Retirement plans based on age of death are risky

August 12, 2007|By Janet Kidd Stewart

Inflexibility can be deadly to a portfolio.

Setting up a retirement income plan based on a single age of death - whether it is average life expectancy or some other number - is one of the biggest mistakes savers make.

It's also quite common. The myriad retirement planning calculators available through advisers and the Internet offer sophisticated simulation technologies that run portfolios through thousands of market scenarios, providing investors with a confidence level that their money will last until a specific age.

But what if you live longer than that? Missing it by just a few years can be devastating to a portfolio, said Christopher Raham, senior actuarial adviser for Ernst & Young. That's because most simulators plan for many market situations, but only provide a confidence level to the precise age. After that, the slope of expected returns drops off sharply, leaving much less confidence that the portfolio will still be standing.

The result is that some retirees spend too much and outlive their savings, while others, fearing that fate, postpone rewards until it's too late to enjoy them.

"Using life expectancy as a benchmark creates a false sense of security" in retirement, Raham said.

As 65 approaches, if market conditions or unexpected savings levels make it clear you won't be able to hit your lump-sum goal to provide the desired income levels in retirement, you often can delay retirement and work a few extra years.

But in the spend-down phase of retirement, Raham points out, it's far more difficult to take corrective action.

Can't a worker simply add a decade or so to the life expectancy number and build in a cushion in case something goes wrong?

Not so easy, Raham said.

"When you plan to age 100, for example, you need so much money it isn't realistic, or you have a very depressed level of spending," he said.

With the baby boom generation bearing down on retirement, several investment firms are working on new computer calculators that will apply so-called Monte Carlo simulation strategies on age as well as market returns.

So a couple would be able to see how their portfolio might sustain decades of market performance, while also factoring in many different scenarios for how long each spouse lives.

Richard J. Lindsay, senior vice president for the annuities division of Symetra Financial Corp. in Bellevue, Wash., wrote a report on different retirement planning uses for Monte Carlo simulations when he was with another firm.

Using the simulations to show how a portfolio could run out with only a few more years of life than planned startled clients into not pushing withdrawal rates to their limit, Lindsay said.

"It opened their eyes like nothing else did," he said, noting that retirement plan participants who had been counseled about longevity risk saved at much higher rates than those who hadn't.

Until this virtual retirement plan is widely available to retail investors, however, what can be done?

One lower-tech strategy would be to run several traditional calculators, using the same portfolio and withdrawal strategies but a different age at death for each one. For example, according to the free calculator at the Web site of investment firm T. Rowe Price (, a 65-year-old worker retiring with $500,000 who wants to be able to withdraw $25,000 a year will be fine if he dies by age 85.

If he lives just five years longer to age 90, however, the simulation no longer gives a 90 percent confidence level that the portfolio will last.

(The example assumes a portfolio that is invested in 60 percent stocks and 40 percent bonds and cash.)

The point of trying these different scenarios is simply to drive home with investors the effect even small differences in spending levels will have on retirement assets, Raham said.

"At retirement, you're trying to find a safe spending amount with the basket of assets you have," he said. "If you blindly use life expectancy [and a static withdrawal rate], there's a good chance you'll overspend" because of the possibility of exceeding that age.

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