How Retirees Can Build a Bulwark Against Longevity Risk

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. As life spans increase, so does the risk that many retirees will outlive their assets. I recently sat down with Vanguard's Steve Utkus to discuss how retirees can build a bulwark against longevity risk in their portfolios.

Steve, thank you so much for being here.

Steve Utkus: My pleasure. Good to be here.

Benz: One thing that many retirees or pre-retirees are concerned about--and it's a good concern to have--is this idea of what if I'm one of those people who ends up living to age 95 or past 100? That means I will need a lot more money and I'll need to be worried that my money will last. Let's talk about who should be concerned about this. You see those ads on TV where they encourage everyone to think they might live to be 100. Who should be realistically concerned about being one of those outlier people who will live a very long life?

Utkus: Of course, we can't predict with certainty our own life span. However, we can take clues from our immediate family and our parents and grandparents and their longevity. And if you have a history of particularly long-lived parents or grandparents who have lived into their 90s, past 95, certainly that raises a warning flag that, as you construct a portfolio at retirement, you should think about more growth assets and more inflation-hedging than an investor who might, say, have a family history that's more in keeping with average life expectancy.

Benz: And I assume that your own health history, at some point in your life, will start to be indicative of what you might expect of your own longevity as well.

Utkus: That's exactly right. In fact, I remember years ago we had a conversation with a group of physicians from the renowned Cleveland Clinic, and we were talking about health versus wealth issues in retirement. And one physician said, "Well, here's what I say to someone when they show up at my office at 40: You need to exercise now, you need to lose weight now because I don't want to see you at 60 and 70 with those problems. It reminded me of us telling 25-year-olds that you need to join your 401(k) plan now; you need to invest in equities now. So, it was very analogous that if you've had a good history of managing your health early in your life and have avoided health problems, there is a likelihood that that will persist. If on the other hand, you've struggled with health issues, then that's obviously a predictor in the other direction.

Benz: One thing someone might think is, if I am starting to think about retirement and I think I may have that very long retirement where I'll need to draw on my portfolio for that many years, maybe I should just hold more stocks because I need that growth potential, particularly given where bond yields are today, very low. What do you think of that strategy of holding, say, a higher-than-average allocation to equities?

Utkus: I think that's an approach, particularly for individuals who don't have substantial drawdowns from their portfolios in the earlier years of retirement. So, I imagine there are many investors who will retire who may have other sources of income. Those other sources of income may be transitional work: I'm retired, but the spouse is working. Or I've downshifted into another form of work, so I don't need to draw down as much from my portfolio. Or perhaps you have a pension benefit as well. And when you have those other sources of income and the drawdown from those early years of retirement is smaller or non-existent, then I think it's perfectly fine to think about taking that risk of taking more equity exposure.

Another option, of course--and some of that has to do with relative valuations--but another option, of course, is to use inflation-hedging assets like [Treasury Inflation-Protected Securities] and to use more of that to at least hedge the baseline cost of living.

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Benz: Let's talk about the logistics of that and how that would work when incorporating that within a portfolio.

Utkus: On the TIPS side or on the equities side?

Benz: Yes, on the TIPS side.

Utkus: I think it's important to think about your portfolio in terms of nominal bonds and inflation-hedged bonds and to think about how you increase that concentration of inflation-hedged bonds in your portfolio over time. Now, the key thing to think about when it comes to inflation protection is that TIPS and other securities are what I call a contemporaneous inflation hedge. They hedge today's inflation. Equities have an inflation-hedging benefit, but often it occurs a decade later. So, one way to think about them is two very different sorts of hedges of cost-of-living increases. One is sort of immediate and contemporaneous and one is sort of longer term--and that points to the need to have that long-term horizon.

Benz: Another idea--and we certainly hear this from many people thinking about strategizing around Social Security--is this idea of perhaps delaying Social Security in order to receive a higher benefit for a long period of time. What do you think of that strategy?

Utkus: Well, the short answer is, you should do everything possible to delay Social Security. Now, there are lots of theoretical reasons why. One is it's an inflation-adjusted annuity contract. It is considered one of the best priced because the government does not sell it with marketing and profit costs bundled into it. It's a great way to purchase additional guaranteed income. And although people tend to think about these issues in terms of when would I break even, it turns out that most of that is based on an assumption that I'm going to live a short life. But delaying Social Security is a particularly beneficial strategy for individuals who are likely to live beyond average life expectancy. So, it's sort of your first simple way to increase the level of guaranteed income, and all it does is take a bit of discipline and planning about timing retirement and timing where you're going to get income from.

Benz: So, this is a particularly attractive strategy, again, for people who think that longevity maybe an issue.

Utkus: That's right. Exactly, yes.

Benz: Let's look at another category. That would be the whole category of annuities. Let's talk about what makes annuities attractive from the standpoint of longevity-hedging.

Utkus: So, they are the pure hedge for longevity. You have a capitalized intermediary--namely, an insurance company--who is going to promise you an income stream for as long as you live. And of course, they do that, as you may know, by taking the assets from people who die early and paying them to people who die later in life, and they do that sort of longevity-hedging over a broad population.

