Forecasting life expectancy can be risky

As a follow-up to our discussion on how to save for retirement in this column on July 22, 2012, some readers wanted to know how to measure life expectancy — how long you’ll live.

This variable is no doubt important in planning your retirement portfolio. But your time will be well-spent in setting up a disciplined approach to saving and investment than measuring your life expectancy. In this article, we show you why.

Why life expectancy

To plan your retirement, you should first estimate how much money you are likely to spend post-retirement at today’s prices.

Then, you have to adjust the amount for expected inflation during your retirement life. After that, you have to forecast how long you will require the money post-retirement. And that depends on your life expectancy.

Life expectancy is also important for choosing investment products that will generate cash flows to meet your monthly expenses post-retirement.

Your retirement portfolio will have investments in bonds and stocks. But you require stable cash flows every month post-retirement.

You have to, hence, sell your investments in your retirement portfolio and use the money to buy appropriate investment products to meet your post-retirement needs.

The products you choose will depend on your life expectancy. If you are in good health and expected to live long, you may want to purchase annuity from insurance companies. If you do not expect to live long, you want to invest in short-term bank deposits.

But forecasting life expectancy can be risky. Suppose your life expectancy is 80 but you actually live till 90.

Your investments may not be enough to support you for an additional 10 years. This is because your investments were made to generate cash flows based on your life expectancy! But how about assuming that you will live till 95 instead?

Measuring

No doubt, assuming that you will live till 95 will reduce the problem of outliving your investment.

But you will have to save considerable sum of money to support the long post-retirement lifestyle; if you retire at 60, you need money for 35 years! This will force you to live on tight budget during your working life. And even if you do save enough but do not live till 95, you would have unnecessarily curtailed your spending in the initial phase of your post-retirement life and left an unintended legacy.

You can alternatively use the mortality table provided by insurance companies; this provides the average life expectancy of individuals who have similar characteristics as you do.

But average can be misleading. Advisors, hence, adjust your mortality rate with your gene pool. If your parents or siblings have lived past 90, there is strong possibility that you will live that long too! But that assumption may be incorrect if your lifestyle is different from theirs.

An easier approach is to use the online life expectancy calculators. Investment advisors in the US are increasingly beginning to use such calculators. Understand how these calculators work before you use them; for most of these calculators can only measure single life expectancy and not the joint life expectancy of a married couple. And then again, these calculators are primarily tailored for individuals in the US.

Conclusion

Save as much as you can during your working life without compromising on your current lifestyle.

On retirement, based on your health, buy investment products that will reduce the risk that you will outlive your investments.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at >enhancek@gmail.com )