Much has been written in actuarial texts about hedging longevity risk for annuitants in pension plans, insurance companies, and reinsurance companies. The risk to a pension plan can be transferred via bulk annuity products in the form of a buy-out or buy-in. Some of the larger plans may even explore exotic products like a longevity swap. Insurance companies can try to offset the risk by selling life insurance policies or distribute the risk amongst a wide portfolio of lives that include a mix of geographies and demographic characteristics (e.g., white-collar and blue-collar job roles). Or they can transfer the risk to a reinsurance company that will distribute the risk further.
But what about individuals? This article explores various methods to hedge personal longevity risk, offering insights into how individuals and families can secure their financial future. Opportunities to manage this risk include strategic planning and a combination of financial products, lifestyle choices, and community support. Retirement practice community members may wish to share this article with less knowledgeable readers such as family and friends as it provides an overview of the various strategies using language accessible for a wide audience.
Annuities
Annuities are an obvious answer, and a well-known financial product for managing longevity risk. By purchasing an annuity, individuals can receive a steady income stream for life, ensuring financial stability even if they live longer than expected. There are various types of annuities, including immediate, deferred, fixed, and variable, each offering different benefits. If the retiree is willing to pay for it, an annuity can be structured to include annual cost of living adjustments as well.
This is a simple transfer of risk to an insurance company. But that comes with a cost, and for many the costs outweigh the benefits. Many will be concerned that if they die early, they are effectively “losing” on the transaction.
Pension Plans
If available, a pension plan can provide excellent longevity insurance. Pension benefits, when taken as an annuity, provide lifetime income. If the participant elects a joint and survivor form of payment, the benefit can provide lifetime income to a spouse as well. The longevity protection is similar to that offered by an insured annuity, but at a lower cost for many participants.
Some pension plans even allow participants to purchase additional lifetime income at a competitive price. For example, by rolling over a portion of the 401(k) balance.
Investment Strategies
Maintaining a diversified investment portfolio can grow savings and provide financial security in later years. A mix of stocks, bonds, real estate, and other assets can help mitigate risks and increase the potential for returns.
Social Security Optimization
Delaying Social Security benefits can increase the monthly benefit amount by ~8% per year until age 70. Social Security benefits are indexed to inflation as well. By delaying benefits, a higher base amount is locked in, which will be adjusted for inflation, providing greater purchasing power over time. It is important not to delay past age 70 because Social Security does not increase the benefit for delayed retirement beyond age 70, and they will only pay up to six months retroactively.
Insurance Products
Long-term care insurance can cover the costs of long-term care services, which can be a significant financial burden in old age. Health Savings Accounts (HSAs) can also help cover medical expenses in retirement, reducing the impact of health care costs. Life insurance provides financial support to dependents and covers final expenses, easing the financial burden on family members.
Health and Wellness
Maintaining a healthy body can reduce medical costs, which in turn extends the lifetime of a nest egg. This also increases the value of each life year, as quality of life is improved.
Working Longer
Working more years increases savings and reduces the number of years that a nest egg will need to survive. While unpalatable for some, this is one of the most effective strategies to hedge longevity risk.
Families
A spouse can provide a form of longevity insurance. When two people are married, their assets are pooled. The likelihood of both people living to an advanced age is very small, so this acts as a sort of insurance mutual with just two policy holders.
Marriage has other benefits as well other than the financial risk pooling. Many retirees suffer from a lack of companionship and care giving, and spouses are excellent providers of both. That said, some expect married people to live longer so this strategy may in fact increase longevity risk.
Extending this concept, families can agree to pool assets with other family members or close relations, creating a larger financial safety net. Multi-generational living arrangements can reduce living expenses and provide mutual support, while family trusts can manage and distribute assets among members.
Community Involvement
Joining a church or community organization can offer informal longevity benefits through social support, volunteer services, financial assistance, and health programs. These communities provide emotional and practical support, contributing to overall well-being and resilience in older age.
Other Innovative Approaches
Tontines offer a unique approach to managing longevity risk. Participants pool money into a common fund, and as members pass away their shares are redistributed amongst the survivors. Long-lived participants are rewarded with larger incomes. While tontines fell out of favor due to regulatory concerns, there is renewed interest in modernizing them as a potential retirement solution. Modern designs are not “winner take all” and instead operate more like a “bumpy” annuity for the plan participants.
Collective Defined Contribution schemes in the UK provide lifetime income for participants. Like tontines, the annual income can go up or down, but it is guaranteed to last for a lifetime.
Conclusion
Hedging personal longevity risk can be a multifaceted approach, combining financial products, lifestyle choices, and community support. Annuities, diversified investments, insurance products, family asset pooling, and community involvement can all play a role in securing financial stability for individuals and families. Other innovative financial arrangements may soon come to market that provide effective lifetime income from defined contribution assets. By understanding and implementing these strategies, individuals can mitigate the risk of outliving their resources and enjoy a secure and fulfilling retirement.
This article is provided for informational and educational purposes only. Neither the Society of Actuaries nor the respective authors’ employers make any endorsement, representation or guarantee with regard to any content, and disclaim any liability in connection with the use or misuse of any information provided herein. This article should not be construed as professional or financial advice. Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries or the respective authors’ employers.
Grant Martin, FSA, EA, CERA, FCA, is a Partner at Aon. He can be reached at grant.martin@aon.com.