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 sound investment choices. Achieving the first two criteria immediately puts individuals on the path to financial readiness. However, overly conservative investment choices may introduce unintended risks to optimal retirement outcomes. Sound financial advice and plan sponsor communication are crucial in highlighting potential pitfalls.
Saving for retirement over the long term is one of the greatest challenges that most individuals face. Although each person’s circumstances are different, a general positive scenario would 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.
In reality, 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 suboptimal 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 trillion 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.
Longer average lifespans are a positive outcome of improved health and mortality, but they can mean significant hardship for individuals without financial security. 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 need sound 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 an analysis available to financial professionals, “Longevity risk: How longer lifespans affect shortfall risk in retirement planning”. To download the thought-leadership analysis, click 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.
Important disclosures
1 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. Refer below to the list of indexes used. It is not possible to invest directly in an index. Past performance does not guarantee future results. 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. View important disclosures below for portfolio compositions and indexes uses. It is not possible to invest directly in an index.
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%).
Equities consist of U.S. large cap, represented by the S&P 500 Index, which tracks the performance of 500 of the largest publicly traded companies in the United States. U.S. mid cap is represented by the S&P MidCap 400 Index, which tracks the performance of 400 mid-cap companies in the United States. U.S. small cap is represented by the S&P Small Cap 600 Index, which tracks the performance of 600 small-cap companies in the United States. EAFE small cap is represented by the MSCI Europe, Australasia, and Far East (EAFE) Small Cap Index, which tracks the performance of small-cap stocks of companies in those regions. Canadian large cap is represented by the S&P/TSX Index, tracks the performance of the Canadian equity market on the Toronto Stock Exchange (TSX). Non-U.S. developed is represented by the MSCI Europe, Australasia, and Far East (EAFE) Index, which tracks the performance of large- and mid-cap stocks of companies in those regions. Emerging markets is represented by the MSCI Emerging Markets (EM) Index, which tracks the performance of large- and mid-cap EM stocks.
Fixed income consists of U.S. investment grade, represented by the Bloomberg U.S. Aggregate Bond Index, which tracks the performance of U.S. investment- grade bonds in government, asset-backed, and corporate debt markets. U.S. long term Treasuries is represented by the Bloomberg U.S. Long Treasury Index tracks the performance of U.S. Treasury obligations with maturities of 10 years or more. U.S. short core investment grade blend is represented by a blend of the Bloomberg U.S. Aggregate 1–3 Year Index, which tracks the performance of the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including instruments with a remaining maturity of one to three years; and the Bloomberg U.S. Aggregate Bond Index tracks the performance of U.S. investment grade bonds in government, asset-backed, and corporate debt markets. U.S. intermediate term credit is represented by the Bloomberg U.S. Intermediate Credit Index tracks the performance of investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate and government-related bond markets with maturities greater than one and less than ten years. U.S. short TIPS is represented by the Bloomberg U.S. 1–5 Year U.S. Treasury Inflation-Protected Securities (TIPS) Index tracks the performance of inflation-protected securities issued by the U.S. Treasury with maturities between one and five years. U.S. high yield is represented by the Intercontinental Exchange (ICE) Bank of America (BofA) U.S. High Yield Index, which tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market and includes issues with a credit rating of BBB or below. U.S. leveraged loans is represented by the J.P. Morgan U.S. Liquid Index (JULI), which tracks the performance of a specific corporate bond or sector against the subset of the most liquid bonds in the investment-grade market. Canadian investment grade is represented by the FTSE Canada Universe Bond Index, which tracks the performance of marketable government and corporate bonds outstanding in the Canadian market. Global investment grade is represented by the Bloomberg Global Aggregate Bond Index, which tracks the performance of global investment-grade debt in fixed-rate treasury, government-related, corporate, and securitized bond markets. Canadian mortgage-backed securities is represented by the FTSE Canada MBS Index 3-5 Yr Non-prepayable, which tracks the performance of Canadian mortgage-backed securities with maturities ranging from 3 to 5 years that are not subject to prepayments. Emerging markets debt is represented by a combination of the J.P. Morgan EMBI Global Diversified Index, which tracks the performance of U.S. dollar-denominated Brady bonds, Eurobonds, and traded loans issued by sovereign and quasisovereign entities, capping exposure to countries with larger amounts of outstanding debt; the J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI), which tracks the performance of U.S. dollar-denominated debt issued by EM corporations; the J.P. Morgan Government Bond Index-Emerging Market (GBI-EM) Broad Index, which tracks the performance of local currency EM government bonds.
