Retirement

The evolution of retirement income

To meet the needs of the estimated 10 million baby boomers who are facing retirement within the next 20 years, the Canadian financial services industry has spent considerable time and effort providing advice on how to accumulate enough wealth to last a lifetime. Perhaps the most common and time-tested approach has focused on asset allocation.

Simply put, asset allocation is an investment strategy that combines different investments in various asset classes, creating a portfolio that corresponds to your tolerance for risk. The portfolios are designed to help you build wealth comfortably during your working years. By spreading your investment risk among stocks, bonds, cash and other types of investments, you can benefit from excellent returns when the markets are performing well and minimize your losses if they perform poorly.

But for boomers facing retirement, asset allocation strategies are not enough to ensure your savings will last a lifetime. Future retirees may need to plan more carefully than previous generations due to a number of factors that are unique to this generation of investors.

FOR BOOMERS, THE NATURE OF RISK IS CHANGING

Future retirees may need to be more aware of the risks that their retirement savings will face. These risks include longevity, inflation and something that is becoming known as the “sequence of returns” risk. Let’s take a quick look.

LONGEVITY RISK

Longevity risk is the possibility that you end up underestimating the amount of time you spend in retirement. The good news is that you can expect to live longer than your parents’ generation – the bad news is that you may outlive your retirement savings.

THE PROBABILITY OF A HEALTHY 65-YEAR-OLD LIVING UNTIL…

Assuming that a married couple both retire at age 65, they may need to provide themselves with 25 years or more of income – that’s approximately one-third of their life!

INFLATION RISK

The problem with inflation is that money saved today will not have the same buying power in 25 years. We’re currently seeing the effects of higher oil and gasoline prices, which have an impact on the cost of goods such as food, clothing and other expenses in our personal lives.

Inflation has the potential to significantly erode your purchasing power during retirement. The combination of longevity and inflation risks is why many advisors consider it wise to include market-based investments such as equity mutual funds in a retirement portfolio. The continued growth potential of the equity markets may help to ensure the value of your savings is not eroded by inflation.

“SEQUENCE OF RETURNS” RISK

Research conducted by Professor Moshe Milevsky, a York University professor and Canadian financial expert, speaks of a significant risk that many retirees face in the 10 years immediately after they begin withdrawing income from their retirement savings. Describing the retirement risk zone, Professor Milevsky’s analysis demonstrates the role that the sequence of returns can play when trying to ensure that your savings last. If you remain invested in the financial markets to obtain returns that will help you offset the corrosive effects of inflation, the order – or sequence – of investment returns you obtain during your transition to retirement can make a significant difference in determining how long your savings will last. Withdrawing regular income from an investment that has declined in value immediately after retirement due to market volatility could mean that you will deplete your savings much more quickly than you would expect.

EFFECTS OF INFLATION ON $1,000

RETIREMENT PHASE

• Portfolio A experiences poor returns immediately after turning age 65 and runs out of money by age 85
• Portfolio B experiences strong returns immediately after turning age 65 and is able to make their savings last well beyond the average lifespan
• Both portfolios achieve the same compound investment return of 6.5 per cent over the respective time periods shown

RETIREMENT INCOME EVOLUTION

The risk of an extended market decline early in one’s retirement is simply too great to ignore. To help mitigate these risks and ensure that boomers will have enough long-term income in retirement, the financial services industry has products such as immediate annuities with guaranteed lifetime income and has introduced new products such as segregated fund insurance contracts with guaranteed minimum withdrawal benefits (GMWBs). What’s missing is an effective strategy that helps investors and their advisors evaluate which of these products is most suitable and how much to invest in each.

INTRODUCING PRODUCT ALLOCATION

The goal of product allocation is to calculate how large a share of your savings should be committed to securing guaranteed lifetime income by using a combination of investments, with some offering guarantees. Based on your personal financial situation, risk tolerance and goals, product allocation will determine which investments are most suitable for you to achieve your retirement income goals and how much of your savings you should put in each to obtain an optimal amount of sustainable income.

INVESTMENTS NOT OFFERING GUARANTEES

Systematic withdrawal plans (SWPs) are widely available and can be applied to investments that include mutual funds, stocks, bonds, GICs, etc. A SWP allows you to automatically withdraw a set amount of income per month by selling a portion of the underlying investments. As long as the underlying investments continue to grow at a higher rate than what you withdraw, a SWP can provide sustainable and often tax-efficient income that can help offset the effects of inflation. A SWP can also allow you to access your money at any time in case of an emergency. A SWP, however, does not provide income guarantees. Therefore, it is possible to run out of money using a SWP if the underlying investments perform poorly, or if your rate of withdrawal exceeds the growth rate of the underlying investments.

INVESTMENTS OFFERING GUARANTEES

A guaranteed minimum withdrawal benefit (GMWB) is a new income guarantee insurance product for Canadian investors. The GMWB can provide a predictable, sustainable and potentially increasing income stream that is guaranteed for a period of time, or for life. The GMWB allows investors to select the underlying investments, and since many of these products provide exposure to equities, you will have the potential to grow your savings to help keep up with inflation. Like a SWP, a GMWB also allows you to access your money at any time if the need arises – and, depending on which investment options you choose, these products also have the potential to provide a tax-efficient source of income. Immediate annuities and other sources of guaranteed lifetime income, such as Defined Benefit Pension Plans, the Canada Pension Plan (CPP) and Old Age Security (OAS), have been popular options for Canadians for decades.

Immediate annuities are attractive retirement investment options since they provide a pre-determined amount of lifetime income that is not affected by fluctuations in interest rates or other market influences. However, once you’ve purchased an annuity, you no longer have access to your savings should an unexpected need arise. Defined Benefit Pension Plans, CPP and OAS are excellent sources of retirement income that provide a pre-determined amount of income each month, and the income is insulated from fluctuations in the market.

PRODUCT ALLOCATION METHODOLOGY

The methodology behind product allocation stresses that none of these products should exclude the others. The ideal retirement income portfolio will be based on how much weight an individual assigns to the risks he or she faces in retirement and his or her retirement goals. The goal of product allocation is to determine how much you should invest in each product category, taking into account your current financial situation, the costs and benefits of each and how they interact with each other over time.

HOW I CAN HELP

As you approach your retirement years, it will be important to determine your priorities and educate yourself on the best ways to help ensure your savings can last a lifetime. The shift from savings to spending necessitates a shift in how you approach investing. It will prove prudent to plan for the different challenges you’ll face in your retirement years – from managing market risk in order to grow your assets, to managing the risks associated with inflation and longevity. To help you determine which combination of investment products will help you achieve your retirement goals, it’s best to speak directly with me. After helping you define your priorities in retirement, I will be able to calculate the ideal portfolio allocation that can help ensure your retirement remains secure.

1 Comment

• 

  By Carl Brodie, June 6, 2009 @ 1:37 am

  Hi Kris,

  Thank you for the complement. You are welcome to take the post for your own site. I would appreciate it if you could indicate my site as the source of the article.

  Thanks,
  Carl

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