Now, most investors are reluctant to part with their capital and purchase annuity contracts. But I think one of the important questions investors have to ask themselves is, "Is the purchase of an annuity like eating your spinach?" It's a bit like this: Investors like active versus passive, investors like local stocks rather than international stocks. Many investors like to pick stocks and funds even though we know they are not particularly good at it. So, there are a lot of things that investors like to do and don't like to do. And I think of annuity contracts as falling into one of those things you ought to do, but you don't really want to consider.

I certainly think every investor who has any expectation of above-average life expectancy needs to think very carefully about what role they can play, even if it's going to be a relatively minor role, supplementing Social Security by a small amount. There is still some benefit of getting that pure longevity protection in your portfolio.

Benz: There are a lot of different flavors of annuity--some of them very high cost, the transparency may be very poor. Let's start with the most basic annuity type: that single premium immediate annuity, the benefits of such a product, how that might work in an overall portfolio plan, and another thing is how much of the portfolio should go into a product like that.

Utkus: So, let's start with the SPIA, as we call it, the single premium immediate annuity. It's sort of a plain-vanilla commodity product, and one of the things we can say about it is that it's relatively straightforward to buy and purchase. Now, you can buy them through online marts, you can buy them direct through brokers or advisors. But there is easy comparability from company to company, especially if you get them quoted on a sort of apples-to-apples basis. And the market is rich and developed in the United States. So, it's not a thin market.

The big question of how much really depends on your full circumstances and your risk preferences about income sources in retirement. So, if you arrive at retirement with Social Security and you've married or lived with someone who's got a big state and local government pension plan, you have probably more than enough annuity income in your portfolio. Or perhaps you had a corporate pension plan. It's probably less of interest to you than it is to the individual arriving at retirement with simply Social Security and other assets. And then in trying to make the decision, it's interesting--there is not a lot of well-developed theory. Different advisors and writers have different rules of thumb. And what I encourage people to think about is trading off a specific lump sum, $50,000 or $100,000, for a given level of guaranteed income. Get those quotes and think about that trade-off and how you'll feel psychologically, having that guaranteed income stream versus having access to the assets in the event of emergencies.

So, it's making that trade-off--and it's a personal trade-off--and thinking about that which will determine how much you should allocate. This is not about allocating 50% or 75% of your assets to annuities. It's really about how much marginal guaranteed income beyond Social Security and anything else you might have from an employer pension you should consider.

Benz: Another annuity type that was recently in the news, because they're now available within the confines of company retirement plans, are longevity annuities. Let's talk about what those products are. It seems like a lot of researchers I talk to think that it's actually a fairly exciting product type that might makes sense, especially for people concerned about longevity protection. Let's discuss the product, and I'd like to hear your thoughts on whether you think they might have a role within retiree tool kits.

Utkus: With longevity insurance, it's interesting. The government has issued new rules to encourage its adoption in retirement plans. So far, though, it's not yet appearing in retirement plans, but you can buy it outside retirement plans from brokers or online marts. The products are just appearing. And so, unlike the traditional single premium in annuity, the market is somewhat thin. It's hard to know whether you're getting good pricing or not. It's early days in this marketplace, so caveat emptor.

Benz: So, the idea with these products is you buy the contract and then it starts paying you at some later date, whereas the SPIA is going to start giving you cash right away. When is a typical start date for one?

Utkus: If you actually go investigate this, you'll actually see there are a number of flavors. So, one idea is, let's suppose you're retiring at 60, there are some contracts where you could just simply say, at 65, 67, or 70, I'm going to defer the income for five to 10 years. But the traditional definition of longevity insurance is that hedge for late-in-life longevity risks. So, I would at 60 take a very small fraction of money and purchase an annuity that would start at age 80. So, you can imagine if that's more of the second half of retirement where you need additional spending for long-term care or other costs of living, then it would start to kick in at that very extended date.

Now, it's very theoretically appealing, right? We all can imagine managing our money for 10 or 20 years in retirement. But we think when we're in our 80s, maybe it's harder to manage money conceptually. We'll have bits of cognitive decline where we want that extra income guaranteed to surface at that point when we most need it. It has this certain appeal, I think, conceptually to most of us.

The real challenge is that it's a very thin market. It requires exceptional patience and discipline. Imagine putting money away today and you only get a benefit if you're alive in 20 years. So, it requires an exceptionally farsighted person to buy it. And I do think it's exciting in that sense, that it can hedge that long-tail risk of living to 100. But on the other hand, it requires an extremely patient and thoughtful investor at age 60 or 65 to purchase it.

Now, the good news is it's cheap, because from now until the next 20 years, the insurer is going to have your money to invest. And they are only going to pay it to the people who do make it to 80, and so it's a really cheap way to buy longevity protection.

Benz: One of the criticisms I've heard is that it doesn't offer inflation protection in those years until you begin taking a benefit from it.

Utkus: That's right. In fact, I was going to mention that. That's a great reminder that most contracts today are structured so that you buy a nominal amount. At age 60, you're buying a nominal amount at age 80. So, you do have to do a little math in your head to figure out, "Well, if there's 2% or 3% inflation for the next 20 years, what number should I be picking?" If you would buy today $10,000 a year in income, you're going to have to be buying a lot more 20 years hence to hedge inflation. So, you do have to do some thinking--you or your financial advisor--about that question.

Benz: Steve, thank you so much for being here. This is such an important topic. We appreciate you sharing your insights.

Utkus: My pleasure.