Tubwell Farm, Tubwell Lane, Crowborough, East Sussex, TN6 3RQ
Longevity insurance is an expression which describes making sure that however long you live you have financial arrangements in place to cope.
Maybe think of it this way, your finances may be fine to deal with all your expenditure needs and your lifestyle desires until your are age 85, but you are unsure what happens if you live to 105. Especially if you need expensive healthcare support in your later years.
That circumstance is quite commonplace.
If you can’t see your finances coping with a very long retirement, then, in effect, you don’t have longevity insurance.
Put another way, the very long retirement period, especially if care is required, is a threat (in that circumstance).
So you need longevity insurance.
This is an expression, rather than an actual insurance product (in the States there is a longevity insurance product, but in the UK we use this term to denote how to set out your plans to ensure, as best you can, you don’t run out of money if you live to a very old age).
You cannot call an UK insurance company and get a quote for longevity insurance.
The idea is that you carefully consider the “what if?” of living to 105 and then look at your finances in this light.
If there are doubts or shortfalls or risks of living this long, then you need to work out what you can do about it and plan accordingly.
What can you do to build in longevity insurance to your plans?
There is no magic money tree that will solve this for you. You have to structure your finances based on what you have available.
The longer you stretch this into the future the more difficult this becomes.
If you retire at age 65 and you can see that you should be able to manage your expenditure until you are age 85, but it gets trickier when you look to 105, you really are up against it.
One of the reasons is that you need to be fairly sure at age 65 you have enough, because it is very unlikely at age 85 you can suddenly decide to pivot, for example by re-joining the workforce.
This is why forms of lifetime guaranteed income, such as a state pension or a pension annuity have such great value. Because they just keep paying year after year, however long you live.
This is why at age 65 you cannot accurately compare a non-guaranteed income option/financial product and a guaranteed income option/financial product.
Such comparisons, when assessed, commonly look at their investment/income values. And that may well favour the non-guaranteed option/investment product.
These comparisons tend to ignore “time value” simply preferring to look at their worth in the here and now.
With some form of time value built in, the comparison changes. The problem is it is very difficult to assess this time value, but academics and mathematicians who have applied measurements to this commonly find their conclusions as to what is ‘best value’ differ from some financial experts.
Another way to think about all of this is to work out what you are comfortable with as you assess your future pathways.
Black swans are sometimes used to describe unusual events.
So, contemplating your retirement if we were to say to you, in 99 out of 100 cases based on your current plans, you don’t run out of money in retirement, but in the 100th case you get wiped out and left with no money, would you stick with you existing plan?
What about if instead of 1 in 100, this was assessed as 1 in 50 or 1 in 20?
Where’s the acceptable point? If indeed there is one at all?
The point about black swans is that they are often misjudged, the probability of an unlikely event can easily be under-estimated.
When the financial sector relies heavily on modelling techniques based on assumptions, which in turn are commonly based on historic patterns, this may be accentuated.
We can assume we are secure when we are not.
Running out of money
There’s almost no scenario, within the UK, where an individual quite literally runs out of money.
Social security and state pension support provides a reasonable buffer against this happening.
Therefore, the idea that there is a risk of complete deprivation is unrealistic.
The risk therefore is one where an individual loses their previously accumulated wealth and/or loses enough of this to seriously and adversely impact their lifestyle or care.
That is a real risk. And one which is subject to the black swan concept outlined above.
The real risk is getting your decumulation “wrong”
Retirement planning, from a financial point of view, is really a case of decumulation planning. How do you plan to spend your money in retirement? Are you happy to see your accumulated wealth depreciate? And if so, how far?
The challenge for most people is to have enough money to enjoy the rest of their lives and to cope with unexpected expenses, such as care fees. Many then also want to leave a legacy and help family.
The risk is, therefore, seeing your wealth/savings and income sources deplete too quickly.
You won’t become penniless because the State provides buffers through social security. But you could lose your ‘lifestyle’, you could lose the ability to fund your care needs yourself, you could lose the legacy you planned to leave.
The decumulation task
Combining these various points above, the goal/task is to decumulate most efficiently against your targeted objectives, whilst not knowing how long you have to plan for.
You also have no idea how markets will perform, how the economy will be, nor what black swans may come along.
Which takes us back to the probability factors. These are ones you cannot accurately measure, so in many ways you need to plan for the worst and this is where longevity insurance has such value.
Like most insurances, the cost of the insurance could end up looking like a major loss of value.
For example, if you pay for home insurance all your life but never make a claim, you could be forgiven for adding up all the annual payments and concluding that was a waste of money.
Of course, it wasn’t a waste of money, as anyone who has made a substantial claim on their home insurance would vouch for.
The same is true if you lock into a lifetime income product of some sort and then don’t live very long.
That, in isolation, would have been a loss compared to other non-guaranteed options.
This is the task you have when decumulating, to balance lifetime income options which are guaranteed against those that are not, and where your capital could be drawn down to a point where you have little or none left.
Guaranteed lifetime income options vs. non-guaranteed lifetime options
The main takeaway we would like to get across is that comparing options of this sort, there is commonly an underestimation of the value of the guaranteed income.
The typical way to compare options is to look at levels of income and compare these, with a little bit of regard for the risk of the capital in the non-guaranteed case. That is not sufficient as proven by copious academic papers on the subject.
Comparing it that way ignores the time value and the certainty of income offered by the lifetime guarantee, which when measured is always higher than the uninitiated would imagine.
What to do?
To conclude, there is no straightforward way that will always work for everyone in every situation. The point is that lifetime guarantees must be considered against their true value, not the oft-misjudged investment comparison.
There is rarely a need to cover all future expenses (both known and unknown) with a lifetime guarantee of income, however there is much to be said for reducing the reliance on non-guaranteed income that many people may have.
Why? Because they are probably far more likely of having a bad decumulation experience than they realise.
As retirement planning (or decumulation planning) is so inherently circumstantial, what should happen is that individuals planning their futures should be doing much more in depth analysis of their options, including thinking hard about how much longevity insurance they need.
Which is likely to be more than they would probably have considered!