It’s no secret that human beings are living longer and should better prepare for retirement than their parents or grandparents did. But the scope of this change may surprise some.
Twenty-five years ago, the annuity factor for a U.S. male aged 65 was approximately 8.5. Today it is nearly 17. Those of you who are not actuaries or students of pension finance, which is to say nearly everyone, are probably asking, “What is an annuity factor, and why should I care about it?”
Simply, an annuity factor is the present value of a dollar paid to our representative male on his 66th birthday, his 67th birthday, his 68th, and so on. If he is alive, he gets his dollar, if he is deceased, he does not. The annuity factor is the product of two inputs: interest rates and longevity.
The higher the annuity factor, the more wealth an individual needs at retirement to sustain a constant (nominal) consumption level in his/her retirement years. Unfortunately, for those looking to retire in the near future, annuity factors have never been higher. Why?
The reason for roughly one-quarter of the increase is good news: We are living longer! Life expectancy for a man aged 65 has increased by about 1.6 years per decade over the last few decades, and so today’s 65-year-old can expect to live on average roughly four years longer than his father. The story is similar for women, although not quite as dramatic.
The second piece of the increase in the annuity factor is attributable to lower, much lower, interest rates. Twenty-five years ago, the yield on the 10-year U.S. Treasury was a little over 8% versus its current level of around 1.5%. The long steady decline in rates is the major culprit, responsible for three-quarters of the increased cost.
In finance we use an interest rate to calculate the present value of future payments, but, to make it more applicable, think about it in reverse: At today’s low rates, savers earn much less yield on the same amount saved than they did 25 years ago.
So three smart things to do: 1) Start saving early, 2) Save more, 3) Work a little longer. Every little bit helps.