In the next couple of articles, I will be looking at the use of mortality tables by financial planners. Not, on the face of it, a terribly exciting subject but I hope to convince you that it is a crucial area of technical knowledge and understanding which is badly overlooked in our examination syllabus.
Just over 10 years ago, when taking my examinations, one of the subjects included a requirement that we had to be able to read, understand and interpret mortality tables presented in different ways. Why bother, I remember thinking to myself. But years later I had cause to apply my knowledge to real-life financial planning situations from which I have made myself a substantial amount of income, as well as giving clients a far better understanding of their financial planning needs.
So, I highly commend these couple of articles to all financial planners who are not yet regularly using mortality tables in their daily lives.
Let us start by looking at the two main ways in which mortality tables are presented. First, and most often quoted, is life expectancy, showing how long a person of a certain age can expect to live on average. For example, a sample mortality table indicates that a male aged 50 can expect to live another 35 years (we will deal with women later).
These figures are published for all ages and both sexes and can be useful in such financial planning areas as retirement income, especially pension drawdown where an individual's life expectancy helps to indicate the period over which income is likely to be needed. I would suggest that these tables could also be useful for portfolio planning, life insurance and inheritance tax planning.
But herein lie a few lessons, some of which do not appear in the text books. Most important, it must be remembered that mortality tables are constructed on an historical basis, recording the number of people who live to a similar age. So, for example, the tables will indicate that males born in 1910 lived, on average, 75 years. Similar tables might indicate that males aged 50 in 1950 lived for a further 35 years on average.
But does this mean that males aged 50 in 2003 can expect to live a further 35 years? Well, if you look at the mortality tables, or any other article or textbook interpreting mortality tables, that is exactly what you might be led to believe but the fallacy in this interpretation comes from the fact that mortality tables are not meant to be predictive – they are historical records.
It is well and reliably documented that life expectancy has been increasing consistently and significantly over the last century and is expected to continue to do so over the next few decades at least. In fact, over each of the last three decades, the life expectancy of a 60-year-old male has improved by around three years. That is three years' improvement every 10 years.
Thirty years ago, mortality tables might have suggested to a 60-year-old that he was expected to live another 14 years or so (just within the latest age to vest pension funds, of course) but most recent mortality tables indicate the expectancy is nearer 25 years.
But even these more recent tables only show us what has happened more recently. They do not show or even pretend to show what might be expected to be a current 60-year-old's life expectancy.
If you work the numbers through, without going into fine detail, if male life expectancy continues to improve by three years every decade, a current 60-year-old might be expected to live not 25 years – to age 85 – but X years. This is because, by the time he reaches 70, he will be told he can now expect to live to 88 and by the time he reaches 80 he will be told he will most likely live to 91. By 91 he will be told 94, by 94 he will be told 95, at 95 he will be given a few more months, after which a couple of extra days, and so on. A bit glib and simplistic, I admit, but not very wide of the mark in reality.
Talking about reality, this same line of reasoning, while accepting that life expectancy is not likely to continue to improve quite so dramatically, strongly suggests that the vast majority of youngsters today will almost certainly live to ages well beyond 100. Speaking as a father of two youngsters, the comment: “Just as long as they've left home” springs to mind.
What does all this mean for financial planners? For a start, it means that we are all going to have to make much greater provision for retirement income because we are all going to live a lot longer than we have previously been told. This, of course, is what all the fuss is about regarding the state pension. We are now going to live an inconveniently long number of years and the Government just cannot afford to continue paying us. Perhaps it will soon start to pay us from the age of 70 or even 75 or (much more likely, most people think) it will means-test the state pension.
This is not, please note, a political issue. Any party in Government (no prizes for guessing the next one) will have to address this problem.
Talking about retirement provision, increasing life expectancy has had a massive impact on conventional annuity rates by reducing them, for each decade's improvement, by broadly the equivalent of a 1 per cent reduction in interest rates. If life expectancy continues to improve, annuity rates will continue to fall, although it must be noted that the major annuity providers have already factored in to today's rates a certain assumption of some future improvement.
The prospect of falling annuity rates makes pension drawdown less attractive than if this issue did not exist. Pension drawdown involves deferment of annuity purchase, so if, by the end of this period of deferment, annuity rates are lower, the client's fund must in the meantime grow faster just to break even.
This increase in life expectancy is also partly to blame for a flood of final-salary scheme closures (more expensive to pay pensioners), increases in taxation (more elderly people in hospitals or other care establishments for longer periods of time) and the likely demise of the state pension as we currently know it.
On the positive side, increasing life expectancy means falling life insurance rates meaning, not least, continuing opportunity to churn (sorry replace) old term insurance policies on higher premiums. It also means, though, increasing PHI and critical-illness premiums as we are more likely to live to retirement and also more likely to suffer some form of critical illness (for the whole-life plans, that is).
In my next article, I will discuss further financial planning implications of longer life expectancy. I will also deal with the situation regarding women and conclude with a few ideas as to how we can use these figures to help our clients and ourselves.