golden eggs sitting on a nest of sticksLee Feldstein
What does retirement really cost? The answer, according to York University finance professor Moshe Milevsky, is the price of a life annuity.
Mr. Milevsky believes that a life annuity is not just another expensive way to fund your retirement or one possible tool in a growing arsenal of products. "Rather, the annuity price is actually a market signal of what retirement really costs. And, it is the cheapest and safest way to convert a nest egg into a lifetime of secure income."
In his column, published in the September issue of Research Magazine, a U.S. trade publication geared towards brokers and financial planners, he says that a growing number of retirement planning tools and philosophies are generating a false sense of security that people have enough when in fact they don't.
Mr. Milevsky, who has written several books on financial planning, begins by figuring out how much of a lump-sum nest egg someone will need to generate a specified stream of income for the rest of their life.
His reasoning goes like this: "If you are retiring at the age of 65 and would like a $1,000 monthly income stream until life expectancy, which is age 84.2 — after which, I presume, you plan to shoot yourself — and this money is invested at a real rate of 1.5 per cent, then you need a nest egg of a little over $200,000 at retirement."
Obviously if you plan to live longer, you will need a significantly larger nest egg. For example, he says, a person who is counting on living until age 97 will need a nest egg of around $306,000.
It is at this point that people start panicking. "Enter the retirement planning software used by confused — or unscrupulous — financial advisers and they seem to offer a better and more soothing answer," Mr. Milevsky says.
Often, that answer is to take on a more aggressive portfolio. But buying more equity-based mutual funds or investing more heavily in stocks is risky and anyone who takes on that risk must be prepared for the possibility that things will not work out, he says.
This is where Mr. Milevsky gets to the crux of his argument: "If you spend $230,000 on a life annuity from an insurance company, it will generate the desired $1,000 per month income — adjusted by the consumer price index — with no investment or mortality risk."
With an annuity, you do not have to make assumptions about how long you will live or what your portfolio will earn over the random horizon of retirement, he said.
"As such, the annuity price is effectively the cost of your retirement income plans and the only answer to the question posed in the title of this column. Any other answer involves extra risk, possibly invisible to the naked eye."
The appeal of life annuities are that they pay a regular, guaranteed amount of money every month for as long as you live. While there are some differences among the kinds of life annuities offered, the basic concept is that you pay a lump sum of money to an insurance company that in turn pays you a fixed amount for the remainder of your life.
Malcolm Hamilton, an actuary at Mercer Human Resource Consulting and an expert on Canadian retirement saving, says that despite the fact that economists agree that annuities should be playing a larger role in retirement savings plans, annuities just are not popular with Canadians.
Part of the reason lies in their irreversible nature, since once you buy an annuity you can not undo the transaction. "People who have been saving their whole life get nervous when you suggest they hand over their entire nest egg for one product," Mr. Hamilton said.
Another major reason, he said, is that people see a rising interest rate environment as a bad time to buy an annuity. People who are not in good health or have a shorter life expectancy, those who plan to depend on government programs and those who are already in defined-benefit pension programs are less likely to consider annuities, he said. In addition, some people believe the insurance companies are pocketing money through annuities, which he maintains is simply not the case.
"I think Mr. Milevsky is right that Canadians should consider them more seriously. But for countless personal reasons, some good and some not, he is swimming against a strong tide," Mr. Hamilton said.
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