Saving for retirement is a challenge for various reasons. For one, it is difficult to balance meeting near-term and intermediate goals and saving for retirement, which may be years away. Two, how much you save for retirement is a function of your life expectancy, which is uncertain.

In this article, we address the risks associated with your life expectancy and post-retirement living. This risk, called longevity risk, is an increasing concern for retirees. We discuss the reason for this concern and how to moderate longevity risk.

Longevity risk
You depend primarily on passive income to sustain your post-retirement lifestyle. Passive income refers to income that you earn from your investments, including rentals and other income such as royalty payments. The question is: What if you are unable to meet your living expenses with your passive income because you are spending more or because of higher-than-expected inflation?

You may have to withdraw money from your investment capital to sustain your lifestyle. But continuous withdrawal may wipe out your account.

So, the risk that you face at retirement is that you do not know whether the money you have in your retirement account is enough to last till you live. This risk is called longevity risk. It refers to the risk that you will outlive your investments during your retirement.

Why should you be concerned about this risk? Improvement in medical technology has reportedly increased life expectancy. At the same time, increased stress from modern-day living has led to deterioration in health among young professionals.

Together, these two factors could mean you could either live longer-than-expected with poor health or you could have a long life without major health issues. In the former case, you need more money to fund your healthcare costs and living costs for a longer period of time.

In the latter case, your concern is primarily to have enough money to sustain a long post-retirement living. Either way, the complexity of modern-day living makes it difficult for you to determine your life expectancy. This poses a problem. Why?

You may stay within your monthly budget and still run out of money because you are living longer than expected. Or you could practice frugal living in your early retirement years, not live longer-than-expected and, hence, leave unintentional wealth to your heirs! So, how can you behaviourally reconcile these conflicting factors?

Time buckets
During your working life, you would have taken care of your children’s education costs and, perhaps, even their marriage expenses. In addition, like most parents, you may choose to leave money for your children after your lifetime (intergenerational wealth transfer).

In the light of this factor, divide your post-retirement goals into two.

The first is to sustain your lifestyle from your retirement date till the age of 80 (or such age that is normal for your lifestyle).

The second goal is to provide for contingency intergenerational wealth transfer. That is, at retirement, set aside money that you would like to transfer to your heirs after your lifetime. But this money will be available to your heirs only if you do not survive past 80. If you live longer, you should use this contingency investment to sustain your lifestyle beyond 80.

The residual amount in this account can be left for your heirs after your lifetime. This way, you will have contingency reserve to sustain your lifestyle should you live longer, failing which you intentionally leave money for your heirs.

Newer-generation insurance products could also help you moderate your longevity risk. How? Insurance companies can offer deferred annuity also called longevity insurance — a product that pays you fixed amount from, say, age 80 till you live.

B Venkatesh
This article was published on August 9, 2015, in BusinessLine (The Hindu)