In today’s low interest rate environment, the rule of thumb that suggests retirees draw down 4% of their portfolio annually to maintain their lifestyle in retirement no longer applies.
Challenging a long-held assumption
A 4% annual withdrawal rate is problematic in today’s economy, when the best we can hope for with fixed-income returns — on 5- to 10-year bonds, for example — is something in the area of 1.29%, based on the Bank of Canada’s posted rates. “If your client’s investor profile is very conservative, it’s unrealistic to expect to draw down assets at a rate of 4% annually, when the mortality tables give men a better than 50% chance of living to age 89, and a greater than 25% chance of living past 94,1” says François Bernier, Director, Advanced Planning, with Sun Life Financial.
Based on these assumptions, a retiree withdrawing 4% of his retirement savings per year every year is likely to deplete his savings by the time he is 89 — he has a one in two chance of still being alive…and broke. “Your client needs to understand that setting too high a withdrawal rate is one of the pitfalls to avoid when planning retirement income,” he says.
So, based on a conservative annual return of 1.29%, what would the optimal withdrawal rate be? “Knowing that the same man has a 10% chance of reaching the age of 97,2 and assuming we want to plan for that eventuality, I come up with a potential withdrawal rate of 3.3% per year,” says Bernier. However, if that rate isn’t enough to cover a retiree’s cost of living, there are solutions that can be considered. For example, if appropriate, it’s possible to raise the level of risk in their portfolio to potentially maximize the income generated by the invested capital. In addition, some financial products provide guaranteed income in retirement.
Let’s take a look at two possible options.
1) raising the level of portfolio risk
Given that expected fixed-income returns aren’t sufficient to support decumulation of more than 3.3% annually, the first logical solution is to try for higher returns on some of the investments in the portfolio.
“If this client’s risk tolerance allows it, of course, you can expose a portion of the capital to equity markets, as part of a slightly more aggressive investment strategy within a properly balanced and diversified portfolio,” Bernier explains. “But be careful. If there’s a sharp drop in the markets early in retirement when the drawdown phase is under way, the result could be faster capital depletion.”
In other words, when the beginning of the withdrawal phase coincides with a series of negative returns in the market, the portfolio is going to last for a much shorter time. There will also be very little time to recover any losses. “Is this client willing to take on this potential volatility risk, even if it means adjusting his lifestyle?” asks Bernier.
Conversely, having an investment that’s earning less than the rate of inflation is a risk in itself. “Your client’s buying power is being eroded and he’ll end up with less,” he says. This shows how important investor profiles really are. “You need to know your clients so you can help them build a solid retirement income plan that suits their needs, risk tolerance and financial goals,” Bernier says.
2) maximizing income from invested capital
A carefully devised combination of products can help boost income at retirement. The client can put their money in a product that offers lifetime guaranteed income and see guaranteed increases to their income for every year they defer starting their income. “For example, Sun Guaranteed Investment Fund (GIF) Solutions Income Series offers a guaranteed withdrawal rate of 4.30% per year for a male at age 60. At age 65, the percentage this same client can withdraw from his portfolio annually goes up to 5.35% with the deferral benefit,” says Bernier.
“With segregated fund products you can reduce risk by protecting the client’s assets with guarantees on their investments and by guaranteeing a flow of income. This means the owner of this type of product can count on a level of income that won’t change during retirement, regardless of stock market ups and downs. Depending on the product, the contract will provide maturity and death benefit guarantees equal to 75% or 100% of premiums invested, reduced for withdrawals,” explains Bernier. In addition, segregated fund products provide the advantages of insurance contracts, including named beneficiary options, potential creditor protection and avoiding probate. “Sun GIF Solutions Income Series gives clients peace of mind with the certainty of guaranteed income for life,” he says.
This financial solution offers other advantages in comparison to life annuities, which nonetheless remain a top choice for ensuring retirees don’t outlive their savings. For example, Sun GIF Solutions Income Series is redeemable at any time and gives the holder’s estate access to the money remaining in the contract. On the other hand, with a life annuity, the holder will have no access to any amount other than the scheduled annuity payments, but in exchange for what could be the highest rate of income when compared to other income-generating products.
“It’s often best to consider going with a hybrid strategy that includes more than one financial solution,” says Bernier. “And you should start talking with your clients about retirement income options at least five years before they retire.”
1 Institut québécois de planification financière – mortality table for male age 60: http://app.iqpf.org/guidelines/life-expectancy