Assessing investment risk through the lens of longevity risk
On average, individuals are living longer than previous generations and facing the potential challenge of funding a longer retirement. Retirement readiness requires committing to an optimal contribution rate, persistently saving over a long time horizon, and making suitable investment choices. Achieving the first two criteria may put individuals on the path to financial readiness. However, we believe overly conservative investment choices may introduce unintended risks to optimal retirement outcomes. Financial guidance and plan sponsor communication are crucial in highlighting potential pitfalls.
Saving for retirement over the long term can be one of the greatest challenges that most individuals face. Although each person’s circumstances are different, a general scenario could be an individual who starts saving at age 25 with a contribution rate of 10%—split between employee and employer contributions—increasing to 15% of income over time, saving for around 40 years until retirement.
It's likely many individuals are at risk of not achieving this due to a combination of settling into a stable career later than age 25, not working for an employer that matches retirement plan contributions, or simply being unable to set aside an optimal contribution rate due to competing life expenses. One challenge of retirement saving is that multiple risks are interconnected and may exacerbate one another.
Through proprietary analysis, we quantified retirement income shortfall risk based on various scenarios that individuals may face, such as low contribution rate, shortened time horizon, or the investment choice. A low contribution rate may increase income shortfall risk by as much as 83%1 for a Canadian woman and 78% for a woman in the United States. Canadian and American men face potential income shortfall risk of 79% and 74%,1 respectively, based on a lower average life expectancy compared with women.
A more familiar scenario that also carries risk is a shortened time horizon. For both American and Canadian women, delaying retirement savings by 10 years increases income shortfall risk to nearly 50%.2 Men aren’t far behind with a risk of 42% (United States) and 40% (Canada).2
Possibly a less obvious risk is the risk of being overly conservative in investment choice. Individuals in defined contribution (DC) plans carry the risk of low investment returns and the potential implications this may have on their long-term retirement readiness. Yet when it comes to investment choice, a baseline of knowledge is required about a relatively complex topic. Many individuals may consider their investment approach and risk tolerance as moderate to conservative, and yet there’s a significant increase in shortfall risk when growth assets are minimized. A record $6.4 trillion3 was invested in money market funds in the United States during 2023. While this represents all investor types in money market funds, it may serve as a noteworthy proxy for investors’ propensity to shift to ultraconservative investments. Over the short term, this approach may hold merit, but for longer-term retirement saving, it has the potential to significantly increase income shortfall risk.
Growth asset exposure is key to help reduce shortfall risk
Longer average lifespans are a positive outcome of improved health and mortality, but they can mean significant hardship for individuals without financial comfort. The risks that individuals face in saving for retirement over the long term are interconnected. A shortened time horizon increases the level of optimal contributions; meanwhile, a low contribution rate extends the time horizon that an investor would need to save to achieve a similar outcome. Moreover, for individuals who successfully meet the contribution rates optimal for their particular circumstances and save over a sufficiently long period of time, making an overly conservative investment choice could lead to heightened risk of income shortfall. Against this complex set of criteria, individuals may require professional advice and regular communication and education from plan sponsors highlighting the potential effects of specific choices on their retirement journey.
This article was extracted from a white paper available to financial professionals, “Longevity risk: How longer lifespans affect shortfall risk in retirement planning.” You can download the full paper here.
1 Multi-Asset Solutions Team, Manulife Investment Management, 12/31/23. Based on a total contribution rate of 5% over a 40-year time horizon. 2 Multi-Asset Solutions Team, Manulife Investment Management, 12/31/23. Based on a total contribution rate of 10% over a 30-year time horizon. 3 "U.S. Money Market Funds Reach $6.4 Trillion at End of 2023," Office of Financial Research, 3/26/24.
Important disclosures
Methodology:
Multi-Asset Solutions Team, Manulife Investment Management, December 23, 2023. Our analysis uses a base-case scenario that includes an accumulation phase of 40 years (starting at age 25); a total contribution rate of 10% (consisting of employee contribution plus employer match); retirement age of 65; target income replacement goal of 70% comprising a combination of 35% government pension (e.g., Social Security) and 35% savings; mortality data for three markets—Canada, the United States, and Hong Kong; a moderate allocation to a target-date portfolio and our capital market assumptions to forecast asset class growth potential. Asset class assumptions data is based on Manulife Investment Management's Multi-Asset Solutions Team (MAST) asset class forecasts, which comprise MAST's expectations of how different asset classes will perform in the future over a 20-year-plus time horizon. Forecasts are derived using quantitative modeling techniques, which are mathematical and statistical based methods—some of which are widely used in financial markets and some of which are developed specifically by MAST—for analyzing complex financial data. In addition, forecasts include estimates of anticipated economic conditions, including, but not limited to, inflation and interest rates, GDP and currency exchange rates, and the anticipated effects these may have on financial markets and asset prices. There is no assurance that such events will occur, and actual asset class returns may be significantly different from those shown here. This material should not be viewed as a recommendation or a solicitation of an offer to buy or sell any investment products or to adopt any investment strategy and are not meant as predictions for any particular index, mutual fund, or investment vehicle. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Data for the United States and Canada: Target-date portfolio at age 25 consists of equities (97%), cash (2%), U.S. Treasuries (1%); at age 65 consists of equities (55%), fixed income (38%), real assets (5%), cash (2%). 60/40 portfolio consists of equities (60%) and fixed income (40%), cash portfolio consists of cash (100%).
It is your responsibility to select and monitor your investment options to meet your retirement objectives. You may also want to consult your own independent investment or tax advisor or legal counsel.
This content is for general information only and is believed to be accurate and reliable as of the posting date but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made.
The information in this material, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for[EJ1] other reasons.
This material should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any investment products or to adopt any investment strategy.
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person.
All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment, or legal advice. Clients and prospects should seek professional advice for their particular situation. Neither Manulife Investment Management, nor any of our affiliates or representatives (collectively Manulife Investment Management) is providing tax, investment, or legal advice.
This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Manulife Investment Management shall not assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment approach, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.
This material has not been reviewed by, and is not registered with, any securities or other regulatory authority, and may, where appropriate, be distributed by Manulife Investment Management and our subsidiaries and affiliates, which includes the John Hancock Investment Management brand.
Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.
4140731
