Let’s say you were considering laser eye surgery, but your eye doctor told you there was a 5-per-cent chance it would leave you blind. Chances are you would steer clear of it. On the other hand, if you planned to go for a walk and learned there was a 5-per-cent chance of rain, you wouldn’t bat an eyelash. Our risk-avoidance decisions in life are dictated not only by the probability of an adverse outcome but also by its severity.
This concept applies to retirement planning as well. Consider Nick and Susan Thompson, a hypothetical couple on the verge of retirement with $500,000 in a registered retirement income fund (RRIF). Nick, 65, and Susan, 62, want a retirement income of $60,000 plus inflationary increases in future years.
Much of this will come from Canada Pension Plan (CPP) and Old Age Security (OAS) benefits, but their RRIF money is essential to fulfilling their retirement goals. The worst financial scenario they could imagine is running out of money before they die. How can they invest their RRIF money to make sure this doesn’t happen?
Recent retirees such as the Thompsons typically invest about 50 per cent in stocks and 50 per cent in bonds and hope to achieve at least a middle-of-the-road return over time, which these days means about 5 per cent a year before fees. If this is what actually happens, the Thompsons would be fine; their RRIF would produce enough income to see them into their 90s.
A 50-50 asset mix with
very poor returns
$100,000
Income from RRIF
Income from CPP & OAS
90,000
Target income
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
65
67
69
71
73
75
77
79
81
83
85
87
89
Age of older spouse
Investing in a Savings Account at 2%
$100,000
Income from RRIF
Income from CPP & OAS
90,000
Target income
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
65
67
69
71
73
75
77
79
81
83
85
87
89
Age of older spouse
JOHN SOPINSKI/THE GLOBE AND MAIL
SOURCE: fred vettese
A 50-50 asset mix with very poor returns
$100,000
Income from RRIF
Income from CPP & OAS
90,000
Target income
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
65
67
69
71
73
75
77
79
81
83
85
87
89
Age of older spouse
Investing in a Savings Account at 2%
$100,000
Income from RRIF
Income from CPP & OAS
90,000
Target income
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
65
67
69
71
73
75
77
79
81
83
85
87
89
Age of older spouse
JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: fred vettese
A 50-50 asset mix with very poor returns
$100,000
Income from RRIF
Income from CPP & OAS
90,000
Target income
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
65
67
69
71
73
75
77
79
81
83
85
87
89
Age of older spouse
Investing in a Savings Account at 2%
$100,000
Income from RRIF
90,000
Income from CPP & OAS
Target income
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
65
67
69
71
73
75
77
79
81
83
85
87
89
Age of older spouse
JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: fred vettese
The trouble is that stocks and bonds are far from a sure thing. By definition, there is only a 50 per cent chance of a median return or better. What if their returns were much worse than median, worse in fact than 95 per cent of all possible outcomes? Under these conditions, the first chart shows what happens. Their RRIF runs dry when Nick is just 82 and Susan is 79, leaving them only with their CPP and OAS pensions. The computer model I’m using, courtesy of Morneau Shepell, indicates there is only a 5-per-cent chance this will happen, but is that level of risk acceptable? The consequences are a lot worse than getting wet in the rain.
Nick and Susan are determined to avoid the situation in the top chart, so they get out of stocks and bonds. Instead, they put all their money in a savings account with one of the Big Six banks. Bank accounts don’t pay much these days, but as long as savers leave their money in the account for 360 days, they will receive interest at the rate of 2 per cent per annum. Investing in a savings account for the long term seems the height of folly, but take a look at the second chart. As long as the 2-per-cent interest rate stands up, the Thompsons can now draw enough income each year until the age of 90 to meet their target, even assuming an inflation rate of 2.2 per cent.
It seems crazy that a savings account could beat a market-based portfolio over a 25-year span. The reason for the bizarre result is that global stock markets have been rising for 10 years and bond prices have been rising for nearly 40 years. There is a greater than normal risk in the years to come of stocks falling and/or bond yields rising. Rising bond yields sounds like a good thing, but it would actually produce capital losses for those who invest in long-term bonds.
Most people will agree that insolvency in retirement is something to be avoided at all costs. While turning your back on the capital markets sounds like a rather draconian solution, the two other options that most couples take instead are really no better.
For instance, the Thompsons could simply choose to spend less until they feel more comfortable that the markets aren’t going to plummet. That might be a long time in coming, though, and it might require them to spend considerably less than they would like in their more active retirement years. Why give up spending more if the savings account approach says you don’t have to?
Another popular option is to stay with a market-based portfolio but to adopt a more conservative investment strategy such as 20 per cent in stocks and 80 per cent in bonds. Unfortunately, my computer model shows this doesn’t work any better than a 50-50 asset mix. Apparently, longer-term bonds have become almost as risky as stocks now that bond yields are so low.
There is a better option than a savings account that would allow the Thompsons to keep their 50-50 investment portfolio and still meet or exceed their income goal. It involves reducing investment fees, deferring their CPP benefits to the age of 70 and buying an annuity with 20 per cent of their savings. This three-part solution would actually work, according to my computer model, but it seems there are few takers.
Frederick Vettese is the former chief actuary of Morneau Shepell and the author of Retirement Income for Life.
