Life Expectancy and Longevity Risk

July 28, 2014 10:37 AM

Bill McBride at Calculated Risk shared an amazing stat a few weeks ago:

Imagine if you were born in 1900. You’d have a 23% chance of dying before age 20 (a 13% change before age 1). You’d have a 38% chance of dying before age 45.

Compare that to kids born recently. You’d have about a 1% chance of dying before age 20, and about a 4% chance of dying before age 45. A dramatic change over the last century.

This reminded me of one of my favorite charts that I’ve used before which shows how the average life expectancy has nearly doubled since 1880:

image

This graph is one of the main reasons many think we have a retirement crisis. But is it really a crisis when people are living longer because of advances in human health? (Each of the white dots on this chart represents a major medical discovery or breakthrough.)

I tend to consider it more of an additional financial planning issue than a crisis. An extended lifespan for investors could have huge implications for the financial markets.

It’s hard to go a day without reading a story from the financial news outlets about the fact that retirees have no good choices for safe fixed income because of the low interest rate environment.  While it would be great if we could all earn a riskless return, a singular focus on investment options that are designed for the short to intermediate term ignores the fact that time horizons are much longer now than they’ve been in the past.

There is a seemingly endless list of risk factors to consider for any investment portfolio, but only one that really matters for every single investor – longevity risk. Longevity risk is simply the risk that you will outlive your savings.

One possible outcome from the steady climb in life expectancy is that investors will have to increase their equity exposure to ensure the ability to keep up with inflation. It’s impossible to predict how this could play out but markets move based on investor preferences above all else.  As pseudonymous blogger Jesse Livermore has pointed out:

Ultimately, the price of equity is determined in the same way that the price ofeverythingis determined–via the forces of supply and demand.  For any given stock (or for the space of stocks in aggregate), price is always and everywhere produced by the coming together of those that don’t own the stock and want to allocate their wealthintoit, and those that do own the stock and want to allocate their wealthout ofit.  If there is a different supply sought by the first group than offered by the second, the price will shift until the imbalance equalizes.

A potential shift in asset allocations is just one of many possibilities. Even though my fellow millennials have been taking a ton of flack for not investing aggressively enough (a view I agree with), as a group we are starting to save much earlier than previous generations.

A recent study from Transamerica showed that 70% of millennials started to save for retirement by age 22. On average, Gen Xers didn’t start until they were 27 while baby boomers began saving at age 35.

Saving money as early as possible is one of the best ways to improve your odds of outlasting your portfolio because of the compounding benefits. Other options for lowering longevity risk include (1) saving more money over time, (2) taking more risk, (3) working longer or (4) dialing back spending in retirement.

It’s up the each individual to figure out which one or combination of these options makes sense for their personal circumstances.

Not everyone is going to be able to stomach an increased allocation to stocks even with a longer runway ahead of them.  This means that most investors will have to choose option number one and rachet up their savings rate to deal with a longer life expectancy.

Saving more money actually lowers your risk in a number of ways while the other choices all carry unintended consequences that could harm your portfolio.

Remember — in most cases saving trumps investing.

Sources:
Demographics and behavior (Calculated Risk)
The single greatest predictor of future stock returns (Philosophical Economics)

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