Real assets are based on global REITs, which are represented by the FTSE EPRA Nareit Developed Index, which tracks the performance of listed real estate companies and real estate investment trusts in developed markets on a free float-adjusted basis. Commodities are represented by futures contracts of commodities. Private infrastructure is represented by the Burgiss Global Infrastructure Funds Index, which is calculated from the Burgiss Manager Index, one of the most comprehensive datasets of private capital funds, funds of funds, and their holdings.
Cash is represented by the Bloomberg U.S. Short Treasury 3–6 Month Index tracks the performance of U.S. Treasury bills, notes, and bonds with no more than six months to maturity. For Canada, cash is represented by the FTSE 91-day T-Bill Index, which measures the performance of U.S. Treasury bills with a maturity of approximately 91 days.
Data for Hong Kong: Target-date portfolio at age 25 consists of equities (95%), cash (1%), fixed income (4%); at age 65 consists of equities (50%), fixed income (45%), cash (5%). 60/40 portfolio consists of equities (60%) and fixed income (40%), cash portfolio consists of cash (100%).
Equities are represented by the FTSE MPF Hong Kong Index, a benchmark index that tracks the performance of the Mandatory Provident Fund (MPF) scheme in Hong Kong. The MPF is a compulsory retirement savings scheme for employees in Hong Kong, and the index includes the constituent funds of the scheme. The FTSE MPF North America Index consists of eligible U.S. and Canadian large and mid cap companies which are listed on the stock exchanges approved by the Mandatory Provident Fund Schemes Authority (MPFA). The FTSE MPF Europe Index consists of eligible large-cap and mid-cap European companies, which are listed on the stock exchanges approved by the Mandatory Provident Fund Schemes Authority (MPFA). The FTSE MPF Japan Index consists of eligible large-cap and mid-cap Japanese companies, which are listed on the stock exchanges approved by the Mandatory Provident Fund Schemes Authority (MPFA). The FTSE MPF Asia Pacific ex Japan & Hong Kong Index consists of eligible large cap and mid cap Asia Pacific companies in the FTSE MPF All-World Index, excluding Japanese, Hong Kong, and Hong Kong listed Chinese companies, which are listed on the stock exchanges approved by the Mandatory Provident Fund Schemes Authority (MPFA).
Fixed income is represented by global core investment grade, which is represented by the Bloomberg U.S. Aggregate Bond Index, which tracks the performance of U.S. investment- grade bonds in government, asset-backed, and corporate debt markets. Asia local bonds are represented by the Markit iBoxx Asian Local Bond Index, which is a benchmark index that tracks the performance of local currency-denominated fixed-rate sovereign and quasi-sovereign debt in the Asian region. Hong Kong bonds are represented by the Markit iBoxx ALBI Hong Kong Index, which is a subset of the broader Markit iBoxx ALBI (Average Life Bond Index) that focuses specifically on the Hong Kong bond market. It tracks the performance of the Hong Kong dollar-denominated fixed-rate bond market, including both sovereign and corporate bonds.
Cash is represented by the MPFA Prescribed Savings Rate, which is used as a benchmark to decide whether MPF trustees can collect fees on their Conservative Fund.
Although the target-date funds are managed for investors on a projected retirement date timeframe, the fund’s allocation strategy does not guarantee that investors’ retirement goals will be met. The target date is the year in which an investor is assumed to retire and begin taking withdrawals.
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