Taming Longevity Risk

"In spite of the cost of living, it's still popular." Kathleen Norris

These words offered by Kathleen Norris decades ago carry more weight than ever before, particularly within the realm of financial planning and saving for retirement. The evolution of medical technology and advancement of life-extending therapies once referenced only in science fiction movies have significantly magnified the implications of longevity for today's investors. The Society of Actuaries' 2013 investor retirement planning survey reports that 66% of pre-retirees and 41% of retirees surveyed expressed concerns of having enough in savings to adequately support them throughout their retirement years.¹ Other highly ranked concerns include keeping up with inflation and having enough in savings to pay for adequate health care.

Their concerns are valid, especially when we consider that global interest rates are hitting previously unimaginable lows. Some regions now offer negative interest rates (not a typo) accompanied by higher market volatility, geopolitical uncertainty, and continued increases in the cost of living that together create vexing challenges.

Considering our current market environment, financial planning for longevity ought to consider not only the preservation of assets but also liability management. An unexpected and significant liability can impair your investments and savings and prevent you from adequately funding your retirement. While beyond the scope of this article, active review of insurance policies that address property losses, long-term insurance coverage, and longevity funding through use of annuities can fill a gap in hedging these undesired risks.

How concerned are you about each of the following (in retirement)?

Source: Society of Actuaries, Matthew Greenwald & Associates, Inc.

From an asset management perspective, withdrawal rates rank near the top of concerns regarding adequate retirement funding. In the not-so-distant past, investors confidently employed a rule-of-thumb withdrawal rate of 5% to 6% so as not to impair their portfolio principal while providing sufficient funding throughout retirement. However these long-held withdrawal rate assumptions are being questioned within professional and academic financial circles as being potentially too high, inadvertently causing investors to experience a shortfall in their savings.

It is incumbent on pre-retirees and retirees to revisit their budgeting and spending assumptions with regard to updated life expectancy rates to determine whether they are realistic and/or adequate. Larry Zimpleman, chairman and chief executive officer of Principal Financial Group, recently cautioned, "The biggest misconception I see about retirement accounts is that what might seem like a large amount (say $500,000) may well turn out to be insufficient when you take account of increasing life expectancies and the current low level of interest rates."² Given that there is a 50% chance that one or both of members of a couple age 65 today will live to age 90 (meaning they'll spend 25 years in retirement), Zimpleman believes new rules of thumb dictate a combination of lower withdrawal rates (3.5% to 4%) and higher retirement savings balances (in the range of $800,000 to $1 million).

For investors with multiple accounts, the objective is to delay withdrawal from qualified retirement investment accounts as long as possible to retain the benefits of tax deferral as those accounts continue to compound. Retirees should focus on withdrawing from taxable accounts prior to qualified retirement accounts. Of course, this is not always possible. Required minimum distribution rules, otherwise known as RMDs, dictate the timing and amounts of qualified account withdrawals. With the exception of Roth IRAs, account holders must begin receiving distributions at the age of 70½. Ideally one would want to draw from other taxable investment accounts to fund living expenses while withdrawing only the required minimum from qualified accounts. It is extremely important that the RMD withdrawals are met as scheduled else you may face potential tax penalties of 50%. Under such circumstances it is advisable to seek individual tax guidance.

If you currently hold your former employer's publicly traded stock in your qualified retirement account, you'll want to examine the rules associated with net unrealized appreciation (NUA) as an alternative means of reducing your tax on withdrawals. The benefit of an NUA is that proceeds from the sale of such stock are treated as a long-term taxable gain rather than a withdrawal taxed at your (typically) higher income tax rate.

Suppose, for example, that you worked at a company that offered stock currently valued at $100,000. Further suppose that your cost basis is $25,000 based on purchases made many years ago and that your current taxable income rate is 35%. Lastly, under this hypothetical example you decide to withdraw the entire $100,000 from your account. Under an NUA-specified withdrawal your taxable liability would be $15,000, a 20% long-term tax assessed against the long-term gain of $75,000, versus a $26,250 tax based on your current tax rate of 35%. This, too, may require the assistance of a qualified tax advisor, because if done incorrectly it cannot be reversed.

