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the long view

Building a risk-proof retirement begins with looking at the world upside down.

For instance, you've always been told that short-term market fluctuations don't matter to a diligent investor. That advice no longer applies in retirement.

During your working life, you've focused on what you would like to have – a bigger house, an exotic trip, a new car. In retirement, your mind should shift to what you must have.

It's a difficult transition for many people to make, says Peter Guidote, director of wealth management at Richardson GMP in Montreal. But it's essential if you want your money to last until you're 95 – a reasonable goal for many people in an era where lifespans keep creeping upward.

To help demonstrate a few of the key questions that a couple should ask, Mr. Guidote agreed to walk us through a hypothetical example.

Jack and Janet are 65 and 63, have been earning $110,000 a year between them, and are now retiring with a paid-off house, savings of $650,000 and a small company pension. Their level of wealth puts them considerably above most Canadians, but still falls well short of true riches. In other words, they're similar to many middle-class couples.

What should they do? Here's Mr. Guidote's approach:

Focus on needs: The biggest fear for many couples is outliving their money and being unable to stay in their home. One potential cure for this begins by identifying what you must have to cover housing, food, clothing, medical expenses and other basic needs.

A couple who have been earning $110,000 might decide they can't get by without a pretax income of $80,000 a year in retirement, roughly equal to the 70 per cent replacement ratio recommended by many financial planners. But don't forget that many expenses fall away in retirement.

If the same couple drills down into their spending, they may be surprised to find they need substantially less to cover all their basic needs – say, something on the order of $60,000 to $65,000.

Tote up guaranteed income: This includes government stipends such as Canada Pension Plan, Quebec Pension Plan and Old Age Security as well as any pension income from an employer.

Mr. Guidote assumes Jack and Janet will receive about $30,000 a year from CPP and OAS and $20,000 from company pensions for a combined total of $50,000 annually. That leaves them considerably short of the $80,000 they would like, but within hailing distance of the $65,000 or so they must have.

Bridge the gap: One way for them to fill the gap is to buy an annuity, a contract with a life insurance company that guarantees them an income for life.

An annuity that would pay Jack and Janet $15,000 a year, not adjusted for inflation, would cost roughly $250,000 at current market rates. While that would gobble up a substantial portion of their nest egg, it would provide them with the security of knowing they would never run out of money.

To be sure, an outburst of inflation would eat into the buying power of their annuity income. That's why investing is still important.

Watch withdrawals: A balanced portfolio of stocks and bonds can provide additional income and also offer a buffer against inflation. But people often overestimate how much income they can expect.

Mr. Guidote says a balanced portfolio has historically been able to generate a 4-per-cent return after inflation. If Jack and Janet buy an annuity for $250,000 and can achieve a 4-per-cent return on the remaining $400,000 of their nest egg, they will wind up with just about exactly the $80,000 they want.

But sticking to any fixed rate of withdrawal poses a risk in itself.

The danger is that you retire just as markets tank. In that case, the double whammy of a market downturn combined with regular withdrawals of money can gut your savings to the point where even strong subsequent gains can't make up for the damage that has been done.

The accompanying charts make the point. When you're working, and not tapping your portfolio, the sequence of market returns doesn't matter. In either Scenario One, when initial returns are good, or Scenario Two, when a downturn hits you immediately, you wind up with the same amount of money five years later.

However, the sequence of returns is hugely important to someone in retirement who is counting on a portfolio to generate a steady stream of annual income. If you enjoy strong returns immediately after you retire (Scenario One), you wind up with considerably more money five years later than if you're immediately sideswiped by a market correction (Scenario Two).

One way to deal with market uncertainty is to put aside a year's worth of income that you can tap if markets turn down; this will give your portfolio time to recover from the drubbing it just took. Still another is to cut down on your spending – and your portfolio withdrawals – if markets go sour.

Putting it all together: Jack and Janet have choices to make. One option is to invest their entire $650,000 nest egg in a portfolio of stocks and bonds, and withdraw $30,000 a year to cover the gap between their $50,000 in sure retirement income and their $80,000 income goal.

Problem is, a historical analysis shows this strategy has a 26-per-cent chance of running out of money by the time Jack is 94. For most people, that's too risky.

Jack and Janet could erase much of that risk by following Mr. Guidote's preferred strategy of buying an annuity to bridge the gap between their current level of sure income and what they must have to meet basic needs. They could then invest what's left.

But it's not the only possible answer. Other solutions include working a couple of years longer, working part-time or rethinking their expenses.

"There's no right or wrong answer to any of this," Mr. Guidote says. "The key is understanding the issues and having an intellectual framework that lets you make good decisions."