Hot topic: Dealing with longevity risk

By Camilla Cornell | December 2, 2014 | Last updated on December 2, 2014
7 min read

When clients transition from their “saving years” to having to live off their assets, they face a number of new risks. Primary among them is longevity risk – the possibility that their earnings won’t sustain their spending and they will outlive their assets.

As of 1979, the average Canadian woman at age 65 could expect to live to 84, while men had a life expectancy of 80. As of this year, life expectancy for women is 87 and for men, 83. That may not seem like a giant leap, but consider that 20 percent of those women and 17 percent of the men are expected to live to 95 or older. How would you suggest clients mitigate longevity risk?

Lise Andreana, CFP, CPCA Continuum II Author, Financial Care for Your Aging Parent, Self-Council Press, 2014

Longevity poses new risks for boomers transitioning to retirement, but it doesn’t affect all retirees in the same manner. Those at highest risk will be boomers who retire on a shoestring and depend on all of their savings for income.

A basic financial projection can tell clients how long their investments should last at a set rate of return and inflation, but it can’t tell them the odds of outliving their resources and being forced to reduce their standard of living in old age. I sometimes use a Monte Carlo simulation as a kind of portfolio “stress test.” It allows you to change various factors such as portfolio size and allocation, annual income to be withdrawn, expected inflation levels, and time horizon to determine their likelihood of maintaining a satisfactory level of income until death.

The most recent report I did for a client showed they had a 37% chance that they would achieve their target income throughout retirement if they held a balanced portfolio of 60% equities and 40% fixed income. When the same test was run for a moderate portfolio with only 40% equities, the odds dropped to 15%.


This client was planning to draw down 7% of his portfolio each year, increasing by 2% for inflation each year, with a 5% rate of return. His plan was designed for perfection – anything less, and the wheels would fall off. The Monte Carlo simulations showed that a variance in income of $10,000, living longer than age 90, or a market set back would derail his retirement plans.

In this case, I suggested the client – who is barely age 60 – should adhere to a balanced fund of high-quality equities and fixed income investments, perhaps pooling all of the funds with a specific fund company to take advantage of low MERs. During the years when his RIF yields a surplus, he should invest the extra cash in a TFSA to be used in leaner years. And at age 70 or older, he should begin purchasing life annuities in stages, so that he can benefit from increasing income as he ages. (The older you are when you purchase them the higher the income.)

I generally advise my clients to have a portion of retirement income guaranteed (either by employer defined benefit pension plans or annuities) and to have monthly operating costs covered with low risk investments. The balance of the assets should be held in a diversified portfolio including equities.

Those clients whose pension income doesn’t cover their operating expenses might allocate anywhere from 20% to 50% of their assets to annuities, spread over a few years. The fewer financial resources they have, the more likely I’d recommend an annuity, since there is no margin for error. For those who want to leave an inheritance, I point out that not all annuities end at death – many now offer return of capital. But of course the more guarantees you add, the lower the annuity’s payout.

I tend to refer to my clients’ homes as the “health and welfare account” since I’d suggest it be the last asset liquidated to meet end-of-life costs. Renters have to be more cautious with spending because there’s nothing to fall back on in the event of a shortfall. And for those clients carrying mortgage or other debt into retirement, I always suggest working longer and reducing debt, especially if their only resources are RSPs or other fully taxable forms of income.

Moshe Milevsky, Ph.D. Associate Professor of Finance, York University’s Schulich School of Business Author, Life Annuities: An Optimal Product for Retirement Income, CFA Research Institute, 2012

(As told to Camilla Cornell)

When it comes to dealing with the possibility of longevity risk, single premium income annuities are often under-rated as a retirement planning tool. These annuities produce a guaranteed income stream over the life of the person who buys them (the annuitant).

Most people will tell you that, given interest rates today, annuities are a bad deal. But mortality credits (annuity payments originally allocated to people who died soon after retiring) can actually augment annuity returns beyond the prescribed interest rate for older annuitants.

Ultimately, though, you have to look beyond the numbers. I think about what my mother wants and it’s peace of mind, stability and predictability. She wants a paycheque in the mail every month. An annuity offers that.


It’s also a great spending benchmark. When you’re working you have a limit on how much you can spend – it’s called your paycheck. You know you can’t buy certain things because you’ll have nothing left at the end of the month. Your clients may lose that compass when they retire. And that’s one of the things an annuity does – it gives them a new spending benchmark.

It can work the opposite way too. Some advisors have clients who aren’t spending enough. They tell them, “Look, you can pull out more money,” but the client is worried about going through his assets. When you buy an annuity for them, it automates the process of spending – they don’t have to fret about spending too much.

That said, annuities aren’t right for everyone. Bill Gates doesn’t need an annuity – he’s not going to outlast his money. And people who have the bulk of their needs covered by CPP, OAS and a defined benefit pension plan don’t need more pension income – they’re over-pensionized.

If you look at the client’s personal balance sheet and more than 70 percent of her wealth is already pensionized, I don’t see the point of buying an annuity. In the same way that if a person already has a whole lot of money in the stock market, you probably wouldn’t suggest investing her RRSP money in equities. It’s a matter of asset allocation.

The prime candidates for annuities are people who are pensionless – they don’t have a defined benefit pension from work and neither does their spouse. And the prime time to purchase an annuity is some time upwards of 65 years old. The older you are, the higher the payout is going to be.

A rough rule of thumb I use is this: if your client’s mortality rate is higher than the interest rate, it’s time to start thinking about annuities. Right now interest rates are at about 2%. Financial advisors should be able to pull up a mortality table from Statistics Canada and say, “Okay, you’re a 70-year-old female, your mortality rate is one in 100 – nah, you’re too young.” Or, “You’re a 70-year-old male and your mortality rate is 2%. It’s time to think about an annuity.” But remember, your client has to be in good health for the annuity to make sense.

I’d also suggest annuities should be purchased over time; perhaps over three to five years in order to average in through the interest rate cycle. So if you plan to annuitize $400,000 of a client’s assets, you might buy $25,000 of annuities once a quarter for four years or more. Advisors can limit the risk that the insurance company issuing the annuity will fail by staying below the Assuris (policy holder protection plan) limits of $2,000 per month or 85 per cent of the promised monthly payment.

I’d suggest the money to purchase annuities come from a client’s bond allocation. When you think about it, bonds are sensitive to interest rates. If interest rates go up, those bonds are going to take a hit, so you might as well use some of them to buy your client’s annuity.

The good news: once people have a steady income stream that covers their expenses, they may be able to allocate the remainder of their portfolio in more growth-oriented assets such as equities. That can provide a fund for unexpected costs, such as extra drug and medical costs that may not be covered by the government in the future. In fact, tilting a portfolio toward medical and pharmaceutical companies might actually allow your clients to benefit from higher drug costs generally.

Ultimately, though, your clients need to be made aware of all the uncertainties going forward and they have to budget for those things they can’t insure against.

Camilla Cornell