The investment world contains different types of risk. Stocks or stock-based mutual funds could lose value during periods of market volatility. The price of bonds or bond funds could also decline, if new bonds are issued at higher interest rates. But most people never consider longevity risk.
Insurance companies and pension funds view longevity risk as the risk they incur when their assumptions about life expectancies and mortality rates are incorrect, leading to higher payout levels. But for an individual investor, longevity risk is less technical and more emotional: it is the risk of outliving your money.
To assess your longevity risk, you need to make an educated guess about your life span, based on health and family history. Plus, consider these statistics: Women who turned 65 in April of this year can expect to live, on average, until age 86.5; for men, the corresponding figure is 84, according to the Social Security Administration.
With a reasonable estimate of the number of years that lie ahead, there are steps to take which can reduce your longevity risk. For starters, try to build your financial resources as much as possible, because the greater the level of assets, the lower the risk of outliving them. So, during working years, keep contributing to IRA and 401(k) or similar employer-sponsored retirement plan.
As retirement nears, more planning is needed. Specifically, compare your essential living expenses – mortgage/rent, utilities, food, clothing, etc. – with the amount of income received from guaranteed sources, such as Social Security or pensions. There is some flexibility with this guaranteed income pool. For example, if Social Security benefits are received as early as 62, the amount of the monthly checks will be reduced by about 30 percent from the amount you would get if you waited until full retirement age, which is likely between 66 and 67.
It is also good to consider other investments that can provide a steady income stream. A financial professional can help you decide the income-producing investments that are appropriate and that fit well with the rest of your portfolio.
After determining that your guaranteed income will be sufficient to meet your essential living expenses, have you eliminated longevity risk? Not necessarily – because “essential” expenses don’t include unexpected costs, of which there may be many, such as costly home maintenance, auto repairs and so on. And retirees always need to be aware of health care costs. Having to dip into your guaranteed income sources to pay for these types of bills, might increase the risk of outliving your money.
To avoid this scenario, think about establishing a separate emergency fund, containing approximately at least a year’s worth of living expenses, with the money held in cash or cash equivalents. This money won’t grow much, if at all, but it will be there if needed.
Careful planning, adequate guaranteed income, a sufficient emergency fund and enough other investments to handle nonessential costs, can help to reduce your own longevity risk. And that may lead to a more enjoyable retirement.
This article is printed with permission of Edward Jones.
Ed Doyle operates the Gorham branch office of Edward Jones. He is experienced in all aspects of financial planning, retirement income planning, tax-advantaged education savings plans.