The great unknown – longevity risk

There are some things in life that we’ll never know and how long we will live is one of those great unknowns. Professional investors, like life insurance companies, typically refer to this as longevity risk, which is where the life of an insured client proves longer than forecast, meaning that payments to the client go for longer than expected and exceed the assets the insurer holds, so they tend to lose money.

Now we can assess longevity risk as it might apply to your investments by imagining that you know, in advance, that you live to 80 or even 90. Would that change the way you think about your working life, savings and superannuation? How about a worse case where you live to 65 and leave behind a financially illiterate spouse and they go on to live another 20 years, would that alter your approach to your finances and portfolio allocation?

I want to recount a meeting I had with a client recently, because it really reinforced a few key fixed investment themes. Let’s call the client Tom. Tom’s very first comment to us in the meeting was that he had “passed his use by date”. He has a degenerative condition and his doctors had not expected him to live to his current age. While Tom’s life expectancy has some boundaries they come with a complication; he has been told that to live his life comfortably, he will need approximately $150,000 per year to cover his medical care. Tom was fortunate enough to have built a fairly substantial portfolio of property and shares but had the foresight to realise he needed greater capital stability and so he approached us to establish a bond portfolio to help him meet his future needs. Share market volatility meant that he could not rely on shares as he had done in the past and property, while a good source of income, did not offer the ongoing liquidity that he would need.

Tom’s strategy has been to gradually sell down his share portfolio and invest in bonds with a high income stream over a range of maturities. The first $50,000 bond matures in 2014, there are no maturities in 2015 but then each year until 2020 there is at least one bond maturing worth a minimum $100,000. The maturity dates were carefully selected to coincide with known expenses. Two of the nine bonds held are issued by international companies and five of the nine are not listed on the ASX which adds diversification to his portfolio. Eight of the bonds are fixed rate, so that means Tom can be assured of a certain level of income. The only exception is a Sydney Airport 2020 inflation linked bond that was added recently given Tom’s concern about inflation in the United States.

Tom still intends to hold shares and property but his bond portfolio will be fundamental in meeting his goals.

If your lifespan is unknown and you are planning on, or in retirement, here are a few portfolio suggestions:

1. Reduce investment risk over time; as investors’ age as they do not have the same time to recoup losses as younger investors. Tom is reducing risk by selling down his shares and adding lower risk bonds with greater certainty.
2. Hold long dated assets that mature over longer terms; much the same way that bonds, in Tom’s portfolio, mature annually to help meet expenses. There are some very long term bonds available out to 2035 and beyond.
3. Add inflation linked investments; one of the main threats to purchasing power in retirement is inflation, so inflation linked bonds should be included in every portfolio. So, if you’re in your eighties, long dated inflation linked bonds might be “a bit ambitious” as one client once told me, but if you plan to leave behind an inheritance or look after a spouse, then they can still be sound investments that protect the holder of the bonds; be it you, or your beneficiaries from inflation.
4. Annuities and longevity insurance are worth investigating.