Retirement Income: Risk Premium versus Risk Pooling

Shelley Yates, Communications Senior Advisor
February 12, 2019

Wade D. Pfau, Ph.D., CFA, a trailblazer on the study of retirement income who bridges the gap between academic research and practical application, recently spoke to financial advisors at the 1st Global National Conference about retirement income risk. Pfau is a Professor of Retirement Income in the Ph.D. program for Financial and Retirement Planning at The American College and a Principal and Director for McLean Asset Management, and he hosts the Retirement Researcher website.

“The costs of retirement grow with the length of retirement,” he said. “If I’m 65 and I build a plan to 95, what happens if I’m still alive at 96?”

Pfau explained that, while many focus on the accumulation of wealth for retirement, far less focus is on how to maintain one’s standard of living throughout retirement of indeterminate length. He explained several ways in which retirement risks change in retirement, including:

  • Reduced earnings capacity
  • Visible spending constraint
  • Heightened investment risk
  • Unknown longevity
  • Spending shocks
  • Compounding inflation
  • Declining cognitive abilities

Because retirees have a finite amount of resources to work with, market movement, tax law changes, rising inflation, increased healthcare costs and other risk factors affect them far more than those still earning a wage. However, the greatest risk to retirement income is longevity risk.

“Longevity risk is the risk of outliving your financial plan,” Pfau explained. “Longevity is not uniform across the population. Your clients, on average, are certainly going to live longer than the average American and that’s because they have all these characteristics associated with having a long-term focus. Your clients will have above average education, earn above average income, [and] the fact they’re working with advisors means they’re saving and accumulating more wealth. They’re also on average taking better care of their health than the average person, so your clients will likely live longer.”

While many cap life expectancy at 95 for planning purposes, he produced data from the Society of Actuaries1 that indicated there is a 40 percent chance that one member of a couple will live past 95. Even viewed separately, there was a 30 percent chance women would live past 95 and a 20 percent men would. How can financial advisors help their clients plan for what is clearly an increasingly longer retirement?

Pfau explained that the investment world plans for an age beyond average life expectancy and plans to spend less in retirement to ensure one does not outlive their retirement savings. He compares this with risk pooling in insurance, where participants spend like they’re going to live to their life expectancy, and those who don’t live as long subsidize the payments for those who live longer.

“We can know, if we’re part of that risk pool, that if we live a longer than average lifetime, we’re going to receive these subsidies from the risk pool that an investment portfolio can’t provide,” he said. “An annuity has survival probability included.”

The crux of his argument is the balance between risk premium with stock market investing and risk pooling through insurance. With investing in the stock market, there may be more left to pass on to the next generation in the case of a short retirement, and the potential for growth could theoretically support greater spending. However, managing assets for longevity and market risks requires more conservative spending without a guarantee of how much and how long the money is needed. With risk pooling in insurance, there is protection from longevity and market risk, guaranteed income for life and greater clarity about true liquidity availability for sudden expenses. Moreover, mortality credits provide a unique source of returns competitive with the risk premium. The answer then may be partial annuitization, which integrates risk pooling and risk premium.

Earlier in the year, Pfau also spoke on the topic of retirement income with 1st Global advisor Jody Padar at the AICPA Engage conference. Click here to watch the interview, and stay tuned to as we share more exclusive insights like this from our National Conference 2018 speakers.


1Society of Actuaries, 2012 Individual Annuity Mortality tables, with projections for 2018