The increase in life expectancy makes ‘shortfall risk’ the scariest risk of all
The essence of financial planning for retirement is the ongoing process of transferring human capital (the resources we can generate while working and earning) to financial capital (the monetary assets we need to rely on to survive when no longer able to work). When we are at the start of our career, our potential human capital is enormous, whilst financial capital often negligible. If we get our retirement planning right, by the time we stop work we have accumulated enough financial capital so that we can live well and enjoy retirement, until the end of our life.
But note, your life expectancy may mean the length of time you need to support yourself in retirement could be a lot longer than you imagine. The spectre of outliving our retirement funds is a very real and serious risk - we call this ‘shortfall risk’.
Figure - Life expectancy at birth, UK, 2013
In a financial sense, when we consider how ‘risky’ we want our investment portfolio to be, we should consider not just our feelings towards risk right now, but how we’ll feel emotionally if we run out of money many years before the end of our natural life. It’s important to take ‘enough’ risk earlier on when retirement planning, for two reasons. Firstly, a long time horizon means that we are comfortably able to weather the ups and downs of the markets in the intervening period. Secondly, in event of any significant losses or worst case scenario, we still have many income-earning years ahead of us to recover.
Hence, naturally risk-averse savers may need to overcome their in-built reluctance to be adventurous when seeking growth in the early years, else be doomed to miss their retirement objectives. We all need to consider selecting a risk profile, and investment objectives, that are appropriate for age and stage of career.
Match Your Risk Profile And Investment Objectives To Your Age And Career Stage
As the latest statistics show, the trends in life expectancies are not slowing down - in fact the curve is steepening.
Most people have a good sense of investment risk. But there is a real danger of not taking enough risk at the appropriate time in our lives - and not planning far enough ahead - which could lead to early depletion of financial resources, and being forced to rely on others in late retirement.