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Retirement Planning - To Cover the Risk of Living Too Long

    Mr. Lalatendu Raju | Wednesday, June 22,2011, 09:38 PM
 

Why Retirement Planning?

Retirement calculations are geared towards estimation and planning for the money one needs in the post retirement years. However, while estimating through static analysis the longevity risk may still remain unplanned. Here is an understanding on a more realistic estimation of life expectancies.

In an era of economic uncertainty and volatility, coupled with lack of social security mechanisms, one requires to plan for securing a financial independence in retirement.

Longevity risk is one of the critical areas that an individual may be exposed to and that can affect him both as individual and as a member of society. Managing the retirement fund assuming that you will live a certain age based on average life expectancy is risky. It must be recognized that life expectancy is based on law of large numbers. In the case of personal life expectancy for any one individual, average life expectancy cannot be a precise evaluation. About fifty percent individuals live longer compared to average life expectancy. Wives outlive husbands in most cases. Further, there are other risks too, like inflation risks, market risk, interest rate risk that the retirees may be exposed to and which need to be addressed. In this paper we have limited the discussions only to longevity risk.

The art of Retirement Planning:

A new challenge for Financial Planning Professionals

It’s time for a new challenge for financial planning professionals. They need to provide a better advice by using dynamic methods of analysis, rather than static methods of analysis. Compared to static methods, dynamic methods of analysis provide more realistic picture for enabling a better decision making. Using static method of analysis, i.e. planning to live to a certain age may be risky or inadequate for most of the individuals. Application of dynamic methods of analysis also requires careful planning because unreasonable assumptions may give misleading results. We have applied the dynamic method in determining life expectancy for individual life and joint life using probability of death, on the basis of actuarial data.

Financial Planners thus need to consider all factors and account for longevity risks that individuals may face in their retirement years.

Understanding Life Expectancy

Life expectancy at a particular age measures the average number of years that you can expect to live. This estimation is based on the mortality rates of the population in a given year. With the improved medical technology along with healthier lifestyles, life expectancy for Indians has increased significantly during the past half century and appears to be improving further. Therefore, one can expect to live longer. In the context of retirement care for life, it also means that an investment portfolio needs to last for 20 years or more if one plans to retire at the age of 60 years. When it comes to retirement care for life, there is a lot at stake. Longevity risk is one of the major concerns while planning for retirement. Based on IRDA 2004-2006 mortality table the average life expectancies for men and women are shown below (Table 1):

Average Life Expectancies

For Men

For Women

Current Age

Expected Additional Years

Expected Age at Death

Current Age

Expected Additional Years

Expected Age at Death

40

37

77

40

39

79

45

32

77

45

34

79

50

27

77

50

29

79

55

23

78

55

25

80

60

18

78

60

20

80

65

14

79

65

16

81

70

10

80

70

12

82

* Data Source: IRDA
The above table (Table 1) just shows the average life expectancy. The average life expectancy means there is a 50-50 chance that one can live longer. But how much longer? Let’s understand this from technical perspective.

Probability of Survival – A Technical Perspective

Most Financial Planning professionals choose a certain life expectancy age (may be 80, 85 or 90) as an input while constructing a financial plan across for clients in all age groups to plan for the payout period in the retirement. Further, planners fail to interpret these numbers. There is major gap that exists in understanding these risks and in the techniques dealing with it. Using probability of survival, let’s interpret the life expectancy numbers used by most of the planners.

The table below (Table 2) which is based on mortality table defines separate mortality rates for males and females of different age group. Caution must be observed in interpreting these probabilities. For example, if the couple both aged 50, there’s a 68% chance at least one of you will live to age 80.

Table 2: Probability of Survival

Probability of Survival

 

Male

Female

One only

To age 80

39%

47%

68%

To age 85

20%

27%

41%

To age 90

7%

11%

17%

To age 95

1%

3%

5%

 

 

Male

Female

One only

To age 80

40%

48%

69%

To age 85

20%

28%

42%

To age 90

7%

11%

18%

To age 95

2%

3%

5%

 

 

Male

Female

One only

To age 80

43%

50%

71%

To age 85

22%

29%

44%

To age 90

8%

12%

19%

To age 95

2%

3%

5%

 

 

Male

Female

One only

To age 80

46%

54%

75%

To age 85

23%

31%

47%

To age 90

     

To age 95

     

Mr. Lalatendu Raju

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