastically, these techniques are uncommon in planning tools today,” the report said. “These models suggest a retirement period last lasting to age 95 (that is, 30 years) would be appropriate for the average 65-year-old male/female couple retiring today.”

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The report also points to oft-noted trends showing that life expectancies continue to increase or “improve,” and that women are statistically more likely to outlive men.  

“For example, the average life expectancy for a 65-year-old male in 1940 was 11.9 years, versus 18.1 years in 2018, and is projected to increase to 20.2 years by 2050,” it said. 

A newborn female in the United States, meanwhile, has a life expectancy five years longer than a male newborn, according to figures compiled by the Social Security Administration. 

“Ignoring mortality improvements can result in underestimating the potential length of retirement, especially for younger individuals (who are further from retirement),” the report said. “For example, a 1% annual improvement in mortality rates can result in a retirement period that is three years longer for someone who is retiring in 40 years (currently 25 years old), versus someone retiring today.”

A number of tools are available to estimate an individual’s retirement his or her age, the report noted, offering “two important reasons these estimates might need to be adjusted when forecasting how long retirement might last in a financial plan.

“First, the retirement period should typically be determined by assuming that the probability of surviving to retirement is 100%,” it said. “While it is certainly possible that an individual may die before retiring, this outcome should not jointly be considered when assessing how long retirement may last (and how much it may cost). Therefore, mortality estimates should be based on the age (or year) of assumed retirement, not today. “

“Second, while life expectancy is a useful metric when estimating how long someone may survive, on average, there is approximately a 50% probability the individual will survive beyond the period. Therefore, even if the individual has a 100% probability of accomplishing their retirement goal to life expectancy, the actual probability of accomplishing the retirement is not 100% because he or she may live longer than expected.”

The report suggested retirement planners instead “consider the probability of surviving to various ages and selecting some period longer than life expectancy to ensure a cushion will exist should the individual survive longer than average.”

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