This article is the seventh in a series on personal finance and investing at different stages of your life. As some issues may overlap the different stages of life, they could be covered in a prior or subsequent article. For the full series go here.
Financially, the fifties and sixties are a sweet spot in the life cycle. Job income is at a peak and obligations, such as kids and mortgage, have dwindled or disappeared. It's a time when many people can ratchet up savings for their retirement years.
Yet, pitfalls lurk. For Jean Lesperance, author of the blog they came with his pension plan. "My worst financial move was taking the commuted value of my public service pension instead of just leaving it there till retirement," he recounts.
The best time to start thinking about retirement is several years before you clean out your desk for good. Then you will have more time to pursue options that will make your golden years more comfortable. Here are 10 pointers to help you avoid some of the pitfalls when planning and investing for retirement.
1. High allocation to stocks?
What is the best investment strategy for someone just starting to live off withdrawals from a registered retirement income fund or other retirement fund? Conventional wisdom dictates a small exposure to stocks. For example, Gordon Pape on his website, www.buildingwealth.ca, recommends "not more than 25 per cent of a RRIF's assets be held in stocks or equity funds."
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York University professor Moshe Milevsky has a different view. For him, the problem with going mostly to fixed-income securities is the increased risk of outliving retirement nest eggs, especially in this era of longer life spans and low interest rates. He prefers higher allocations to stocks because their historically superior returns can deliver more growth to invested funds.
Mr. Milevsky has run, using the Monte Carlo technique, millions of computer simulations on hypothetical retirees with different withdrawal rates, life spans, start dates, asset allocations and other relevant variables. As discussed in his book Are You a Stock or a Bond? , those simulations have found that the chance of outliving retirement funds fall as the allocation to stocks rises - with the optimal weighting being 60-per-cent to 70-per-cent stocks. Such an emphasis on stocks also protects better against inflation risk.
2. Hedging longevity and other retirement risks
While higher allocations to equities help lower the probability of outliving funds (known as longevity risk) and inflation, they still don't eliminate them. In fact, a particular problem with equities is the "sequence of returns" risk. This arises when a retiree begins a program of systematic withdrawals from their retirement fund just as the stock market goes into a bearish phase. The withdrawals leave less capital to appreciate in value when the bullish phase returns, exposing it to swifter depletion.
Life annuities are ways to hedge longevity risk because they provide guaranteed monthly income for as long as the retiree lives. In this respect, annuities function like defined-benefit pension plans (if you have a good-sized one, you may not need annuities). Annuities are usually arranged through an insurance company by handing over a large sum of money on an irrevocable basis. They also provide relatively high monthly income because part of the payment is the return of your capital plus the return of capital "from those who died at a younger age than average," explain Warren MacKenzie and Ken Hawkins in The New Rules of Retirement .
Variable annuities, to a certain extent, can be used to hedge longevity risk. They also come with other embedded guarantees that Mr. Milevsky believes make them worth considering for hedging "sequence of returns" and other risks. "Think of a variable annuity as a mutual fund with a selection of different investment options, together with a number of implicit and explicit guarantees," he says. The features include systematic withdrawal plans that guarantee a minimum income for a period, and the ability to convert the best value of the policy into lifetime income.
3. Importance of product allocation
While life annuities are good at insuring against longevity risk, the fixed-income payments will lose purchasing power over time (2-per-cent inflation cuts the real value of payments by a third after 20 years). And while some types of variable annuities are good at protecting against "sequence of returns" risk, only a few versions offer true longevity insurance and/or some protection against inflation via step-up payments.
Given the varying strengthens and weaknesses of systematic withdrawal plans, life annuities and variable annuities, Mr. Milevsky believes the best approach is a mix of the three products, tailored to the requirements of the retiree. As retirement approaches, asset allocation gives way to the "much more important and critical" choice of product allocation, he says. "By the term product allocation, I mean the decision of how much of your retirement income should come from conventional financial instruments such as mutual funds, and how much should be generated by pension-like products such as life annuities and variable annuities."
The product-allocation decision should be undertaken with reference to the personal needs of the retiree. If they want to leave an estate behind for a spouse or loved ones, don't go with a lot of annuities since the capital stays with the insurance company when the annuitant dies. Two more criteria are liquidity (ease of accessing funds) and avoiding behavioural mistakes in investing. For further details on how to select a suitable mix (including a proprietary algorithm), see Mr. Milevsky's book, Are you a Stock u a Bond? There may also be more detail in his new book, Your Money Milestones , which is due out in January.
4. Fine-tuning the product allocation
Money can also be allocated to other retirement products as part of a comprehensive risk-management strategy. Long-term care insurance could have a place. And life insurance could play a role, if only for estate planning purposes. Home equity is a significant factor for many.
Not all products should necessarily be in the portfolio. "A reverse mortgage is an expensive way to borrow money … for those who require equity from their home, downsizing and moving to a small house usually makes more economic sense," argue Mr. MacKenzie and Mr. Hawkins. They're not fans, either, of structured notes, such as principal-protected notes (PPNs). They are complex, hard-to-understand products with high fees. "If you have a well-diversified, effectively managed portfolio, you have nothing to gain by purchasing PPNs," they suggest.
Product allocation need not be decided all at once. In fact, it may be a good idea to delay purchases of life annuities - especially since interest rates are so low, currently. "With interest rates at artificially low rates, annuitizing - and locking in these yields for ever - makes less sense," Mr. Milevsky advises. Not only will monthly payments be higher in the future because of higher interest rates but the older you start an annuity, the higher the monthly payments due to the disbursement of funds left behind by deceased annuitants.
