Plan Beyond Average Life Expectancy

Using a SPIA to Provide Guaranteed Income

A current article from CNNMoney illustrates why it’s important to plan beyond average life span statistics when estimating how long savings need to last in retirement. The article also focuses on devoting a portion of savings to an immediate annuity to provide guaranteed income and protect against outliving retirement savings.

Planning for retirement includes factoring in a reasonable estimate of your life expectancy. The number represents the average number of years a person of a given age is expected to live. Simply put, many people will live longer than average and therefore need to factor that into their financial planning decisions.

In "The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty," Stanford management-science professor Sam Savage illustrates the folly of planning utilizing averages by telling the story of the statistician who winds up drowning crossing a stream with an average depth of three feet. The problem, of course, is that while the river is shallow close to the shore, it's 12 feet deep towards the center.

The thought that using your average life span for figuring out how long your savings will need to last in retirement is equally all wet -- and would leave you in the unfortunate position of having no revenue or savings but a lot more living to go.

Life expectancy is not an estimate of how long you are going to remain alive. It represents the typical amount of years a person of a given age is expected to live. Nowadays, the life expectancy of a healthy man at age 65 is an additional 20 or so years, whereas for a woman of the identical age, it is an additional 22 years.

Many will live longer. A man of 65 years has a 30% chance of living to 90; a woman of 65 years has a 40% probability. The chance that at least one member of a couple age 65 will be alive at 90 is greater -- 60%.

Whenever you plan your finances based on how long someone your age is thought to live, you might be giving yourself a false sense of security.

For instance, let’s say you are 65, have $500,000, and would like to withdraw a sufficient amount every year to live comfortably, but not so much that you’re going to spend your money too soon. Should you assume your money will need to carry you for 20 years only, you could withdraw 5% of your savings at first and then increase it for inflation annually. With that routine, you'd have about a 10% probability of running out of money earlier than age 85.

Should you live longer the chance of your money being completely depleted early increases. It jumps to greater than 30% if you live to 90, and nearly 50% at age 95 at the same withdrawal rate.

If life expectancy is not the correct figure to use for retirement-planning, which is?

There is no one correct figure. In its Retirement Income Planner tool, Fidelity makes the default age 92 for a man age 65, and for a woman, 94.

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In actuality, the overwhelming majority of us will not live to 100, or even our nineties. Then how do you balance the chance of assuming too brief a life span and spending down your assets too quickly, vs. erring on the side of longevity and living more frugally than need be?

Deciding between these two potentialities is personal. My take is that the prospect of having to worry about making ends meet in your final years -- or, worse, having to depend on the kindness of others -- is more unsettling than the potential of dying with unspent assets.

In the event that you have major health problems or a family history of passing away at an early age, plan on living into your early or mid-nineties. If your ancestors were long-lived, it may be in your best interest to aim for age 100. Couples might want to plan for their husband passing first seeing as women live longer on average.

In the end, you’ve no way of knowing for certain when you'll die. Even online instruments that fine-tune the life expectancy based on your health, behavior, and family history are only generating an average.

With that uncertainty, it’s worth hedging your longevity bets in other ways when you retire: Dedicate an allotment of your savings into an immediate annuity, which will pay guaranteed income regardless of your longevity.

What you shouldn’t do is plan as if your savings have to last for an average life span. If you do so, you may find yourself in deep water later.