A lot of the research on retirement planning assumes a planning horizon of thirty years. Indeed, it was one of the explicit assumptions in Bill Bengen’s 4% rule (which applies to US investors and ignores charges). UK research also tends to make the same assumption.

But we’ve been seeing life expectancy increase over time (and it’s likely to just keep increasing into the future). Which means that you may want to plan for a longer retirement.

How long will your retirement last? The impossibility of answering this question with any long-term accuracy is one of the key challenges of planning a retirement income strategy.

The nature of longevity risk is that we know our life expectancy, but it is based on an average with a large range. Two general approaches exist to deal with this unknown element of longevity:

1. Planning for a fixed retirement duration that is somewhere beyond life expectancy, and
2. Making plans that specifically incorporate mortality rates by age into the calculations.

The former method is the most common, but both approaches have their merits.

Using a Fixed Retirement Duration

Planning for a specific retirement time horizon begins by selecting a duration you are unlikely to outlive, and then developing a plan that covers the entire time. The duration should be greater than life expectancy, as you have a 50% chance of living longer.

In 1994, Bill Bengen considered thirty years to be a reasonable planning horizon for sixty-five-year-old couples, resulting in a planning age of ninety-five. Today however, many people use longer planning ages. We are simply living longer than we did in the past. And it’s very likely that medical advances will continue, meaning that current retirees will benefit from treatments that don’t exist today – meaning that future life expectancy may continue to increase. It’s not uncommon to use a planning age of 100 or 105 to account for these longer lifespans. This means that someone retiring at sixty-five would need to plan for a thirty-five or forty-year horizon.

The assumed retirement duration is important. Cashflow forecasts based on longer time horizons tend to favour:

• Lower withdrawal rates (i.e. the percentage of the value of your retirement savings which you should withdraw every year). If you use Bengen’s approach, extending the retirement duration from 30 to 40 years reduces the amount you can spend in the first year by about 7.5%.
• Higher allocations to shares and other risky assets
• A stronger case for annuities.

The disadvantage of this approach is that it results in your spending less in early retirement, despite the low chance of living to 100. You are less likely to spend all of the money you have saved for retirement.

Using Mortality Rates

Using a long retirement duration is the conservative approach, but you will have less to spend and will most likely leave a larger than planned estate to your beneficiaries. But if you plan for a shorter duration, this could mean you spend too much, and, in the worst case scenario, you could outlive your retirement savings.

Longevity risk is a contingent risk. As we age, our life expectancy actually increases – or more specifically, it decreases slower than we age. So, it is much more likely that a 99 year old will live to be 100 than a 65 year old. Essentially, the 99 year old has not died prior to being 99, whereas the 65 year old still has the possibility of dying before reaching 99.

This means that instead of using a fixed duration, the duration can instead be adjusted during your retirement. So, instead of simply saying that you will use a planning age of 100 or 105, you can start there, and then adjust your duration, based on your personal circumstances. Not only will you be able to adjust your planning horizon based on your changing life expectancy as you age, but you can also incorporate information about your personal health.

I’m not keen on this latter approach, as it means that the amount you can spend changes from year to year, and average life expectancy is only ever an estimate, with a wide range.

Consideration of potential life expectancy is important as it teaches us that it is just as important a risk for retirees as the other risks, such as inflation, taxation and investment risk. It also teaches us that one of the concepts you need to consider when you retire is whether you are more comfortable “front end loading” your retirement spending and running the risk of having to reduce your expenditure later, or “back end loading” and running the risk of not using all of the money you have saved so hard to accumulate whilst you were working.

If you would like to discuss how best to approach your retirement plan, please contact us.

Philip Wise | philip@sussexretirement.co.uk

Managing Director and Chartered Financial Planner

This blog is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.

The Financial Conduct Authority does not regulate Cashflow Planning.