With decumulation, everything is a variable: when you’ll die, how much you’ll consume, market returns, volatility, taxation and unexpected expenses. Put all that together and it gets messy.Ray Orton/iStockPhoto / Getty Images
This is the first in a four-part series examining the decumulation product landscape in Canada and how advisors can explain the options to clients. Read Part 2 next week.
We’ve been hearing about it for decades: The baby boomers, one of the largest and wealthiest population cohorts in Canadian history, will soon retire and face the challenge of converting their retirement savings into retirement income.
At the end of 2023, one in five Canadians was over 60 years old. That means the decumulation challenge is here – and it’s not to be underestimated.
Bill Sharpe, Nobel Prize winner in economics, famously called decumulation the “nastiest, hardest problem in all of finance.” With decumulation, everything is a variable: when you’ll die, how much you’ll consume, market returns, volatility, taxation and unexpected expenses. Put all that together and it gets messy.
Take a 65-year-old couple retiring today with full Canada Pension Plan and Old Age Security benefits. Their combined registered retirement savings plans (RRSPs) total $1.36-million and earn 5.22 per cent annually, and they spend $100,000 a year adjusted for inflation.
The couple wouldn’t bounce their last cheque until the year they turn 95.
However, when you factor in volatility, thereby introducing sequence of return risk, the picture is not so rosy. At 85 (approximate life expectancy), the couple has a 12.5 per cent chance of running out of money. This increases to 35 per cent at age 90 and 63 per cent at age 95. Any surprise expenses or spikes in inflation could increase the probability of ruin significantly.
The wealth management industry has addressed this issue primarily through income and yield investing, focusing on interest and dividend generation over capital gains. But the need to consume is not the same as the need to generate certain returns, and this approach doesn’t do anything to extend the life of the asset pool. At best, it’s a naive strategy that seeks to consume the yield but not the principal.
Unfortunately, that leaves consumption at the mercy of interest rates and corporate dividend policy, or forces one to consume the principal they sought to protect. Most people wouldn’t be happy to curtail their lifestyle because their favourite bank stocks’ dividend rate hasn’t kept pace with inflation.
The good news is that the market for decumulation products in Canada has seen more activity in the past few years than in the past century. Until about 2017, the only option for mortality risk hedging available to investors was annuities. Even those invested in legacy versions of segregated funds with guaranteed minimum withdrawal benefits (GMWBs) saw their positions hard capped in the early 2010s, with no ability to add to them.
However, since 2017, we’ve seen the return of GMWBs, the creation of two different types of tontines, and the addition of the advanced life deferred annuity (ALDA). In this four-part series, we’ll examine the decumulation product landscape in Canada and how advisors can explain the options to clients.
The first of these options is the single-premium immediate annuity.
Annuities: The oldest (and most underutilized) decumulation tool
An annuity – a contract in which a lump sum is exchanged for a stream of payments over a fixed period of time or for life – dates back to ancient Egypt; and modern fixed annuities have been around since the 1500s.
Yet, despite annuities’ multi-century history, they’re barely discussed in most retirement planning circles. This inconsistency between consumer behaviour and what is mathematically and logically optimal is commonly known as “the annuity puzzle.”
After all, if someone’s goal is to ensure their lifestyle in retirement, and the date of death is unknown, wouldn’t everyone want a guaranteed lifetime income stream?
There are many explanations why people avoid annuities: underestimating or misunderstanding the concept of life expectancy, investor overconfidence, impatience, or simply the anxiety and fear generated by cutting what could be the largest cheque of an investor’s life short of buying a home.
One common issue contributing to low annuity uptake in Canadian financial planning is an over-reliance on linear projections versus Monte Carlo analysis.
Take the 65-year-old retiring couple cited earlier. How would an annuity help in their situation?
Let’s say the couple took approximately one-third of their nest egg ($460,000) and purchased an annuity paying $1,729.22 a month indexed to inflation at 2.2 per cent a year (FP Canada’s current long-term inflation rate guideline). When combined with OAS and CPP, this would increase their amount of guaranteed income from 46 per cent of their $100,000 a year need to 66.5 per cent (approximately $66,500). Then, at age 75, when OAS increases for both of them, the guaranteed income increases from 48 per cent to 68 per cent of their desired expenditure.
The results don’t look quite as rosy as the linear non-annuity scenario. The client runs out of investment assets at age 94, resulting in a deficit of $118,100 over the last two years.
The Monte Carlo analysis has similar results, with the probability of ruin increasing to 15.9 per cent versus 12.5 per cent in the traditional analysis at age 85; 40.5 per cent versus 35 per cent at age 90; and then getting better at age 95, dropping from 63 per cent to 57.8 per cent.
At first, one might ask why anyone would consider buying an annuity in this situation, given it results in shortfalls on a linear basis and higher probabilities of ruin before age 95.
The reason is simple: it’s not just about the odds of ruin – it’s about the magnitude of ruin.
If you were to run out of investment assets in retirement, which situation would you prefer: being able to spend 48 per cent of what you were spending before you ran out or 68 per cent?
Hopefully, most investors wouldn’t spend every last penny they have, leaving themselves with nothing more than OAS and CPP. Still, even in such a scenario, the reduction in spending would be less severe given the higher guaranteed income floor.
All that said, putting such a large sum aside for an annuity – something clients can’t see or touch – is enough to give anyone pause. But there are ways around this concern.
Planning and education about the risks associated with decumulation are important. There are also different ways to design the annuity to appease some concerns: reduced payouts on the first death to lower the premium and guarantee period, refund or premium options, or life insurance to reduce the sense that clients are losing it all if they die early.
Whether clients proceed or not, we owe it to them to make sure they’re making informed decisions when it comes to the oldest tool in the decumulation arsenal.
Next week, we examine GMWBs and ALDAs.
Jason Pereira is a senior partner and financial planner at Woodgate Financial Inc. in Toronto.