A Two-Prong Approach to Funding Retirement

One way to handle the uncertainty of longevity is to divide retirement in two phases. The first phase would last approximately 20 years, from age 65 to 85. The second phase would last from age 85 until the death.

A key challenge for retirement planning is the uncertainty about how long retirement will actually last. The Society of Actuaries calculates the average life expectancy for a person who turned 65 years old in 2015 to be approximately 87 years. Men are projected to die at a slightly younger age and women are projected to die at a slightly older age. These are just projections; many people will live into their 90s or even 100s.

Since longevity is uncertain, it is difficult to project how long a person should plan on having retirement savings last. Worse yet, the decisions on whether enough has been saved, what type of withdrawal strategy should be used and what assets should be held all must be made before or at the time of retirement. Though changes can be made in retirement, there is less flexibility and time to do so.

Peter Tsui, the director of global research and design for S&P Dow Jones Indices, thinks a way to handle this uncertainty is to divide retirement in two phases. The first phase lasts approximately 20 years, from age 65 to 85. The second phase lasts from age 85 until the death.

At retirement, a deferred annuity designed to begin payments at age 85 is purchased. This annuity guarantees that a stream of income will exist late in retirement. The remaining savings are then used to fund the first 20 years of retirement. Since the period of time these assets must last is known, the wealth planning process becomes easier.

To demonstrate how this works, Tsui used a fictional couple who are both age 65 and are retiring with $1.25 million in savings. They will need $5,600 in monthly income to supplement their Social Security benefits. At retirement, the couple spends $200,000 to purchase a joint life deferred-income annuity that will provide the necessary stream of income starting in January 2037. The purchase leaves the couple with approximately

$1 million to fund the first 20 years of their retirement.

Tsui acknowledges the reduction in purchasing power that inflation would have on the annuity’s future payments. He says this could be partially offset by inflation adjustments to Social Security benefits and/or by purchasing a larger annuity contract.

Source: “Rethinking Longevity Risk: A Framework to Address the Tail End,” Peter Tsui, S&P Dow Jones Indices, March 2017.