In addition to tax management, it is also important to consider when to tap your Social Security benefits. The longer you can defer benefits the better, because each year you delay your benefits Uncle Sam will increase your annual payments by approximately 8%. When you consider the current low interest rate environment, an 8% annual increase guaranteed by the US government warrants merit.

Let's examine a hypothetical scenario. If you were born in 1960, your full retirement age (FRA) is 67, with partial retirement benefits available as early as 62 (at 70% of your monthly FRA benefit). If, however, you defer your Social Security benefit payments until age 71, you could expect to receive approximately 130% of your FRA monthly benefit.³ Alternatively, you could begin taking Social Security payments earlier and invest them, thereby creating an additional savings pool. Ultimately, circumstances regarding your health, family longevity characteristics, retirement plans, gift planning, and other personal factors will determine whether and/or how long you can defer benefits. Professional services offered by a Certified Financial Planner® along with resources provided by the Social Security Administration can assist the decision process.

Another area that can affect your retirement savings pool is asset allocation, which refers to your proportional exposure to bonds, stocks, real estate, and other investment assets. If done appropriately, your asset allocation reflects your risk tolerance and is structured to accomodate your individual investment time horizon, liquidity needs, tax considerations, and desired long-term rate of return. Historically, investors employed a simple meme to assist in their asset allocation by subtracting their age from 100 and using this as a proxy for stock allocation. For example, a 65-year-old male investor would allocate 35% of his investments to stocks (100 – 65 = 35). The problem is that according to Social Security life expectancy tables, that same 65-year-old man with an average health profile can be expected to live to age 84. This leaves him with another 20 years predominantly exposed to fixed income investments that are not structured to grow income during his retirement years. It is important to point out that these are just averages. About one out of every four 65-year-olds today will live past age 90, and one out of 10 will live past age 95.4

A Forbes Magazine article catchily titled "Americans Clueless About Life Expectancy, Bungling Retirement Planning" adeptly points out "once folks get the notion that half of the people will outlive the average life expectancy of their age group...they need to revisit their financial planning time horizon."5 Ultimately this may be another instance of conventional wisdom gone obsolete. The combination of a lower interest rate environment and longer life expectancies leading to longer investment time horizons may require higher exposure to investment assets that offer greater income potential through growth than fixed income-producing assets. Such a substitution may include dividend-paying stocks with the potential to increase income over time.

Retirement planning is a continuous process that does not end on the date of your retirement. The earlier you can begin, the better chance you have of achieving the retirement lifestyle you hope for. Active planning and careful, regular reviews of your asset allocation, tax considerations, and Social Security strategy can improve the likelihood that that your proverbial golden years are enjoyed to the fullest extent.


¹ 2013 Risks and Process of Retirement Survey Report of Findings. Society of Actuaries, December 2013. Figure 163: Issues of Concern, page 94. https://www.soa.org/files/research/projects/research-2013-retirement-survey.pdf

² Common Retirement-Account Misconceptions. At A Glance Blog, January 1, 2015. WSJ.com. http://blogs.wsj.com/briefly/2015/01/01/common-retirement-account-misconceptions-at-a-glance

³ Social Security Administration. When To Start Receiving Retirement Benefits. http://www.socialsecurity.gov/pubs/EN-05-10147.pdf

4 Social Security Administration Life Expectancy Calculator. http://www.ssa.gov/planners/lifeexpectancy.html

5 Ebeling, Ashlea. Americans Clueless About Life Expectancy, Bungling Retirement Planning. Forbes, August 10, 2012. http://www.forbes.com/sites/ashleaebeling/2012/08/10/americans-clueless-about-life-expectancy-bungling-retirement-planning/

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Copyright 2015 Saturna Capital Corporation and/or its affiliates. All rights reserved. Vol. 9 · No. 3

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