5. Calculate your income gap
Product-allocation strategies depend on the retiree's income gap. The latter is the amount of income needed to meet lifestyle requirements after netting out guaranteed retirement income from pensions, annuities and government programs (Old Age Security and Canada Pension Plan). This gap is the amount that needs to be financed from your own savings.
Therefore, for most people nearing retirement, an important task is to calculate the size of their income gap. To begin, "you must conduct a 'needs analysis,'" says Mr. Milevsky. "Pertinent questions would include: What standard of living would you maintain during your retirement years? Do you want to travel the world? Will you stay at home?" This will yield the annual income required during retirement.
Then you need to tally up the income expected from guaranteed sources and deduct it from the required annual income. Calculate the amount in real terms (adjust for inflation) and on a pre-tax basis. If your savings exceed this figure more than thirty-five times (years), risks such as outliving your retirement funds are low and so would be the need for high equity allocations and insurance products. The further someone is below 35 times, the more consideration should be given to such strategies.
6. Insuring v. self-insuring retirement risks
The stage of life before retirement is usually when people are capable of saving the most. There may also have been major appreciation in the value of their home. Such a period of financial strength may open up the possibility of "self-insuring" against the retirement risks mentioned above. If an income gap is anticipated during retirement, perhaps it can be eliminated through lifestyle changes in your fifties and sixties - for example, by saving at a higher rate, working longer, tapping into home equity, or deciding to have a less luxurious lifestyle in retirement.
Such sacrifices will not be for everyone. But if you grow your nest egg large enough relative to needs, you may be able to live off the dividends and interest, or a modest systematic withdrawal plan. This scenario could appeal to people who have qualms about some retirement products. For example, they may not like certain aspects of annuities such as: counterparty risk (default by the insurance company), complexity (especially for variable annuities), high fees, irreversibility, inability to bequeath the capital, and erosion of real value through inflation.
7. Should I take CPP early?
Perhaps one of the more frequent questions asked by people approaching retirement is: Should I start taking CPP payments early? The answer once was that, in many cases, it did make sense to start early. But government proposals to amend the CPP are changing the landscape.
Under current rules, which remain in effect until 2011, starting CPP at the earliest age of 60 entails a 30-per-cent reduction in monthly payments but "you would have to live well past 75 in order to receive more from the plan than by waiting until the normal retirement age of 65," writes tax and estate lawyer Christine Van Cauwenberghe in her book, Wealth Planning Strategies for Canadians 2010 . "Also, once you begin receiving payments, you will no longer need to make contributions to the plan even if you decide to go back to work - which would save you approximately $2,000 on an annual basis and double that if you are self-employed."
After 2011, according to Department of Finance proposals, (www.fin.gc.ca/n08/data/09-051_1-eng.asp) the penalty for starting CPP early will rise from 0.5-per-cent to 0.6-per-cent per month over a five-year period so that by the end of the phase-in, taking CPP at 60 will entail a 42-per-cent reduction in monthly payments. Moreover, if you return to work, you will have to continue making contributions to the CPP (although the amount of your CPP benefit will be increased by the contributions).
8. Pension or cash?
Many retirees face the choice of taking monthly payments from their employer's pension plan or transferring the commuted value into an investment account. The latter option may make sense for someone who wants to leave behind a bigger estate.
Otherwise, it is usually better to opt for the pension income. For one thing, it pays out until the retiree's death, which insures against longevity risk. It also avoids the stress of making withdrawals from a retirement fund during a bad run in the stock market. And many pensions have a cost-of-living adjustment.
When stock markets are in a bull run earning 12 per cent or more a year, it's easier for financial advisers to convince clients to cash out their pension plans. But the fact remains that the effective 7- to 10-per-cent payoff from pensions are certain and stable. On a risk-adjusted basis, they usually can't be beat. "In most cases, I advise choosing the pension over the commuted value as long as the plan appears to be solvent," observes Mr. Pape on his website.
9. Time to get philanthropic
If you are heading into an affluent retirement, it's time to think about giving away some of the wealth you'll likely never consume. For example, "grandchildren may come along, so perhaps you should fund a registered retirement savings plan for them," says Adrian Mastracci of KCM Wealth Management Inc. (www.kcmwealth.com).
Your own children may appreciate a helping hand, like a contribution towards a downpayment on a house. But remember, nearly half of marriages end up in divorce and half of your gift could end up in the hands of your child's ex-spouse. If you don't want that to happen, there are steps you can take, as outlined in the article, Marriage and Personal Finances (www.canadianbusiness.com/columnists/larry_macdonald/article.jsp?content=20091203_151647_5464)
10. Low-income retirees
Low-income persons who contribute too much to a registered retirement savings plan may reduce their entitlement to government old-age benefits. If their retirement income ends up too high, the Guaranteed Income Supplement could be lost, as well as Old Age Security payments in part or whole. Other benefits may be affected, such as subsidized housing and nursing care. The good news is that the tax-free savings account (TFSA) allows low-income people to save for retirement without having to worry about clawbacks.
If you are heading into a rather impoverished retirement, don't be proud. Seek help from your children if they are well off and relations are good. If they are well off but won't have much to do with you, consider filing for financial support. "In most jurisdictions in Canada, adult children are legally liable … to pay parental support if their parent supported them financially when they were minor," notes Ms. Van Cauwenberghe.
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