Longevity Risk

Longevity risk has become one of the defining financial challenges of modern retirement planning. Life expectancy in the United States has increased substantially over the twentieth century, and demographic data from the Social Security Administration shows that a 65-year-old today has a significant probability of living into their mid-80s or beyond. When both members of a couple are considered together, the probability that at least one partner survives to age 90 or 95 is meaningfully high, implying that retirement assets may need to last 25 to 35 years or more.

The risk is compounded by several factors. Healthcare costs in retirement — particularly for long-term care services such as assisted living or nursing home care — tend to increase with age and can be extraordinarily large. Inflation erodes the purchasing power of fixed income sources over long retirement horizons, reducing the real value of spending. Cognitive decline can impair the ability to manage complex investment portfolios, making withdrawal strategy execution more difficult in advanced old age.

The insurance concept of risk pooling provides the most direct solution to longevity risk. Life annuities, including immediate annuities and qualified longevity annuity contracts (QLACs), transfer the longevity risk from the individual to an insurance company that can spread it across a large pool of annuitants. The insurer can guarantee lifetime income because, while an individual cannot know how long they will live, the insurer can predict with reasonable accuracy what proportion of a large pool of similarly-aged annuitants will survive to each future age, using actuarial mortality tables.

Social Security is often described as the most accessible longevity hedge available to American workers. Delaying Social Security claiming beyond the full retirement age increases the monthly benefit by approximately 8% per year up to age 70. Because Social Security is inflation-indexed and backed by the federal government, each dollar of Social Security income provides a more secure and inflation-protected income floor than most private alternatives.

Research by academic economists and actuaries has documented what is sometimes called the annuity puzzle — the fact that most retirees do not purchase life annuities despite the theoretical benefit of doing so. Explanations include the high perceived cost relative to surrender of liquidity, bequest motives (the desire to leave assets to heirs), default risk of the insurance company, and the crowding-out effect of Social Security and defined benefit pensions that already provide longevity insurance to many households.