Longevity risk – the risk of running out of assets before running out of time – is a fundamental consideration in retirement planning. Budgeting for an uncertain horizon is never easy, however, as most people have problems with probability.

In one Duke University study, in which people were asked whether they would live to age 85, 55% said yes. But when the question posed to another group became whether they would probably die by 85, 70% said yes.

As a result, financial advisors need to reshape the retirement conversation when discussing how long clients believe they will live and whether they are spending too much, retiring too early or not saving enough, says Moshe Milevsky, associate professor of finance with York University’s Schulich School of Business in Toronto.

Milevsky, writing in the March/April issue of Financial Analysts Journal, suggests that advisors should start by providing clients with an estimate of the number of years their portfolio will last, using a framework that can be easily understood and communicated.

Retirees should be familiar with the concept of life expectancy – the expected number of years they will live – which Milevsky labels the “expected horizon” (EH). At retirement, the value of EH is somewhere between 15 and 30 years, depending on gender, health, race and ethnicity, he notes.

Milevsky suggests that advisors employ the same language for the retirement income portfolio, viewing the longevity of the portfolio (i.e., “estimated longevity” [EL]) as a parallel to personal longevity. EL also can be measured in years and approximated by a function of three variables.

The first variable is the withdrawal rate, which, he believes, is better measured in dollars per year, not as a percentage of assets. The second variable is the money currently in the client’s nest egg. The third, most critical variable is the annual growth rate of the portfolio, as measured by percentage and net of management charges, taxes and inflation.

The resulting equation, which is most useful when clients seem to be at risk of spending more than they earn, highlights how many years the nest egg will last.

For example, suppose your client has $750,000 in investible retirement assets. You anticipate that the client’s portfolio will safely earn 2.5%, on average, in real terms. The client wants to spend $65,000 a year (in real dollars) for as long as he or she lives.

Plug these three values into the equation and the result is a portfolio longevity of 13.6 years.

Is this result good or bad? Neither, really, but it is a conversation starter, Milevsky maintains. Say your client’s doctor gives the client approximately 20 years of longevity (EH), but the client’s portfolio has roughly only 14 years of life (EL) left in it. There is a mismatch, and you and your client have to do something about it.

When making financial plans, Milevsky adds, explaining to clients that the longevity of their portfolio is random also is important because two (possibly even three) of the variables will fluctuate. Thus, the client probably should think in terms of maximum possible lifespan rather than life expectancy, the latter of which is based on averages.

But, he adds, introducing the concept of EL to quickly remind clients that they may be heading down the wrong path is a useful first step.

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