Longevity: calculating the incalculable

Running out of money is one of the biggest challenges people face when they retire. So while the Chancellor’s decision to allow over 55s complete access to their entire pot has features that have been welcomed by many, the changes do increase the need for education in how to make a pension last throughout retirement.

The key to addressing the problem is giving employees a better understanding of what actuaries call ‘longevity risk’ – the risk that they will live longer than they expected and run out of cash.

Over 50s regularly underestimate how long they are going to live – research from the Institute for Fiscal Studies has found women underestimate their life expectancy by around four years, while men do by two years.

According to the Office for National Statistics, 65 year old women should expect to live a further 20.7 years, while men can expect on average a further 18.2 years.

The government is concerned that the freedoms announced by the Chancellor could result in retirees running through their cash too quickly. So the Department for Work and Pensions has announced plans to write to retirees telling them how long they should expect their retirement to be, based on factors such as gender, where they live and whether or not they smoke.

But experts point out that understanding your average life expectancy is only part of the problem. The bigger challenge is in understanding how accurate this prediction will be, and then realising it will probably be wrong. In fact, the only certainty when it comes to life expectancy is that almost nobody will be completely accurate in estimating how long they will live.

If 65 year old men do aim to spend their money by the age of 83.2 years, a substantial proportion of them are in for a surprise – ONS figures show that around a fifth of them will make it to 95. That makes a further 12 years unplanned living expenses to think of.

In the current market, annuities are often the best answer to the problem of longevity risk. Yes, the younger you die, the less value you get from them. But if you happen to be one of the ones that makes it to 110, or even 95, your income is secure.

But, savers have lost faith in annuities – the market is inefficient and woefully uncompetitive. So, the challenge lies with the industry to develop more innovative products that help savers to manage longevity risk while retaining some degree of flexibility.

Other countries around the world are also trying to persuade their retirees to protect against longevity risk. Australia, which has had a flexible drawdown system similar to the one the UK is moving towards, is consulting on making its rules more restrictive after it found a quarter of pension savers had spent their entire pot by age 74.

In the early years following the launch of auto enrolment, most savers’ pots will be relatively small so the only sensible thing to do will be to take their pension as cash. But, as auto enrolment matures and pot sizes increase, ensuring there are the right products to help savers make the right choices is imperative.

Responsible employers will want to educate workers young and old that retirement planning is not just about accessing a big pile of cash the day they retire, but about understanding the best way to make their money work for them over an indefinite number of years.

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