The Misunderstanding Of Life Expectancy & What It Means To Your Retirement
Perhaps the most misunderstood and inappropriately applied concept in retirement income planning is life expectancy, but it is absolutely essentially to get right for a long, healthy, and fulfilling retirement.
Hopefully, the insights presented below will help clarify some of these common misconceptions and lead you to a better financial strategy for retirement.
If you were to ask an actuary to define life expectancy, he/she would tell you that it is a weighted-average time of future death. Actuaries calculate life expectancy as follows:
- Select an appropriate mortality table, that is representative of the mortality of the individual in question (e.g. do they smoke? what is his/her gender?)
- Convert the applicable mortality rates into probabilities of survival to different times in the future, typically in one year increments (probability of surviving one year, two years, etc.).
- Combine the probabilities of survival and the probabilities of death, to derive the probabilities of surviving to and dying at each different time in the future.
The results of such an analysis for a 65 year old male may look something like this:
The grey bars indicate the probability of surviving to each, while the yellow line indicates the probability of surviving to and dying at each age.
Insight #1: The Uncertainty of Lifetime
The life expectancy for the 65 year old male illustrated above is approximately age 85, or in other words this person would on the average expect to live another 20 years. However, the probability of this person actually dying at this age is only 3.8%. This demonstrates one of the great misunderstandings relating to life expectancy – that we will die with 100% certainty at this age. In fact, there is approximately a 50% chance that you will live beyond your life expectancy.
Insight #2: Probability of Death at Older Ages ≈ Probability of Death at Younger Ages
Examining the yellow curve also reveals another interesting fact – that the likelihood of dying at some older ages is approximately equal to the likelihood of dying at a corresponding younger age. For example, by drawing a red horizontal like across the graph we can see that the probability of dying at age 68 is approximately equal to the probability of surviving to and dying at age 98 (both are equal to approximately 1.3%):
This probably strikes many as counter-intuitive, as we have a hard time believing that we will be able to survive that far beyond life expectancy; however, statistically they are just as likely to occur.
Insight #3: Life Expectancies Increase As We Age
Another not-so-well-understood axiom of life expectancy is that it increases each year we survive (assuming that there is no change in health condition or other factor that might affect expected mortality). For example, if this male were to reach attained age 84 his life expectancy at that time (using the same mortality table used above) would be approximately age 91, or another 7 years, not the one year you might otherwise think if you thought the original life expectancy were applicable.
Implications for Retirement Income Planning
The insights presented above have several implications for retirement income planning:
- Don’t create a retirement income strategy that assumes you will die at life expectancy. As mentioned above, there is a 50% chance you will live beyond this time, so a thoughtful strategy will have a clear and unambiguous strategy to provide income for these later years if needed. Consider variability about the average.
- Because your life expectancy will generally increase as you age, so should your financial portfolio! In other words, you should have some mechanism or product in place that will provide some assurance that your money can stretch out over longer period so time as you progress into retirement.
- Because of the chance of surviving beyond your life expectancy is greater than you might have thought, consider what your needs at that time might be. Chances are you will need to provide for more healthcare related expenses, which tend to inflate at a high rate. This should be given just as much consideration as whatever you may be planning for the next few years.
- Think through what your portfolio might look like when you reach your life expectancy. As shown in the example above, you will probably need to provide income for many more years to come – work through where your current financial strategy will take you, and what will be in place at that time to provide for your needs from that point forward.
In short, life expectancy may be a single number, but by itself it can be quite deceiving. Be sure to provide for the highly likely chance that you will outlive it.
John Bevacqua on March 30, 2012
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n fact, there is approximately a 50% chance that you will live beyond your life expectancy.