Advisors discussing retirement with clients should forget talking about fixed withdrawal rates and focus on “longevity risk aversion,” according to Moshe Milevsky, professor of Finance at York University.
Longevity risk aversion, or LoRA, refers to the degree that clients are concerned about living to an advanced age and cut back on their current standard of living to compensate for that risk.
For example, if a client fears living to 100 and is willing to put up with a lower standard of living to ensure there is enough money available during those later years, that client can be said to have a high LoRA.
A client with a low LoRA would prefer to have a higher standard of living in retirement today, and cut back on spending later on, if the client happens to live that long.
When calculating how much annual income a client needs in retirement, the industry needs to move away from discussing fixed pensions, and calculate pensions as a function of LoRA, said Milevsky, who spoke Thursday at the Segregated Funds Annual Conference in Toronto. The conference is hosted by the Canadian Life and Health Insurance Association.
“The industry seems to be obsessed with fixed withdrawal rates and clients having a flat pension profile,” said Milevsky. “With the chances of a person living until 100 being quite small, isn’t it better to enjoy a higher standard of living earlier in retirement and cut back later on if necessary.”
LoRA can be determined by asking clients how worried they are about living to age 100. “If they can’t sleep at night because they are worried about that, their LoRA is very high.”
Considering the true probability a client will live to 100 is about 5%, it’s a client’s perception of that risk that is most important in a retirement plan, added Milevsky, not the probability of it actually occurring.
It’s also why a fixed pension plan isn’t suitable for most clients, said Milevsky, since many clients would prefer to make the tradeoff between enjoying a higher standard of living in their earlier retirement years and cutting back to adjust for old age risk for themselves.
Using LoRA, retirement product allocation should be split into three different pots, Milevsky added: pensions and annuities, securities and products with downside protection.
The securities pot refers to cash, mutual funds and stocks. The annuities and pensions category refers to fixed income in retirement.
The third pot includes products with downside protection, such as segregated funds, investments that act like mutual funds with a guaranteed downside. This pot would behave as a pendulum — swinging to increase a client’s security assets in good times, with the guarantees kicking in during bad times.
The allocation of assets within each pot is linked to a client’s financial risk tolerance, whereas the size of each of pot is based on LoRA. For example, clients with a high LoRA and afraid of outliving their retirement savings would want more money invested in annuities, as well as guaranteed products.
“Everyone has a unique LoRA, and level of financial risk tolerance, and we want to make both of those aspects a part of the conversation,” Milevsky said.