Morneau Shepell's Chief Actuary Fred Vettese says that typical retirement planning strategies fail badly when confronted with a worst-case scenario on the stock markets.
Vettese notes that most people believe that Canada Pension Plan (CPP) payments should start immediately, that annuities are unattractive because interest rates are so low, and that retirement income needs to rise with inflation every year. He argues that, in a worst-case scenario, those who take this approach will end their days in penury.
Spending slows down as one ages
Vettese calculates that pensioners who earn poor investment returns for several years could end up depleting their nest-eggs by the time they reach 75; by drawing an increasing income from a declining pool of assets, they risk becoming destitute for the last years of their lives.
Central to the problem is the idea that income always needs to go up. While it may be natural to assume that one’s retirement expenditures will always rise with inflation, Vettese points to research which has found that spending actually slows down as one ages. "This has more to do with an ever-diminishing inclination or ability to spend money than with a lack of money," he writes. Instead, he suggests that spending will drop 1% a year throughout one’s 70s, by about 2% a year in one’s 80s, and that there will be a single 30% decline in expenses after the death of a spouse.
Reducing equity exposure
Last month, Vettese made the case for taking a higher income from defined contribution (DC) pension plans in early retirement and postponing CPP payments to age 70. In this paper, he also considers what happens when investors use low-cost exchange-traded funds (ETFs) to reduce their fees and allocate 30% of their savings at age 65 to the purchase of an annuity. If pensioners leave the asset mix the same on the remaining 70% of their portfolio, he says that buying an annuity essentially reduces their equity exposure.
With these adjustments — even if retirees earn low, 5th percentile investment returns year after year — the same investors who would have been impoverished by a traditional retirement planning approach still have enough income for the rest of their lives. Regulations must be changed, however, before this strategy is available to everyone; some provinces (notably Ontario) do not currently allow variable income payments to be made to retirees from a DC pension plan, which makes this front-end loading approach impossible.
The full paper is available as a PDF on the Morneau Shepell web site.