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Worried About Outliving Your Assets?

Longer Lifespans Increase the Risk of Outliving Your Money

By Fred Yager
ConsumerAffairs.com

October 30, 2006

Annuities • Annuities: Fools' Gold or Fiscal Smarts? • AARP Launches Annuity Program for its Members • Worried About Outliving Your Assets? You Should Be • Longevity Insurance: OK If You Live Long Enough --- • California Shuts Down Annuity Sales Scam • Minnesota Sues Another Annuity Insurer • North Carolina Shuts Down Living Trust Scheme • Illinois Sues Annuity Salesmen for Using Deceptive Mailers • Senior Investment Fraud Increases as Population Ages • California Sues "Living Trust Mill" • Merrill Lynch to Pay $10 Million in New Jersey Settlement • Pennsylvania Sues Living Trust Scheme • Consumer Complaints about Annuities

This is one of those "good news, bad news" stories. The good news is that overall we're living longer. The bad news is that some of us are going to run out of money before we die.

This is increasingly becoming a concern for baby boomers just entering their retirement years. In fact, there's even a financial term for it -- "longevity risk" and it refers to the risk of outliving our money.

You have to figure that if the finance experts have a name for a problem, then they probably also have a solution. Recently, a pair of investment gurus were awarded a patent for inventing a system that directly addresses the challenge of outliving our assets.

Moshe Milevsky, from York University in Toronto and Peng Chen, president of the investment advisory company Ibbotson Associates were issued U.S. Patent 7,120,01 for coming up with a system that takes longevity risk into account when recommending investment strategies to those looking to finance their retirement.

The system considers three basic risk assessments when making asset and product allocation decisions in retirement:

• financial market risk,
• inflation risk, and
• longevity risk.

This model integrates all of these risks and provides a solution to help investors have a comfortable retirement.

How It Works

Here's more or less how the Milevsky-Chen invention works. Keep in mind the goal is to provide retirement income while hedging longevity and financial risk. It's sort of like your own personal hedge fund that includes a hedge against a long and healthy life.

The first thing you have to consider is how to manage your financial risk. One of the best ways to do that is through diversification and asset allocation -- not keeping all your eggs in one basket. That way you spread the risk around.

Here's where it gets a little tricky: If you diversify a lot and minimize the risk too much, your money is going to be safer but it's not likely to grow much either. So you need to keep enough risk in your investment portfolio to grow your money at a rate that will cover what you have to live on.

Putting it another way, stocks tend to be riskier than bonds but also offer great growth potential, so in most cases you want to make sure you put more of your money into stocks than bonds.

Next is dealing with longevity risk. One way to do that is to do what insurance companies do. They spread the risk of living a long time across a pool of assets to come up with an annuity, which will pay you so much income annually for each year of your life.

Milevsky and Chen figured out that by combining an annuity with an investment portfolio, you can at least lower the probability of running out of money before you die.

Annuities Aren't Cheap

Where does the money to buy that annuity come from? It comes from your assets. The key question is how much then do you need to purchase an annuity that provides an income that lasts a lifetime, or at least your lifetime?

That depends on a number of things. Do you want to leave an inheritance or are you, as they say, taking it all with you? Are you wealthy enough that you don't even have to worry about money? If that's the case, then why are you even reading this article? Do you expect to live a long time? Don't we all? And finally, how much does the annuity cost?

You may have to buy the annuity from an insurance company, and they don't give them away. There are costs involved.

According to the Employee Benefit Research Institute, today's workers can expect to receive only one-third of their retirement income from Social Security and traditional company pension plans. That means the bulk of your retirement money has to come from somewhere else and that somewhere else is personal savings, unless you're planning on winning the Australia lottery or getting money from a Nigerian prince.

So how much do you need to save by the time you retire? There are a lot of "guestimates" but the low end number seems to be around $450,000. Anything lower than that and it becomes a real struggle. To live really comfortably, you need close to $1 million in savings.

Let's say you were smart and by the time you and your spouse retired at age 65, you've saved $1 million. To cover living expenses beyond what you get from Social Security and pensions you'll still need an extra $50,000 a year to live comfortably.

So what do you do? You could invest that $1 million into a portfolio of 60 percent stocks and 40 percent bonds. Unfortunately, if that's all you do, there's a 10 percent chance you'll run out of money by the time you reach age 84, a 25 percent chance by age 87, a 50 percent chance by age 92.

If you live to a 100, there's a 90 percent chance you'll be broke before you die. You may think that by that time you won't care but don't count on it.

Now, let's use the Milevsky-Chen model. You would take $400,000 of that money and buy an annuity or maybe even a mix of annuities. This model provides for a combination that includes a portfolio of stocks and bonds and fixed and variable annuities.

It is this combination that hedges the longevity risk as well as any financial market risk. In fact, if you follow the Chen and Milvesky system there's only a 10 percent chance of running out of money at age 92.

Longevity Insurance

Insurance companies have started coming up with policies to address this issue as well. You can now buy something called "longevity insurance." For example, MetLife has a retirement income insurance policy that for $30,000 would pay a 65-year-old male retiree lifetime monthly payments of $2,200, or $1,250 with a death benefit, starting at age 85.

The main drawback here is that you have to live to 85 to reap the benefits. As I said before, they just don't give it away.

Best thing you can do to prepare for retirement is to start saving as early as possible. If you're already a boomer and you haven't put away $500,000 in savings, you may have to take other action, such as selling your house and moving to a less expensive location or getting a reverse mortgage.

The Milevsky-Chen model may not work for everyone, but then nothing does. At least they're taking the issue of "longevity risk" seriously, and you should too.

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