Defined benefit pensions are becoming ever rarer, with the exception of the state pension. Most people are going to need to derive some of their retirement income from drawing down from accumulated savings. This means there are two questions that often arise. Firstly, how long will my savings last? Secondly, how long will I live? If we underestimate our lifespan, withdrawing too much too soon can increase the chance of funds being exhausted during retirement. If we overestimate it, withdrawing too little can reduce discretionary spending during retirement.<\/p>\n\n\n\n
At any given age, it’s possible to estimate our average life expectancy. There are numerous online calculators to help with this. But using average life expectancy as the target number of years for drawing down our savings may not be sufficient for planning purposes. Life expectancy is the average over a large group of people. This means that half the people will live longer than the average. The other half will live shorter. For the moment, let’s ignore other uncertainties. Even if we planned to draw down our savings exactly over our average life expectancy, the median nature of life expectancy means that around half of people live longer than that figure; this highlights the risk that a plan based solely on average life expectancy may not last for a full lifetime.<\/p>\n\n\n\n
To overcome this, some planning approaches suggest using a longer life expectancy. For example we could add 10 years to our average life expectancy. This can reduce the chance of underestimating longevity, but it’s arbitrary, and comes at the cost of over-estimating it. How can we be sure that planning on this basis will be reliable? The problem is that life expectancy is not the only uncertainty. Investment returns are also both uncertain and volatile.<\/p>\n\n\n\n
Let’s take an example. A 65 year old single man retires with a \u00a3500,000 retirement fund. Suppose he doesn’t mind if he leaves no legacy. Let’s assume for this example that his average life expectancy is 20 years. He decides to plan based on living another 30 years. In conjunction with a financial advisor, he devises a drawdown plan for withdrawing \u00a320,000 in year one, and uplifting the amount by the rate of inflation in each subsequent year. Let’s say that his financial advisor calculates that this level of drawdown will last for 30 years with 90% probability, with a 10% probability of running out of money.<\/p>\n\n\n\n
How much confidence can he place in this calculation? Does this mean that his drawdown plan has only a 10% chance of failure? In this example, the answer is no. The calculation has failed to take into account the small, but significant, possibility that the man will live longer than 30 years. The actual probability could be higher than 10% once longevity variability is included.<\/p>\n\n\n\n
That’s not quite the end of the story. The actual probability of the 65 year old man surviving a full 30 years is quite small. Because he has a meaningful chance of living a shorter lifespan, he may end up spending less than he could have afforded.<\/p>\n\n\n\n
For a couple, the probabilities interact differently. Suppose that the husband and the wife each have a 10% probability of surviving 30 years. Then the probability that at least one of them will survive 30 years is 19%, and therefore the actual probability of funds being exhausted during their joint lifetime must exceed 10%, and could exceed it by more than in the single\u2011person case.<\/p>\n\n\n\n
In practice, it’s very difficult to plan for savings to last exactly until the end of life. Planning for a fixed number of years can be limiting. Life expectancy is an uncertain variable in retirement planning calculations. It can be treated as such, just like the volatility of investment returns. If my financial advisor tells me that my plan has a 10% probability of funds being exhausted, then I want to know that he has taken the variability of life expectancy into account.<\/p>\n\n\n\n