ADDRESSING LIFE EXPECTANCY IN GBWM
In a previous installment of OUR PROCESS, a series of whitepapers written to advance the education and understanding of our Goals Based Wealth Management (GBWM) process, we discussed the importance and application of taxes and inflation assumptions in the modeling or future-casting. For this issue of OUR PROCESS, I want to review another equally important assumption – life expectancy.
Life expectancy is relevant to the planning process because it affects duration i.e. how long the plan needs to last. To be certain, we want a plan that we build/craft for a client to last as long as or longer than they do. I think we would all agree that failure in this matter embodies the universal fear all retirees share.
But as is the case with many inputs in a forward looking analysis, we don’t see the future and therefore can never know with any degree of certainty how many days have been apportioned for us on this earth. So what scientific and/or logical approach can we take to be as accurate as possible? Well notwithstanding any responsibilities we may have for the well-being of others, the least expensive scenario is an immediate passing. Dead people don’t spend money and have no material/financial needs. It is therefore sound to assume the opposite is also true – i.e. that the most expensive scenario is to be alive for a very long time. Prudence therefore suggests that a plan should address the most expensive outcome.
Current mortality tables suggest that setting a life expectancy in the mid 80’s may be very reckless- analogous to the flip of a coin which bears a 50%/50% probability of either being heads(live) or tails (die). Similarly, extending the life expectancy of a financial plan to 113 years of age simply because there is a minute chance of living to that age is neither practical nor realistic. In an abundance of caution yet maintaining a strong dose of realism, we can apply the perato principle (80/20) for a sound life expectancy assumption. In other words, in our plans, we assume the plan needs to last until the client reaches the 20% percentile of being alive or conversely have an 80% likelihood of having passed. For men, this typically falls around age 93 and for females it is usually 95.
We treat this age as if it were a normal “bell” shaped curve. Family genetics as well as known medical conditions are then used to either skew or extend the “mean” life expectancy of each member in the plan.
Finally, it bears mentioning that with all good financial plans, the whole process is very dynamic. For example, I recently audited the Goals Profile of a client who will be turning 97 later this year. The life expectancy assumption has been extended several times already and most recently was set at 102. Sadly, I also have experience with adjusting a life expectancy to 73 for a client diagnosed with terminal cancer at the age of 68.
In summary, a key tenet in GBWM methodology is to control what can be controlled and measure the uncertainty of what cannot be controlled. The life expectancy (LE) assumption in our goals Profiles are no exception. The process described in this paper for selecting an LE for a client is realistic yet conservative. It is adjusted based on known i.e. controlled facts and modified as needed.
By following this process along with numerous others that comprise GBWM, a client’s Gaols Profile can be a reliable tool upon which actual real-life decisions can be made and upon which COMFORT and CONFIDENCE can be attained.
Regards,
Richard Van Der Noord, CFP®
Certified Financial Planner™
Registered Investment Advisor Representative
Notice: Van Der Noord Financial Advisors, Inc. is a Registered Investment Advisor in the State of South Carolina. This should not be construed as a solicitation or investment advice.
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