Trent Hamm* says most people only plan to live till they’re 80, but there’s a risk they could outlive their savings and explains how to set a financial plan with this in mind.
Most of us are familiar with the idea of mortality risk. It’s the risk that we die earlier than expected, perhaps leaving behind people that we need to care for.
The solution for taking care of that risk is pretty well known, too: life insurance.
Buying a term life insurance policy covering enough years until the worst of that risk is over ensures that even if you do pass away before you expect to, your loved ones are cared for.
The opposite problem is much trickier, though. How do you handle longevity risk?
What’s longevity risk?
Longevity risk simply means the risk that you’re going to live much longer than you plan to.
Most of us plan for the future as though we will have an average human lifespan — 75 to 80 years — or maybe a bit longer.
Very few of us expect to live deep into our 90s and beyond.
How do we plan for that? When you plan to live 20 to 25 years after retirement, what should you do if you live longer than what you budgeted and saved for retirement?
How to manage and approach longevity risk
Don’t worry about it, keep working and rely on family
This is the strategy that many people follow when it comes to this type of risk. They simply don’t worry about it.
The solution to people in this situation is to continue to work until the end of their lives, only retiring if they are truly unable to work in some capacity.
In other words, their plan for longevity risk is to simply keep working.
Obviously, this plan has some potential flaws.
As you grow older, your physical capacity gradually declines, shutting you out of some jobs and reducing your employment opportunities.
The older you get, the more prevalent this becomes, until it becomes difficult to find employment.
If someone lives an exceptionally long life and has children, they may end up becoming reliant on those children for care very late in life.
This aspect of the plan relies on the health of the children as well as a sustained good relationship with them.
Save for retirement, then spend carefully when you get there
Roughly half of Americans have at least some money saved for retirement when they reach retirement age, according to data from Bloomberg.
This allows them to have some additional assets beyond their Social Security checks when they choose to retire.
If you have retirement savings and intend to use that to help with longevity risk, you should approach spending that money in a way so that it never runs out, keeping your annual withdrawal rate at three per cent or lower.
If you withdraw only three per cent of the balance each year and it is suitably diversified, your money should never run out.
Coupled with Social Security, that can provide enough money for many people to live a reasonably comfortable life for the rest of their years.
The big problem with this approach is that whenever you do die, you leave behind quite a bit of money that you worked for but never used.
You invested life energy into accumulating wealth and never used it during your life.
Sure, it will pass on to the beneficiaries of your estate plan, but that occurs on the timetable of your life, not when it would most benefit them.
Save for retirement, then buy an annuity
Another option is to save for retirement and use most of or all of your retirement to buy a lifetime annuity.
A lifetime annuity is a policy you purchase from an insurance company for a big lump sum payment, then for the rest of your life, that insurance company mails you a check no matter how long you live.
Whether you die at 58 or at 98, the checks keep coming until then.
Annuities are available for couples as well, providing coverage that lasts as long as one of you is alive, or gives a somewhat reduced benefit once there’s just one of you left.
Obviously, insurance companies are in this to make money, and that means that they calculate how long they expect you to live and price the annuity such that they will make a profit unless you significantly exceed that calculation.
Of course, you don’t have to spend all of your retirement savings on an annuity.
Rather, you could just buy one large enough to provide a healthy income for you for the rest of your years and hold on to the rest to distribute to family members or to charities as you see fit over your remaining years.
The biggest drawback with an annuity is that unless you live significantly past the average expected age, it’s not a good investment.
It only starts to really work out in your favour if you have above average longevity.
Use a reverse mortgage
A reverse mortgage is essentially an annuity, a version of the above plan, except that you’re using the value of your house as the basis for that annuity.
You essentially sell your home to an insurance company and the proceeds of that sale are used to buy an annuity.
You retain the right to live in that home for the rest of your years rent-free, at which point the home fully becomes the property of the insurer, and it’s sold to recoup the money.
The drawback here is that the insurer often provides a rather low estimate of your home value when buying it from you, often significantly below market value.
However, if you were to directly sell your home and buy an annuity, you’d still need a place to live.
Another issue is that, late in life, you may no longer want to live in that home because it no longer works well for your needs.
Upon moving out, you’ve still got the annuity, but you need to find another place to live out-of-pocket and you don’t have the equity in the home to help you find new housing.
Unless you live in a home that’s very well set up for you in a period of declining health, you may want to pass on this option.
However, if you live in a home that is well suited for you for the rest of your years, a reverse mortgage is worth considering.
Cohabitation
A final option is to simply live in a multigenerational home where you contribute to the home’s finances and your children and perhaps grandchildren help provide for your care later in life.
This arrangement varies greatly among families, but it often involves the parents helping the children to purchase a suitable house for everyone involved and then contributing to the ongoing expenses of that house from their Social Security and other income.
This is a good plan if you have family members who are engaged with this plan and willing to do it.
In other words, it hinges heavily on having children with whom you have a strong relationship.
Without that strong relationship, a plan like this doesn’t work.
It helps greatly if your culture naturally involves this type of continued parent/child relationship, but it is often not the standard culture in the United States.
Before banking on this, you need to be very confident that this plan will be acceptable to your children because if it is not, there will be a hard road ahead for you.
*Trent Hamm is the Founder of The Simple Dollar.
This article first appeared at thesimpledollar.com
