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Longevity risk: are annuities the solution? Print
From a financial point of view, we can divide the life of an investor into two parts: a first phase of accumulation of financial assets, and a second phase of distribution or withdrawal. Our site focuses mainly on the first phase and on the related risks confronting investors, including the choice of an appropriate Asset Allocation to manage the financial risk of their portfolio. Today we begin a series of commentaries on the second phase, the risks associated with it, in particular the so-called longevity risk, and techniques to manage these risks, including the possible purchase of single premium immediate life annuity (SPIA).

Your greatest concern as an investor during the accumulation phase is not to set aside sufficient financial assets to meet your needs and those of your spouse during retirement. The amount of savings and the time period over which they are invested are the main factor contributing to the successful accumulation of assets; see savings and retirement on our site. Another concern is to avoid taking undue risks in the management of your portfolio, to avoid incurring unexpected investment losses; see the sections asset allocation and diversification and asset classes . The life risk during this phase is to die prematurely, without having benefited from the savings achieved, and without having put beside the amounts required either to allow your family to receive an adequate amount of capital, or to allow bequests to charitable or other works. The management of this life risk can lead the investor to consider purchasing term life insurance.

During the distribution or withdrawal phase, your objective as an investor becomes managing your  financial assets to ensure an acceptable standard of living during retirement, and possibly to  leave a certain amount to heirs or to charitable or other  works. The financial management during this phase involves selecting an appropriate asset allocation (again!), but superimposed on this is a second challenge, choosing the percentage of our assets to withdraw annually from our portfolio without running the risk of outliving our money. We recently published a commentary on this percentage; see the Post-retirement investing guru here , or in our Archives .

The life risk during this phase is the inverse of the first; it is the risk of living beyond your financial assets, with as a result a dramatic reduction in your standard of living, if not an unwanted dependence on the generosity of others. The life risk here is called the longevity risk (see definition doc.1040X in Investopedia), i.e. the risk of living longer than expected. Unforeseen financial demands or other supplementary income sources of income that do not materialize may also come complicate matters during this period. The management of this life risk can lead investors not to want to buy life insurance, the solution during the first phase, but rather an annuity typically issued by a financial institution and payable during the lifetime of the investor alone or together with his or her spouse.

Last Updated ( Tuesday, 16 December 2008 )
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