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.Report Typo/Error
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