Longevity Risk vs. Market Risk

Words matter. The words that are used to describe something color—even distort—how we think about that thing, and can easily mislead us.

I read an article about a retired person’s risk of running out of money before she runs out of pulse. Financial professionals call that “longevity risk.” What I don’t like about those words is the connotation that running out of savings during retirement is somehow your fault. You chose to live too long, you selfish Baby Boomer. It’s not something that happened to you, it’s something you brought on your own damn self. Or maybe it’s your parents’ fault for bequeathing you such sturdy genes. Where’s George Carlin when we need him?

But the risk of living too long is minor compared to the risk of living through a crummy market environment. And the market environment is not something you brought on yourself, like healthy living; it’s something that’s thrust upon you (and all your classmates) by the accident of when you reached retirement age. 1926? A great year to retire. 1969? Terrible.

In what way is market risk greater than longevity risk? Here’s a little fairy tale.

Goldilocks has turned 65 and is about to retire. She needs for her savings to generate $50,000 per year, plus inflation. She has saved up $649,271, which, it turns out, is just right if she lives an average female life expectancy (which at age 65 is 20 years) and retires in an average market environment.

But wait! Goldilocks is smarter than that. Despite the bear thing, which happened when she was very young, so it doesn’t count. She realizes she might live longer than average. So to be cautious, she magically increases her savings to $849,006. (This is a fairy tale, so she can do that.) That’s the amount she’ll need if she lives to age 98, which only 5% of 65-year-old women are expected to do. (These projections came from a table of life expectancy statistics on the Social Security website.) So by increasing her savings by $200,000 she is 95% sure not to get stung by longevity risk.

But wait! What about market risk? Goldilocks prudently plans to invest her savings 50% in stocks and 50% in bonds. What if the upcoming future for stock returns, bond returns and inflation is worse than the historical average? It turns out that market risk is much scarier than longevity risk. Goldilocks studies 83 20-year periods from 1926 through 2008 and sees that during 10 of them—more than 15% of the time—her extra $200,000 of extra savings would have been an insufficient cushion; she would have run out of bucks before the end of her average 20 year life expectancy.

Goldilocks's extra $200,000 of savings bought her 95% certainty of avoiding longevity risk, but only 85% certainty of dodging market risk.

It turns out that market risk—the one that’s shared by you and everyone who got the gold watch in the same year—is bigger than longevity risk—the one that’s unique to you. And 2008 turned out to herald a very inauspicious start for the current crop of graduating retirees. Can you just picture a whole cohort of 65-year olds, eyes glazed over, all wandering around Miami Beach at 4:30, all looking for the same early bird special?