Retirement planning: How not to outlive your money

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Shortly after my great-uncle and great-aunt retired, they came up with what seemed like a foolproof plan.

They would take the modest pension that my Uncle Jim had accumulated since emigrating from Scotland, sell their house, and say goodbye to brutal Lake Erie winters forever. As my Aunt Mary told my parents, they intended to spend "the last few years we have left" enjoying the sun and heat of Florida.

Good plan. Bad timing.

The year was 1969. Over the next few years, rampant inflation gobbled up the real value of their pension. Every dollar they possessed lost half its buying power in the first decade of their Florida retirement.

And those "few years"? They stretched on and on. Uncle Jim passed away at 86; Aunt Mary just kept on going. She died in 2000, shortly before her 101st birthday.

Uncle Jim and Aunt Mary taught me that life's twists can derail even a reasonable retirement plan. Their example underlines an important truth: Stuff happens. Perhaps you live longer than you expected. Perhaps investments don't perform as you hoped.

Retirement is ultimately an exercise in risk management – and dealing with risk involves an educated understanding of how unforeseen events can sabotage your golden years.

The greatest single hazard is what planners call "longevity risk" – the possibility that you may outlive your money.

Actuaries tell us that a woman who is now 65 can expect to live, on average, to 88, while a man can look forward to reaching nearly 86. Remember, though, that those are averages – about half of retirees will outlive those figures. In fact, if you are now a 50-year-old woman, there is nearly a 10 per cent chance that you will live to celebrate your 100th birthday.

How do you plan for a retirement that may be as long, or longer, than your working life? For the dwindling number of Canadians who are members of defined-benefit plans with automatic cost-of-living adjustments, there's little to worry about. For most of us, though, there is a lot of risk in planning three decades ahead – especially given two additional hazards.

One is the danger of inflation eating away at the purchasing power of our savings. It doesn't have to be the out-of-control inflation of the 1970s – over the course of a couple of decades, even a modest 2 per cent annual rise in living costs can blow a hole in the purchasing power of a pension that's not adjusted for rising prices.

Then there's market risk as well. In theory, a steadfast investor who builds a well selected stock portfolio should do well over time. But, in practice, the payoff can require more patience than most people possess.

Someone who held an S&P 500 index fund for a decade between 2000 and 2010 would have lost money (excluding currency gains). An investor unlucky enough to retire in 2000 or 2007 with a bulging stock portfolio would have seen their holdings nearly instantly eviscerated.

A good retirement plan should address longevity risk, inflation risk and market risk. Here are the pros and cons of three key risk-management tools:

Annuities

An annuity is essentially a contract with an insurance company, which guarantees to pay you a steady stream of income until the day you die.

If you don't already have a pension, it makes good sense to devote part of your savings to purchasing an annuity. By doing so, you gain some peace of mind as well as the ability to invest the rest of your portfolio more aggressively.

But there are drawbacks. Annuity rates are tied to interest rates. With rates so low today, annuities are expensive. Plus, most offer no protection against inflation.

Work

Taking a part-time job in the early years of your retirement can make a big difference to your financial picture. Earning even $4,000 a year replaces the income you could reasonably expect to generate from a $100,000 portfolio. It also provides a buffer against unexpected inflation.

The obstacle, of course, is that many people find it difficult to find employment in their senior years. And some of us simply never want to see a workplace again.

Your portfolio

Many people can achieve big gains from simply adjusting their portfolios to reduce the cost of investing and to ensure the right mix between income producers (like bonds) and more inflation-proof investments (like stocks).

The problem? Many people don't like managing their own money. If you've never taken an interest in investing, retirement is not a good time to start taking charge of your own portfolio.

The bottom line

It all sounds very intimidating – but doesn't have to be. Despite their challenges, Uncle Jim and Aunt Mary never complained, but simply found ways to live on less.

They enjoyed their retirement. You can too.

Next week we'll explore the details of how a middle-class couple can build the retirement they want.