People are living longer today than ever before, which is music to some people’s ears, as it provides more time with loved ones and the ability to have more and varied experiences. However, living longer poses an unanticipated risk—the possibility of outliving your money.
According to the World Bank, the average life expectancy for a person born in the U.S. in 2015 is nearly 79 years, compared to 75 years in 1995. In 2015 there was 72,000 centenarians living in the U.S. and this figure is expected to surpass 370,000 by 2050.
In addition to more Americans living longer, the population growth is slowing, resulting in an older America. This shift in demographics will have ripple effects for financial advisors and the U.S. economy. My esteemed colleague, Chief Macro Strategist, David Ader, has done some fantastic work regarding the effects an aging U.S. population will have on long-term economic growth.
“When you consider the rapid aging of the population, the data are particularly striking. Back in 1990 those 55 years of age and older represented 25.5% of the U.S. population. Today that figure is 34.7% and by 2030 it will rise to 36.7%. The median age in the U.S. was 37.8 years in 2015; by 2045 it will reach 42 per Census Bureau projections,” notes Ader in his “Aging America to Stifle Growth” article.
“The bottom line is that an aging population tends to consume less than its younger cohorts, which means that overall spending (especially for discretionary non-necessities) is likely to moderate. Consider that Consumption is the single largest contributor to GDP: over 69% in the third quarter, which is pretty much a record. It hovered around 67% from 2002-09 and averaged 64% from 1980-2000,” Ader concludes.
Confronting potential tepid economic growth and preserving retirement savings will provide future obstacles for financial advisors. According to The Economic Policy Institute retirement savings is alarmingly low, with the average retirement savings for all U.S. families just north of $95,000, and half of the working age families having zero saved for retirement.
It is imperative that clients have clear goals and priorities in place so financial advisors have solid targets to aim for. Once the goals are in place, investment portfolios can be constructed to achieve the income requirements, which is easier said than done, as key decisions lie ahead.
For example, a retired couple in their early 70s has saved $1,000,000. They strive to enjoy their lives to the fullest, but wish to pass at least $500,000 in today’s terms (inflated at 2.25%) to their heirs. With these requirements in hand, we now can formulate a portfolio to achieve these goals.
In figure 1, we show a moderately conservative portfolio (40/60) that includes REITS. Based on the index returns and standard deviations from the past 15 years, this portfolio has an expected annualized return of 6.2% and standard deviation of 7.4%.
Using this return distribution, we can determine if the goals are attainable.
In order to maintain their desired living standard, an annual withdrawal rate of 5% inflated at 2.25% is required. Due to increased longevity, goal number one is in jeopardy, as some of the Monte Carlo simulations start going broke in year 24 (figure 2).
Their second goal of leaving money to their heirs is also in question. There is a 36% chance that $974,697 ($500,000 inflated at 2.25%) will be available in 30 years (figure 3).
For these goals to be more achievable in the face of increased longevity, the couple can either scale back their annual withdrawals to 4% or adjust the portfolio allocation to increase the return distribution. To increase the likelihood of achieving goal number two to 85%, the return requirement increases to 10% while the standard deviation jumps to 14%.
At the end of the day, investors with goals in place shouldn’t worry so much about the path taken to achieve the goal, but rather just focus on getting there. Standard deviation is nice, but should an investor worry about how far portfolio returns deviate from their mean if they are on track to reaching their goals?
Hedging drawdown risks and black swan events should be emphasized to provide more capital appreciation potential for longer time periods.
Capital preservation statistics such as pain index, pain ratio, and max drawdown should be part of every advisor’s key statistics, as well as tail risk metrics like value at risk, omega, skewness, and kurtosis. These statistics provide insight into how a portfolio performs during down markets or rare events.
In figure 4 we take a closer look at the capital preservation characteristics of the above Enhanced 40/60 portfolio, a basic 40/60 portfolio, S&P 500, and Barclays U.S. Aggregate indexes. As you can see, the “Basic 40/60” portfolio consisting of 40% S&P 500 and 60% Barclays U.S. Aggregate does a better job of preserving capital across the board, however the return is 80 bps lower. One must determine if a higher return is worth the additional drawdown risk and what portfolio provides the greatest probability of achieving the extended long term goals. Using mean variance optimization tools are critical when trying to determine the return risk trade-off.
Figure 4 - Enhanced 40/60 and Basic 40/60 portfolios rebalanced annually.
Obviously, no two portfolios are made the same, and decisions need to be made on what portfolio is best suited for the investment goals and objectives of the client so they can enjoy their extended years. Longevity plays a significant role in this decision-making process, as financial practitioners must understand their client’s time horizon and what risks might inhibit achieving a goal that is 30 years into the future.