Thank you so much for your question. Longevity risk in the context of investment planning is the risk of outliving one’s investment capital. No one knows how long they will live and, as such, building realistic life expectancy assumptions into one’s retirement planning is an important part of the process. However, through effective planning, longevity risk can be mitigated to a certain degree thereby giving the investor greater peace of mind, particularly later on in retirement.
As you are no doubt aware, when you formally retire from a retirement fund, you must use a certain portion of the capital to purchase an annuity which will provide you with an income during your retirement. At this point, you will need to make some strategic decisions to mitigate the two biggest risks that you’re likely to face, namely (a) the risk of inflation and (b) outliving your capital. Generally speaking, you have the option of using your retirement capital to either purchase a life annuity or to invest in a living annuity, with the two vehicles being fundamentally different – specifically when it comes to longevity risk.
A life annuity is an insurance policy taken out by the annuitant which involves the insurer taking on all longevity, investment risk, and inflationary risk. The annuitant and insurer effectively enter into a contract whereby the insurer promises to pay the annuitant a predetermined, guaranteed income for the remainder of their life.
Generally speaking, the policy terminates on the death of the annuitant or the death of the second-dying spouse. When structuring the policy, the annuitant can select how their annuity income should increase over time to keep pace with the costs of living.
How long the annuitant will live is anybody’s guess and knowing that their retirement income is guaranteed for the remainder of their life can provide enormous peace of mind.
When it comes to investment, the annuitant has no say or insight into how or where this capital is invested, nor what returns the insurer receives. As such, all investment risk in a life annuity structure is borne by the insurer, making it an attractive option for those who have a low propensity for risk and market volatility.
On the other hand, a living annuity is an investment held in the name of the annuitant, and this investment is typically housed on a linked investment services provider (LISP) platform. It remains the responsibility of the annuitant to determine how much they want to draw from their investment, which must be within the prescribed range of 2.5% to 17.5% per annum of invested capital.
Any capital that remains in the event of their death is available for distribution to their heirs and beneficiaries.
As such, the onus falls onto the annuitant to ensure that they draw from their investment at a sustainable level so as to ensure that they do not outlive their capital, meaning that the longevity risk falls squarely on the annuitant.
All investment risk in a living annuity is borne by the annuitant who has full autonomy when it comes to choosing a LISP platform, the underlying investment strategy, and asset allocation.
This means that the annuitant’s capital will be exposed to short-term market volatility which, in turn, can impact the value of the investment in the short term and subsequently the value of their drawdown.
Which one is for you?
As is evident from the above, understanding the longevity risk that you face and how to suitably mitigate against it is an important part of the retirement planning process, which is always best navigated together with an independent financial advisor.