Retirement Income Redesigned: Master Plans for Distribution: An Adviser's Guide for Funding Boomers' Best Years

Chapter 18. Longevity Risk Insurance

roger g. ibbotson, michael c. henkel, and peng chen

The standard of living of the elderly depends on total retirement income, which comes from three main sources: Social Security benefits, defined-benefit pensions, and personal savings. Although Social Security and pensions continue to provide a foundation for retirement income, retirement savings plans and other personal savings are expected to become the main sources of retirement income. This shift in retirement funding from professionally managed defined-benefit plans to personal savings vehicles means that investors need to make their own decisions about how to manage risks and generate income in retirement.

Our discussion of the three risk factors investors must confront when making saving and investment decisions for their retirement portfolios appears in chapter 15 of The Investment Think Tank (Bloomberg Press, 2004), edited by Harold Evensky and Deena Katz. They are: financial market risk, longevity risk, and the risk of not saving enough. In this chapter, we review the importance of taking longevity risk into consideration in planning retirement income and extend longevity-risk analysis to the various types of income sources and investment instruments to determine their effectiveness in alleviating that risk. Using Monte Carlo simulations, we illustrate the benefits of including lifetime-payout annuities—including immediate fixed- and variable-payout contracts—in retirement portfolios ...