Facing up to the risk of living too long

(MoneyWatch) Most people aren't prepared to live a long time or know how to cope with the uncertainty about the lengths of their lives, something the experts call longevity risk. This post follows up on my posts earlier this week that addressed a pending retirement crisis caused in part by a failure to understand and prepare for longevity risk.

So what can you do to protect yourself against the risk of living too long? To guard against unpredictable events that may have serious financial repercussions, you must buy insurance. People buy life insurance to protect their families in the event of the breadwinner's premature death; health insurance to protect against serious medical setbacks; homeowners insurance to protect against fire, theft, and other catastrophes; and car insurance that comes into play in the event of an accident.

If you don't insure against any of these risks, you're actually "self-insuring" against them. Which means you hope to have enough assets on hand to protect you and your family if one of the above events occurs. Many people self-insure their retirement because it usually takes a long time to outlive their money; it doesn't happen suddenly like an accident, fire or theft. So they ignore the risk and hope it doesn't come back to bite them.

But ignoring the problem won't make it go away. One way to insure against longevity risk is to maximize your Social Security income. Because Social Security pays a lifetime retirement income, waiting until age 70 to begin drawing down on benefits helps protect against longevity risk because this strategy will provide the highest amount possiblefor the remainder of your life. If you can't wait that long, at least consider holding off until you reach full retirement age (age 66) to access Social Security benefits. This will give you a higher income than if you had started at age 62, when many people begin receiving Social Security income.

If you've earned substantial benefits under a traditional pension plan that pays you a lifetime retirement income, they can also protect against longevity risk. Your best bet is to elect a monthly retirement income that will last the length of your life no matter what happens to the economy. With some plans you can choose the lump sum in lieu of the monthly retirement income; if you elect this option, you'd be throwing away longevity risk protection and instead choosing to self-insure your retirement.

You can also buy insurance to protect against the risk of too long a life, known asan annuity. It's best to buy a simple income annuity, where an insurance company sends a monthly paycheck as long as you live, or as long as your spouse or partner lives if you buy a joint and survivor policy.

There's some concern out there that if you buy an annuity and die early in your retirement, you may not get back all the money you paid to buy the annuity. But that's the wrong way to think about this concern. With any type of insurance -- annuities included -- if you experience an event you're insured against, you get back more in benefits than the premiums you paid. If the event does not occur, the reverse holds true. Consider an annuity to be an insurance policy that will pay more benefits than you paid in premiums in the event of a long life. If your life is abbreviated, the protection is unnecessary and your benefits will amount to less than your premiums.

You don't need to invest all or even half your retirement savings in an annuity to address longevity risk. You can buy an annuity that, combined with Social Security and any pension you might receive, will cover your basic living expenses. You may then want to self-insure your discretionary living expenses -- investing and drawing down on the remainder of your retirement savings. Diversifying your sources of retirement income is an instance of a well-regarded strategy, the one that tells you not to put all of your eggs in one basket.

Annuities sometimes get a bad rep resulting from their high transaction costs or expensive bells and whistles. But these are the expensive variety, and you're better off buying simple fixed-income annuities purchased through a competitive and transparent online bidding service such as Income Solutions or ImmediateAnnuities.com.

As with any financial product or instrument, there are always good buys and lemons. Your job is to do your research and select the most efficiently priced annuity, just as you'd do with any important purchase.

As stated above, Social Security benefits and pensions play a role similar to annuities in that they also insure against longevity risk. A combination of all three should allow you to live long and prosper.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.

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