Successful retirement planning includes an assessment of many risks, including how much annual retirement income will be needed, whether an individual will be able to retire at his or her desired age and whether the individual’s savings will generate sufficient investment returns—both before and after retirement—to achieve his or her retirement goals.
In addition to the above-noted risks and challenges, it is important that a person planning for retirement understands longevity risk. This issue is particularly relevant for those who will rely on the income generated from RRSPs or DC pension plans.
Longevity risk is the risk that a person’s retirement savings turn out to be insufficient because the person lives longer than anticipated. While we would all agree that living a long life is a good thing, it is important that each individual has adequate protections in place for the financial consequences of longevity.
Employers should not assume that employees understand and factor longevity risk into their retirement planning. As part of your communication and education efforts, provide clear definitions of the risk and personalized examples to demonstrate why plan members should pay attention.
The following is an example that employers can use in their own communications to illustrate for plan members why longevity risk matters. However, note that numbers may need to be adjusted for consistency with the particular retirement programs that the employer offers.
Example
Sarah plans to retire from her bookkeeping job in 2017, at which point she will be age 60. In order to live comfortably in retirement, she has determined that she needs enough savings in her DC pension plan account to provide an annual income of $50,000. She now wants to calculate how much DC savings she will need to accumulate by age 60 in order to provide an annual income of $50,000 during retirement.
In order to calculate how much savings she will need, Sarah needs to make an assumption about the number of years she will be drawing on her retirement savings (i.e., how many years after age 60 she will live). Based on mortality tables commonly used by pension actuaries, the life expectancy of a female retiring at age 60 is 27 years. If Sarah’s DC account will earn an investment return of 5.5% per year during retirement, she needs to accumulate $714,000 by age 60 in order to draw an annual income of $50,000 until age 87.
However, it is important for Sarah to understand that her expected age of death at retirement (i.e., age 87) represents an average. Her actual age of death could be very different. Chart 1, which shows the number of expected survivors by year from 1,000 females who retire at age 60, gives an indication of how different from age 87 her actual age of death may be.
While the average age of death for the 1,000 retirees is 87, the following should also be noted:
- more than 550 of the retirees are expected to live beyond age 87;
- more than 200 retirees (one out of five) are expected to live to at least age 95; and
- 60 of the retirees are expected to live to at least age 100.
Sarah is concerned about the financial implications of living beyond age 87, so she does the following additional calculations (see Chart 2).
- She needs to accumulate $790,000 in her DC account by age 60 in order to draw an annual retirement income of $50,000 until age 95. This is $76,000 (11%) more than the amount needed to provide an annual income until age 87.
- If she wants enough savings to last until age 100, she needs to accumulate $824,000 by age 60, which is $110,000 (15%) more than the amount needed to provide an annual income until age 87.
Sarah faces the following dilemma: If she doesn’t plan for the possibility that she may live longer than expected, her savings may run out during retirement, or she may have to manage on less income during retirement. On the other hand, if she does save more prior to retirement or draws less income during retirement in order to deal with the longevity risk, she may be making unnecessary sacrifices in her standard of living if it turns out that she does not live longer than expected.
In the example above, a lack of understanding of longevity risk early in her career could lead Sarah to be dissatisfied with her employer’s capital accumulation plan—and her own retirement savings—now that she is approaching retirement. If Sarah is no longer confident that she has accumulated sufficient savings to sustain her in the event of a longer-than-expected retirement, she may delay retirement.
Most individuals already have some protection against longevity risk through participation in government programs such as the CPP and QPP. However, employers can offer additional protection by providing employees with longevity education. Educated employees will be in a better position to decide whether it would be prudent to use some of their retirement savings to purchase a product, such as an insured annuity, that provides protection against the financial risks associated with a very long life. This includes weighing the need for the longevity and other protections provided by an annuity against the cost of the annuity.
Employees who are educated by their employer about retirement planning, including risks such as longevity, are more likely to be satisfied with the retirement programs provided by their employer—and are more likely to make the appropriate decisions to address the many retirement risks and challenges they face.