One of the biggest factors in gauging how much you need to save for retirement is also something that’s impossible to know: how long you’ll live.
You don’t want to outlive your savings (also known as longevity risk), but you also don’t necessarily want to save for a wild over-estimate of your longevity such that you can’t enjoy your retirement.
Here are a few things to consider regarding longevity risk when planning and saving for your retirement.
Average life expectancy is a statistical, actuarial number. It describes a cohort of people, and it means that within that cohort, statisticians expect half of the cohort to die before that number and half to die after that number.
It also changes, because the cohort you’re part of has changed as previous members of the cohort have died. If your life expectancy at birth was 84, but you’ve already reached age 65, odds are good that you’ll live past 84 and perhaps even into your 90s.1
Your longevity, on the other hand, is how long you, personally, are likely to live, which is affected by health, family genetics, sex, marital status, profession, and more. For example, those who are more affluent can often expect to live longer than average. For both affluent men and women in reasonably good health, living into their 90s isn’t out of the question these days.2
While life expectancy tables published by the Social Security Administration are useful as a starting point for your own planning purposes, think about how long your parents and grandparents lived and any factors in your own life that would add to or subtract from your longevity.
Having a plan for your retirement savings is critical. Hopefully you’ve been saving and investing for retirement since you started working, but as you get into your 40s and 50s and beyond, it’s important to regularly look at your likely longevity, your needs in retirement, and your current retirement nest egg and model whether or not your savings are likely to meet your needs.
As you do these reviews, don’t be surprised if your strategies and plans need to be updated, because things change. Investments may not do as well as you had hoped over some time periods, leaving you a little lighter in savings than you’re comfortable with. Changes in your health may mean you’re planning for more health care spending in retirement.
As you get close to and in retirement, there are active steps you can take to help minimize longevity risk.
A key factor in whether or not your retirement nest egg will last through your retirement is how you pull money out of your investment and savings accounts into your spending accounts. This includes not only how much you withdraw annually, but which accounts you tap for retirement income, and in what order.
There are lots of different withdrawal models out there, including the 4% rule and various dynamic strategies that change based on the market or other circumstances.
One strategy that accounts for the different time horizons of retirement is the bucket strategy, which has been espoused by Morningstar’s Christine Benz among other experts. The bucket strategy entails dividing your retirement assets into three buckets.3
Bucket 1 is used to meet near-term expenses. This bucket would typically be invested more conservatively in low-risk investments like money market funds. This bucket might include a year’s worth of living expenses in cash investments, and another year or two in very-low-risk interest-bearing investments.
Bucket 2 is the intermediate bucket, which focuses on funding your living expenses for the next three to five years, and would contain a conservative mix of investments that combine income and growth. This might include quality fixed-income investments, dividend-paying stocks, balanced mutual funds, and others.
Bucket 3 is the longer-term growth bucket. This portion of the portfolio would likely be dominated by stocks, including equity ETFs and mutual funds, and perhaps high-yield bonds. This bucket will generally require the most maintenance and rebalancing over time as it will be the most volatile part of the portfolio.
Under this strategy, your annual withdrawals would come from Bucket 1, the lowest-risk portion of the portfolio. Each year some of the money in Bucket 2 would move to Bucket 1, and some of the money in Bucket 3 would move to Bucket 2.
Having your money divided based on a combination of risk and the time until it will be tapped for retirement is fundamental to preserving your retirement savings and combatting longevity risk.
Another important aspect of mitigating longevity risk is managing taxes, as excess taxes reduce your nest egg further. As you begin tapping your various accounts to fund your retirement, looking at the tax implications of tapping one account versus another is crucial.
Tapping a traditional IRA will result in full taxation of the money withdrawn. Tapping a taxable investment account may result in lower or no taxes, and withdrawals from a Roth IRA are not taxed.
While you’ll eventually be tapping all of your accounts, and required minimum distributions (RMDs) mean that you may have to withdraw funds from your traditional IRA or 401(k), paying attention to your overall income and withdrawing accordingly can help minimize what you owe.
For example, if you’re in a higher income year, for whatever reason, withdrawing from your Roth IRA could help ensure you aren’t getting pushed into a higher tax bracket. Lower income years might be ideal for withdrawing from your traditional IRA to take advantage of a lower tax bracket.
Managing longevity risk involves not just how much you withdraw, but from which accounts when.
Social Security is an important source of income for most retirees. It may not cover all of your retirement spending needs, but it does offer a steady, dependable stream of guaranteed income for life. Social Security also offers an annual cost of living adjustment (COLA) to help recipients keep up with inflation.
Social Security retirement benefits can be claimed as early as age 62, but waiting until age 70 to claim would get you the maximum benefit available. The difference between claiming at age 62 or age 70 can be as high as 70% or more.4
There is a clear tradeoff between claiming earlier and receiving benefits for a longer period of time versus waiting to file and receiving a higher benefit, but the right decision for you will depend on several factors, including when you retire, other sources of income, and, yes, your likely longevity.
A break-even analysis looks at how long you’d have to live in order for waiting to claim to pay off. The break-even point between claiming at 62 and 67 (full retirement age for those born in 1960 or later) is generally about age 78;5 the break-even for waiting until age 70 is generally around age 81.
In deciding when to claim this important benefit, look at all the sources of your retirement income. If you can wait, the larger benefit can go a long way toward helping to combat longevity risk.
In general, living longer is a good problem to have, even if it increases longevity risk. With some planning, ongoing review and adjustment, and thoughtful withdrawals, you can manage that risk and make the most of your many, many golden years.