Retirement may be the new 40, some advertisers suggest: Retirees are only as old as they feel, and the world is their oyster.
That may well be true, but their savings accounts don’t have the same elasticity as they did at 40. There are wrinkles — some deeply etched ones, in fact.
After all, at age 40, there’s still time to earn money enough to erase the physical evidence, though not the memory, of bad financial judgments. At age 65, the wrinkles have dug deep grooves, and the memories remain.
But they don’t have to.
Moshe Milevsky, a professor of finance at York University’s Schulich School of Business, and Alexandra Macqueen, a former advisor who now works on special projects for the Quantitative Wealth Management Analytics Group in Toronto, open their book, Pensionize Your Nest Egg, with a telling example.
Gertrude 1, an 85-year-old, lives comfortably on $50,000 a year from all guaranteed income sources combined. Meanwhile, Gertrude 2, also 85, has amassed some savings in mutual funds. The authors don’t specify the amount, but let’s assume that nominally, she could withdraw $50,000 a year. Yet she frets constantly about spending money.
The difference? One has a secure, if modest, guaranteed income for life, while the other is wrestling with whether she can afford to spend money without depleting her savings.
From the perspective of a 40-year-old, these may seem like slender differences. Both Gertrudes have plenty of money. And unlike the 40-year-old tied down with mortgages and school expenses, the Gertrudes are debt-free. They have money to spend. But one can spend without worry, the other can’t. Advisors need to make their clients aware of the differences.
Two decades ago, when I began a career in financial journalism reporting on the last great recession, I was struck by the spending habits of my peers — the original Generation X. They suffered, I thought, from the pension illusion. They spent freely in the here and now, assuming that, like their parents, pensions would pave their passage through old age.
Of course, they didn’t have pensions. As Milevsky and Macqueen note, few workers in the private sector do. Almost all civil servants do, and three-quarters are in defined benefit (DB) plans, often inflation-protected.
But in the larger private sector, only 17% of workers participate in DB plans, while 72% have no pension plan except for their RRSPs. And advisors know how few people max out their RRSPs: Only 30% contribute anything at all.
But even if everyone maxed out their RRSP, they wouldn’t have a real pension, as Milevsky and Macqueen define it: “A pledge that you — the retiree — will receive a real, predictable, and reliable stream of income for the rest of your natural life.”
That reliable income stream doesn’t come cheap. If you wait, say, until age 62, a guaranteed $60,000-a-year life annuity will cost $1 million. So how do advisors solve this $1 million question? First, we need to understand where the solution comes from.
In the first part of their book, Macqueen and Milevsky tackle retirement costs, the sequence of returns, and longevity risk. You can gauge retirement costs through a life annuity. That may not be a hopeful exercise for potential annuitants. But it’s the fail-safe option.
When it comes to certainty, the fail-safe option trumps a portfolio — stocks and bonds — because it doesn’t matter whether your magic number is 4% or 5%. You get what you agreed to, and give up growth in return.
But is this prudent? Consider your longevity risk, and its standard deviation. A 65-year-old can expect to live another 18.3 years, give or take 8.7 years.
That’s a huge variation. And so, as investors approach their retirement years, they need more than “naked” retirement planning. Entry to successful retirement requires taming a dog with three heads: Inflation; Market risk; and Longevity.
Hence the meat of part 2, which focuses on three key ratios: The retirement security quotient (RSQ);The wealth-to-needs (WtN) ratio; and The financial legacy value.
For advisors with very-well-off clients, there’s no need to read further. If your client has a WtN of 40, they’ll survive fine. But that WtN ratio also means having 40 times asset coverage for annual expenses.
What if the WtN ratio is lower? Let’s put it at 25. That means drawing out 4% a year in income.
Is that sustainable? Factor in a retirement security quotient. That’s a little more complicated, because the risk of ruin — that is, the risk of outliving your savings — has to be calculated.
But let’s assume a pensionized amount of, say, one-third of WtN. The rest comes from investment income. It probably won’t produce a high RSQ; maybe a 65. But that’s better than a systematic withdrawal plan with a 4% rate, which might have a sustainability level of only 50%. Milevsky and Macqueen would prefer something higher: 90% to 95%.
In this case, pensionization begins to move the needle in the middle ranges, boosting an RSQ from 60 or 70 to 90.
Costs of increasing the RSQ
How do investors get there? It’s a matter of product allocation — a topic Milevsky has written about before.
Essentially, there are three silos relating to product allocation, and each one comes with a cost:
- Annuities for safety, though they mean forgone growth;
- Equities for growth, though they mean uncertain immediate returns, despite long-term market averages; and in between variable annuities with guaranteed riders,
- Guaranteed life withdrawal benefits (GLWBs), which navigate both worlds, providing certainty and growth.
But there are no free lunches. Someone has to assume the risk.
That’s frequently a difficult concept for investors, but an extremely important one. Insurance of any sort involves a risk transfer, whether it’s a life policy, a term-certain annuity or a GLWB.
For the investor, the risk is simple: will there be annuitizable assets there at age 65? The lifeco doesn’t have the same horizon: it’s not winding up when the investor is 65. It can diversify across multiple lives and across time.
The investors benefit from what Milevsky and Macqueen call “phantom income credits.”
Those with longer lives benefit from the contributions paid by those who didn’t live as long.
That’s the pure theory of insurance, but lifecos still face mortality experience (and investing experience) that may not have worked out to plan. They have to build in buffers, should they have to make higher payouts than expected.
So there’s a cost to the guarantee. What’s that guarantee worth to the investor? That’s the key question advisors have to consider.
A GLWB, to the degree that it provides income security, allows investors to worry less about the performance of their non-guaranteed portfolio. It gives them flexibility. It also allows them to take more risk with their non-annuitized investments — whether they want to leave a legacy, spend the money, or at least ride the roller coaster with less fear.
There’s a lot more to the discussion. Life annuities versus GICs, for example, or even such topics as what your number is (that is, what’s the size of your nest egg) and how much of it you can safely withdraw.
Is it $1 million or $2 million? Is it 4% or 5%?
Still, when it comes to a retirement income that can be counted on forever and a day, the debate has to go beyond that.
And really, that’s a discussion more and more boomers could benefit from.
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