Longevity risk is an essential planning concept that’s misunderstood by advisors and clients alike.
Professor Moshe A. Milevsky of York University kicked off IMCA’s 2015 Advanced Wealth Management Conference by outlining the seven most important retirement equations (talk about giving the people what they want, nothing like some hard math at 8 a.m.!) and how to use them. Among those equations, longevity risk took center stage.
The first important differentiation to make in any discussion of longevity risk is that it isn’t the same as life expectancy, he said. Similar to tracking variance in portfolios, longevity risk is concerned less with the average age of death in any given period and more with the rate of variance from that average. It seeks to establish the level of randomness inherent in determining how long a given client will live into retirement.
He used the stock market as a frame of reference in regards to volatility over a 10-year period. The “volatility of your longevity is at the same order of magnitude as that of the stock market,” Milevsky said.
Unlike the stock market, however longevity risk tends to adhere to a bell curve structure. Although life expectancy has steadily increased, variability has remained fairly steady at 10 – 12 years. Since most clients’ greatest fear is outliving their retirement plan and running out of money later in life, advisors can use the bell curve to identify that the risk of extreme longevity (the far right end) is about 5 percent to 10 percent.
“Extreme longevity is a small probability/high magnitude problem that we should consider insurance for," he said, adding, “lifecycle asset allocations will have to change to include an insurance solution.”
Understanding the basics of longevity risk is just one part of the equation. Communicating these concepts to your clients and assessing their tolerance for certain risks is equally as important.
“Clients underestimate the risk of likely causes of death and overestimate the risk of unlikely ones,” he said, stating that they underplay the danger of factors like heart disease and cancer and are greatly concerned with more fantastical, primarily non-natural ways to die.
In fact, the very way you frame your questions about mortality to your clients can affect their answers. Milevsky described a Duke University survey where retirees were asked “Do you think you’ll live until you’re 85?” Sixty percent of females and 50 percent of males answered yes. When the same group was asked “Do you think you’ll die by 85?” Sixty-five percent of females and 75 percent of males answered yes. That’s a huge turnaround. According to Milevsky, “clients’ own estimates of mean life expectancy are 7.3 – 9.2 years longer if you use positive language when asking the question. Words really do matter.”