Proper retirement planning requires planning for the worst, so deciding what to focus on in a retirement plan is no easy task. More often than not, financial planners think in terms of accumulation. But, once you switch from the accumulation stage to the distribution stage, the math is entirely different. While you can talk about asset allocation and diversification for an accumulation portfolio, you must talk about income allocation for the distribution stage. While you can use the “average” growth rate for accumulation, you must use only the “unlucky” growth rate for the distribution stage.

There are three significant financial risk factors for a retiree:

  • Longevity risk (a.k.a. living too long): When designing a retirement plan, make sure to use an age of death where the probability of survival does not exceed 15%. In most cases, that age is 95. Don’t look at the average life expectancy, because it only tells you the age at which half of all people die.
  • Market risk: The market risk quantifies the probability of portfolio depletion. Make sure this number does not exceed 10% at the age of death. Otherwise, irreversible calamities can happen. If the market risk is over 10%, even slightly, you would need an exponentially higher level of genius or luck to recover from a routine market correction.
  • Inflation risk: The inflation risk refers to the ability to maintain purchasing power. My limit is 10%, i.e., the purchasing power must stay above 90% of the requested amount. This becomes important when we talk about guaranteed income classes such as variable annuities, variable pay annuities, or index-linked annuities. Many of these income classes do not provide inflation protection.A retirement plan must meet all of these criteria to be considered a well-designed plan.

    Let’s walk through two fictitious clients, Jane and Steve. Both are 65, and have $300,000 in their RRSPs. Both have the same asset mix: 50/50 equities and fixed income.

    Jane does not need to draw from her savings. Her CPP, OAS and company pension pay her enough retirement income. Her RRSP savings are only required to pay her travel expenses to warmer locales for a few weeks during the winter. She considers this non-essential, and she only needs $4,000 a year for that.

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    On the other hand, Steve has no company pension. After doing his budget, Steve says he needs to pull $15,000 a year from his savings, indexed to inflation.

    Let’s first look at Jane’s case. Her withdrawals from her savings are discretionary. Because she does not depend on this money, there is no need to allocate any of her RRSP savings to a life annuity or a variable annuity with guaranteed lifelong income. That would be waste of her resources. She will convert her RRSP into a RRIF at age 71, the maximum age for this conversion.

    The chart below shows all historical outcomes, if Jane were to retire in any of the years since 1919, when the S&P/TSX equity index began. This is called an “aftcast,” as opposed to a forecast with deterministic projections (“assume 8% average growth rate, 3% inflation”), or a Monte Carlo simulation (“assume 8% average growth rate with 20% standard deviation, run ten thousand times”). The aftcast does not assume anything; it just shows the market history for a particular client-specific case.

    The aftcast indicates that Jane’s RRIF portfolio is more than enough to cover her travel expenses. After age 71, the RRIF minimum payments are a lot higher than what she needs. So, she takes out the minimum, pays income tax on that and then saves any remaining money.
    Let’s move on to Steve’s case. His aftcast (see graph below) does not look so good. History shows that there is a 72% chance that his RRIF portfolio would run out of money by age 95. This is totally unacceptable; it is way over 10%!

    So, Steve needs to export his longevity, market risks and inflation risks to an insurance company. The only purpose of an insurance company is to minimize the risk for its clients. So, Steve should look for insurance providers with a solid track record in risk management and he should avoid those that take higher risks with the sole purpose of improving their bottom line.

    A life annuity costs $285,000. It pays him $15,000 annually for life, indexed to actual CPI each year, with a minimum 15-year guarantee period, should he die prematurely. Steve has $15,000 left in his RRSP. He does not need any income from that. He converts it to a RRIF at age 71. Income from this RRIF can be used for extra expenses, or saved for a rainy day.

    Steve asks about the variable annuities with guaranteed withdrawals for life. Variable annuities convert the longevity and market risks into the inflation risk. Even though sales brochures describe how the annual income might increase if markets do well, the market history shows that there is only a 17% chance that payments will maintain the purchasing power. Anyone who purchased such products during the last five years will likely see no increase whatsoever for the rest of their lives. The chart below shows the aftcast for a variable annuity.

    In conclusion, when it comes to retirement planning, there is no such a thing as allocating “rule of thumb” percentages to different income classes. Leave that cookie-cutter type of claptrap to academics. Each client is different, each scenario is different, each solution is unique and this is our purpose as financial planners. We were able to find solutions for both Jane and Steve in their quest for lifelong income with minimum ongoing risk. Our foremost duty to our clients is not selling dreams, but preventing nightmares during their senior years.