How big is longevity risk?

In a defined contribution pension arrangement, individual retirees are subject to both investment risk (i.e., uncertainty about what their investment returns will be) and longevity risk (uncertainty about how long they will live.) But which of these is bigger?

Putting longevity risk into more familiar terms

A fundamental difference between a defined benefit (DB) pension plan and a defined contribution (DC) pension plan is that, with DB, the plan participant generally receives a known income throughout retirement that lasts as long as they do. With DC, the plan participant instead usually has an account balance, and must decide how quickly to draw down that money after retirement. This decision is difficult, because the individual does not know how long they will live, nor what their investment returns will be.

In a new paper, I compare those two sources of uncertainty. It turns out, for example, that for a 65-year-old female retiree, the uncertainty associated with the unknown future life span can be roughly equated to investment volatility of 5.2%. That is less than the volatility of most real-life portfolios. What’s more, the way that the two risks interact means that the combined impact of both forms of uncertainty is only slightly more, in this example, than the impact of investment risk alone.²

However, these results vary significantly at different ages, as shown in the chart above.

So even though investment risk is the dominant risk at younger ages, longevity risk takes on greater significance over time.

Solving the lifetime retirement income challenge

The challenge of converting an account balance into lifetime retirement income is one that is being looked at closely in regulatory circles. The discussion is of interest to several groups: to individuals who need to plan their retirement strategy; to the regulators who would like to facilitate a more effective system; to financial firms who want to offer the best products to meet the needs of this market. The findings above about the relative size of investment risk and longevity risk are relevant to that discussion.

In particular, the purchase of any form of annuity product is both a longevity insurance decision and an investment decision. As such, variable annuity contracts or deferred annuities (such as QLACs) may offer a better fit to the typical retiree’s needs than a traditional fixed annuity contract.

These questions are timely, with the first wave of the DC generation—those facing retirement relying primarily on DC assets—just now reaching retirement age. The retirement income challenge is likely to be a lively topic in the next few years.