Increasingly, retirees need to factor in longevity risk to their retirement planning.

Simply put, longevity risk is the risk that longer-than-expected life expectancies may cause retirees to run out of money—or run so low on money that they need to seriously compromise their lifestyles during what are supposed to the their “golden years.”Longevity risk can be tied with another key retirement issue: Inflation risk—or the impact of rising prices on retirees’ purchasing power. That’s because inflation has more time to compound and erode that purchasing power for retirees who have lengthy retirements.

People are living longer

Longevity risk has become a growing concern for retirees, for a very simple reason: People are living longer during retirement than ever before—and that trend shows little sign of slowing. What used to be a 20 year retirement horizon could be a 30 year horizon or longer today. Larry Fink, CEO of Blackrock, was recently quoted as saying, “Statistically now, if you’re 60 and in good health you’re going to live to 90.”

Figure 1 below shows this trend over time, according to a study by the Society of Actuaries. Back in the 1980s, a 65-year-old male could be expected to live to age 80. But by 2029 the number is expected to reach 88. These simple averages show how retirement horizons are getting longer, subjecting retirees to increasing longevity risk.

Figure 1: Increasing Life Expectancies Over time

Source: Society of Actuaries, Aon Hewitt, November, 2014

We can see how likely these long retirement horizons are for individuals and couples alike by using the most recent Society of Actuary mortality tables. Figure 2 shows the survival probabilities of retirees age 60 and in good health. There is a nearly 90% chance of a 20-year retirement horizon for either the husband or the wife, and a 50% chance of a 30-year retirement horizon.

Figure 2: Survival Probabilities for a man, woman, and couple

Source: Society of Actuaries, Aon Hewitt, November, 2014

The takeaway: Retirees today and in the future need to be preparing for retirements that could last several decades.

Investment growth can stretch your dollars

Of course, we all know that investing for a secure retirement is great idea. But investing while in retirement is also important because it can stretch retirement savings and help fight longevity risk.

Figure 3 shows how various levels of returns can combat rising inflation and aim to add more spending years during retirement. It shows a benchmark case for an investor with a $1 million account initially spending $50,000 per year, with spending increased by 3% annually. As many retirees have both qualified and non-qualified retirement savings, we show both before- and after-tax estimates.

For non-qualified savings, a 6% annual return can double an investor’s expected spending years compared to keeping savings in cash that returns 0%—from 16 years to 32 years. For qualified savings that are taxable upon withdrawal, a 6% annual return can add an additional nine years of spend—from 14 years to 23 years.

Figure 3: Number of years an investor could expect to spend $50 k per year growing at a 3% inflation rate, assuming a $1 million account earning various annual returns and a 20% tax rate.

Source: Estimates determined by Horizon Investments using an annual annuity cash flow model.

The good, the bad, and the normal – long-term returns

So what types of investments might generate strong enough returns to add a substantial number of additional years of spending in retirement?

Figure 4 shows where to find the returns needed for longer retirement horizons. Note that, after taxes and inflation, bonds historically have not been a good source of the annual investment returns needed to combat longevity risks. But stocks have been a generally preferable long-term source of stronger returns. Indeed, stocks have outpaced bonds during all 20-year rolling periods since 1926.

Most impressive is how even when stocks were at their worst—averaging 3.3% annually for 20 years—they still beat the best returns that bonds could muster (2.9% annually). And a mix of 50% stocks/50% bonds during a bad period nearly matched bonds at their best (2.7% versus 2.9%, respectively).

Figure 4: Average annualized returns for stocks, bonds, and a 50 / 50 mix after taxes and inflation since 1926.

Source: Ibbotson SBBI database, Stocks are the S&P 500, Bonds are Intermediate-term government bonds, and inflation is the change in CPI. Bad is equal to the first quartile (25th percentile) of 20 year rolling returns, normal is the median of 20 year rolling returns, and good is the 3rd quartile (75th percentile). Taxes assumed to be 20%.

The data sends two clear messages:

1. The investment returns that are potentially available from stocks can be beneficial in battling longevity risk during retirement. Stocks generally have generated stronger returns and have outpaced inflation over time.

2. While fixed income assets have historically been favored in retirement portfolios, they may not generate strong enough returns by themselves to comfortably see investors through lengthy retirements. While fixed income investments may experience only mild fluctuations in value over short periods, they may not be as beneficial as stocks when it comes to the pursuit of long-term retirement spending goals.

Learn more about Real Spend®, our retirement income solution designed to mitigate longevity risks.