On Quitting Early, the Decumulation Problem and Living to 100

The missing, ambiguous, and/or dubious information that has to be considered when making financial decisions is why people should use Annie’s advice when making important choices with respect to their lives and their money.

Annie was on my podcast a few weeks ago talking about Quit – a book that addressed one very important decision that is fraught with uncertainty as well as more than a little psychology.

As an actuary focusing on retirement income strategies, I was naturally interested in Annie’s views on one the most important “quit decisions” that we have to make – i.e., when to stop working and begin living on all the assets we have accumulated along the way.

In talking about that decision, Annie said that too many people view the decision to stop working as “last and final” when it really isn’t. She suggested that “status quo bias” keeps many people working past the time when they should be retiring.

When I pressed her on the financial aspects of knowing when you have accumulated enough to live on for the rest of life, she said that that was a question of determining whether you have “enough runway” for a safe landing while you consider what to do next. She did, however, acknowledge that when approaching the end of a career, there is a “stickiness” associated with your shortening time horizon that might keep you working longer than you otherwise might.

She said that while this “time element” is important, the more important question for those who are tired of their jobs and are contemplating retirement to ask themselves is “For how much longer are you okay with being miserable at your job?” Once you have answered that, set a date and hold yourself accountable to that timetable.

The above is great advice for thinking about when to retire. But whether poker, chess, or actuarial science is the right thinking to use in developing and managing a retirement income strategy is an open question. Once you have made that first and most important quit decision, i.e. actually retired, you face the decumulation problem. That is where even though “thinking in bets” might be helpful, there are clear, quantifiable risks where the actuarial perspective is extremely useful. Here too though, Annie’s insights regarding our cognitive biases and systematic miscalculations are well worth heeding.

Actuarial science attacks problems where time, risk and money all play a part. Generally, actuarial science focuses on quantifiable risks and things that are easily measured, leaving it to others to guide individuals through the minefield of human nature that we have to traverse before making our choices. That is why Annie’s books are so worth reading. She enumerates and addresses the myriad of ways we end up making choices we later regret. Annie discussed many of those biases on our podcast, but also noted that some of her approaches to making decisions under uncertainty need to be modified based on the timeline over which you are making decisions. Plans can become more “sticky” when your timeline is short, and quitting becomes less of an option as you get closer to the end.

The time element is also important for those who have already quit working and have begun drawing down their assets to sustain themselves for the rest of their lives. In fact, many of us retire because our timeline is shorter even if its actual endpoint remains, except in rare circumstances, highly uncertain.

The nature of the problem

Decumulation is a brutally difficult problem. There are four distinct risks that retirees face during this phase of life that are either immaterial or non-existent during the years when you are working and saving for retirement. For a more detailed description of each risk, see my previous article.

Each of the four risks has its own unique aspects. The effectiveness of the different techniques that can be used to manage each depend on when they are deployed during retirement. For example, an unexpected “spike expense” is less dangerous to your financial health if it happens early in your retirement, since you will have longer to recover the assets lost and/or modify your future drawdown strategy to accommodate your “post-spike” income/expense planning.

But the one risk that always manifests itself at the worst possible moment is longevity risk. Longevity risk only manifests when you are older than you ever expected to be – exactly at the point where your financial resources may be running out. Therefore, if you don’t consider longevity at the outset of your retirement, even if you manage the other three risks effectively, you may struggle to make ends meet at the very point in life when you have limited resources to draw on diminished assets and few options for addressing the prospect of running out of money.

Longevity is hard to think about as a “risk” because the benefits of living a long, healthy life are, for most of us, overwhelmingly positive. No one wants to think about the downside of living to 100, or if we do, we discount it as either wildly unlikely or as something that is best ignored. It is a long way in the future, so why bother thinking about it?

I agree with Annie’s view that people often wait too long to decide to retire, not realizing that it is possible to “unretire.” But most people who have no serious health issues should consider the fact that their retirement may last much longer than their life expectancy suggests.

The problem with longevity risk is that it gets more acute (and harder to deal with) the longer you live and the healthier you stay. For example, a 65-year-old man in decent health should expect to live another 20 years until his mid-80s. However, once that man reaches 80 and is still in good health, he has a better than 50-50 chance to make it into his early 90s with a decent shot at making it to 100. That is not the worst of it.

If you are a woman, your odds are even better and the risk that much more acute.

How to manage longevity risk

Because longevity risk gets more acute and difficult to manage as you get older, it should be most cost efficient to think about the possibility you might reach age 100 long before you approach that age. That is where my colleagues and I have begun to research risk mitigation approaches. Below are three techniques for addressing this risk directly:

1. Purchase longevity insurance. At age 65, you can buy a 20-year deferred-income annuity (DIA, where payments begin at age 85) to insure against the risk of outliving your assets. And because so many 65-year-olds will not stay healthy enough to collect much if any of their benefit, the price can be very reasonable. But like any insurance, the price is set to make a profit for the insurer; in that sense, it is a “bad” bet. But expensive as longevity insurance might be, it should be considered in the same way most people buy fire insurance. It is a means of protecting yourself against a risk you can’t afford to bear and something that could be devastating to your financial wellbeing.
2. Become your own “insurance company” and self-insure the risk. When my colleague Barry Sacks and I first started discussing the dynamic nature of longevity risk, I suggested buying longevity insurance from a Life Insurance company. Barry asked, “Why do you need an insurance company? Can’t retirees do it themselves?” Barry was right. What an insurance company does to provide that DIA is to take in premiums (as a lump sum or installments) and invest the money in a laddered bond portfolio (i.e., a series of bonds of varying duration) that are held until maturity. As each bond matures, the proceeds are reinvested in the longest-duration bond available. Since insurance companies sell many annuities, they have the cash to make payments when the annuitant reaches age 85. As an individual, you can do that too, though managing the cash flow on the back end is tricky. More generally, you can reduce your longevity risk by simply reducing your drawdown and investing what you save in a separate account that can be drawn on when your current assets begin to run out. But without a careful, disciplined approach you may end up substituting additional investment risk for the assurance that you won’t outlive your assets.
3. Become your own actuary and reevaluate your retirement income strategy every year. Ken Steiner is a retired actuary who has been thinking about the decumulation problem for more than a decade. He has identified many of the unique risks associated with drawing down assets to live on well before it became apparent to the rest of us. His view on how to develop a retirement income strategy is that we all need to become our own actuaries. Just like the way we serve our pension clients, we should annually reevaluate our assets, liabilities, income and expenses as well as the key assumptions, including how long you expect to live. We should use that data to project and manage drawdowns and expenses. From a theoretical standpoint, he is right, but many will find the task of implementing Ken’s idea arduous and complicated. That being said, Ken’s approach is described here and is well worth considering.

With respect to retirement income planning, longevity risk has no perfect or “cost free” solution. There are, however, at least a few approaches retirees can consider that will make this risk less dangerous than it might be if it is ignored completely.

Peter J. Neuwirth FSA, FCA, is an actuary specializing in retirement plan issues. He is a 1979 graduate from Harvard College with a BA in mathematics and linguistics. After leaving Harvard, he went to work at Connecticut General Life Insurance, now CIGNA, and for the next 38 years he worked continuously as an actuary holding significant leadership positions at a variety of firms around the country including most of the major consulting firms (Aon, Hewitt Associates, Watson Wyatt, Towers Perrin and finally Towers Watson).

Read more articles by Peter J. Neuwirth