Thanks in part to COVID-19, interest rates have never been lower. This is great for borrowers but terrible for savers.
When assessing the yield on a particular GIC or savings account, we are now compelled to think in terms of basis points – one hundredth of a percentage point – instead of per cent. We are lucky to scratch out a yield of 50 basis points – half a per cent – on a savings account balance, and even less on T-bills.
This is depressing enough for younger investors, but how can retirees produce a reasonable amount of income these days?
When it comes to decumulation, retirees have two obvious goals: maximizing the income they can generate with their savings, and making sure they don’t outlive their money. A simple example, however, will show that the decision-making process is more complicated than that.
The accompanying chart shows three options facing a 65-year-old investor with a nest egg of $100,000. Since mortality rates come into play, we will assume a male investor in this example.
Option A looks least attractive since the investor never gets more than $2,000 a year and doesn’t even get $1,000 in the first three years. What the chart does not show is that the initial $100,000 investment would still be intact at the time of death. That money won’t help the investor, of course, but it would benefit his heirs. By the way, even the low amount of income shown for Option A is not guaranteed. I have assumed interest rates will rise gradually but that may not happen.
Option B provides more than $5,000 a year in income, more than double the amount from Option A. Moreover, this amount would be paid without fail, even if the investor dies at 105. The only negative is that the $100,000 initial investment would not be available after death.
If retirees made their decisions based solely on income level and lifetime guarantees, Option B would be the clear choice, yet, in real life, almost no one chooses B. It seems that other considerations figure into our decision-making process; but which, exactly?
An obvious factor is people wanting to be able to leave money to loved ones in the case of early death. Option A does that but not Option B. It’s not that simple, though, since it doesn’t explain the widespread appeal of Option C.
As the chart shows, Option C pays less than Option B up until about age 85, which is around the time most people expect to die. C does eventually pay much more than B, but not until one nears 100. The bigger stumbling block with C is that none of the initial $100,000 is payable after death. Option C should therefore be no more appealing than Option B, and yet it used to be wildly popular.
It is time to describe the options.
- Option A is an investment in T-bills or guaranteed investment certificates. I started with a current interest rate of 40 basis points, which I optimistically assume will rise over the next nine years to 2 per cent and then plateau.
- Option B is a life annuity purchased from an insurance company. (Thanks to Cannex for the annuity quotes.) A Canadian insurer has never reneged on an annuity payment so we know annuities are safe.
- Option C is a tontine arrangement. In a tontine, you receive dividends as long as you’re alive; as other tontine participants around you die, the annual amount paid to you grows. The term “tontine” conjures up 1940s murder mysteries in which investors died suspiciously until the sole survivor gets all the money.
Real-life tontines were less dramatic but still gained a huge following. Questionable practices by the insurers eventually led authorities to shut them down early in the 20th century but they were popular right up to the end. (Incidentally, the foremost expert on tontines is Moshe Milevsky, a professor of finance at the Schulich School of Business.)
The fact is, life annuities and tontine arrangements are essentially the same. Both offer more secure income than other investments, and for the same reason: The survivors are benefiting from the money left behind by those who die early on. Both offer limited or no death benefits.
The one big difference is that tontines do not involve a “middle man.” I’m referring, of course, to insurance companies who manage annuities. It seems insurance companies are not popular, even though they absorb the mortality and investment risk.
Maybe this allows us to crack the annuity puzzle. Based on the tontine experience, I can identify three other potential reasons that retirees dislike annuities: They are boring, they involve insurance companies and they are a black box, meaning the annuitant doesn’t know what the insurer is doing behind the scenes. None of these additional reasons are sufficient grounds to dismiss annuities as an option.
Retirees who are eking out a modest income from GICs or savings accounts waiting for things to change should give annuities a second look with at least a part of their registered retirement savings plan or registered retirement income fund. It is a safe bet that low interest rates are not going away any time soon.
Frederick Vettese is former chief actuary at Morneau Shepell and author of Retirement Income for Life. The second edition was released on Oct. 20.
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