The value of expecting the unexpected

Picture this: you’re packing for a five-day vacation. You check the weather report, consider your itinerary and decide to pack a small carry-on suitcase. Easy enough — but what if you didn’t know how long your trip was going to last? Or what type of weather or activities you might encounter? Would you stick with a small suitcase of essentials or would you break out a bigger suitcase in order to pack more options? In this situation, I imagine most of us would prefer to be over-prepared in the face of uncertainty. So why can it be so hard to apply this logic to other areas of uncertainty — such as investing for retirement?

The unknown variables of retirement investing

There are at least two elements of the retirement planning equation that are fundamentally uncertain: market movements and the investor’s length of life. As an industry, we’ve developed tools and strategies to help anticipate investment opportunities and mitigate risks. But when it comes to estimating longevity, we face several challenges:

• No one can see the future (or if you can, please let me know).
• There are no perfect tools to predict longevity.
• Investors tend to underestimate their life expectancy.¹
• Many investors prefer to dramatically dial down investment risk once they reach retirement, potentially limiting growth opportunities during what could be a lengthy period of their lives.

Going back to our suitcase analogy, the risks of financially “under-packing” and even “over-packing” for retirement can be severe, leading a client to run out of money too soon or significantly reduce their quality of life when they didn’t need to. So what do you do? In my conversations with advisors, there seems to be a short list of methods of estimating longevity for financial planning:

• The “Pick a number” approach
• The “Dust off the actuarial table” approach
• The “Break out the calculator” approach

Some advisors “pick a number” for projected life expectancy that represents a conservative estimate — perhaps age 90 or 95. Over time, they will likely adjust that number based on information about health and family history gleaned from planning conversations. Some advisors refer to actuarial tables, which represent the probability of a person's death before their next birthday, based on their age. But these “mortality tables” are primarily beneficial in situations where pooling a large set of data to find a probability is useful — such as in determining annuity values or pension plan projections. For an individual investor, this information simply can’t accurately reflect personal circumstances and risk tolerance or the myriad influences on length of life. That’s where “longevity calculators” come in. In recent years, a variety of tools have sprouted up claiming to offer a better estimate of life expectancy based on information entered in a questionnaire format. Consider this example, based on a colleague of mine who filled out several longevity-predicting calculators available online:

Longevity tool2	Number of questions	Projected life expectancy
A	12	90
B	2	85.6
C	14	93
D	9	82.2
E	23	91.6
F	7	78.2

This information is provided for illustrative purposes only.

As you can see, the results of these tools vary widely. Going by these estimates, Amanda can expect to live between 78.2 and 93 years. If Amanda retires at 65, she is likely to find the difference between a 13-year retirement and a 28-year retirement financially significant.

The power of growth in retirement

In the absence of a perfect tool to predict longevity, I believe we have to add a fourth method to the list above: The “If you don’t know, you gotta grow” approach. In retirement planning, one of the ways you can potentially create a "bigger suitcase" of sustainable income is by not backing away from growth strategies in retirement — and yes, that requires some investment risk.

Many of your clients might be surprised to know that according to Russell Investments’ 15/35/50 Retirement Lifestyle Rule, 50% of an individual investor’s retirement income is likely to come from investment growth after retirement. That means that if a newly retired investor shifts their portfolio to a very conservative mix of fixed income strategies and cash, they may miss substantive growth opportunities that could help support their lifestyle in retirement.

But how much investment risk is the “right” level of risk? At Russell Investments, we believe that understanding each investor’s ability to accept market risk and generating a sustainable stream of retirement income requires careful consideration of the investor’s assets and future liabilities, or what we call the Personal Funded Ratio. Developing more customized retirement income projections for clients can help balance investment risk with longevity risk — or the risk of running out of money before they run out of life.

So in your next planning conversations, help your clients see that the length of their retirement journey may be unavoidably uncertain. But that doesn’t have to be a source of stress if they are “packed” appropriately.

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¹ Source: Society of Actuaries 2011 Risks and Process of Retirement Survey Report.

² Sources:

Tool A: Life Expectancy Calculator: http://www.confused.com/life-insurance/life-expectancy-calculator

Tool B: Life Expectancy Calculator: https://www.ssa.gov/OACT/population/longevity.html

Tool C: Abaris Life Expectancy Calculator: https://www.myabaris.com/tools/life-expectancy-calculator-how-long-will-i-live/

Tool D: Calculate Life Expectancy and More: http://www.bankrate.com/calculators/retirement/life-age-expectancy-calculator.aspx

Tool E: Project Big Life: Life Report https://www.projectbiglife.ca/life/results.php

Tool F: The Death Clock Calculator: http://www.death-clock.org