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Retirement Planning for retirement? Think outside the box and avoid the great annuity paradox

A friend who has been retired for many years has both a defined benefit pension from her former employer as well as significant savings of her own, which she invests in stocks.

I asked her how she felt about buying a life annuity with some of those savings. As a refresher, a life annuity is like a defined benefit pension, except the fixed monthly payments come from an insurance company rather than a former employer. My friend didn’t hesitate with her answer. “No way," she said, “My savings give me extra cash and I might need that in the case of an emergency. Besides, I have been picking my own stocks for years and I think I’ve done pretty well.”

Fair enough, so I asked her a second question. If her former employer allowed her to convert her monthly defined benefit pension into a lump sum that she could combine with her other savings, would she do so? Her answer to this question was also no: “I like the steady monthly income I’m getting from the pension plan.”

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And there, in a nutshell, you have the annuity paradox. I believe my friend is typical of most people; they would never use their retirement savings to buy an annuity. And if they are lucky enough to have a defined benefit pension from a workplace pension plan (essentially an annuity), they wouldn’t think of trading it in for a cash lump sum.

Maybe my friend was lucky (or smart) and happened to have precisely the right blend of investable savings and annuity income already. But this cannot be true in general. Most retirees in the private sector have no defined benefit pension apart from government pensions and yet they don’t buy annuities. As for the public sector, the many civil servants have only defined benefit pensions and they are quite content to keep it that way.

A better explanation for the paradox is that we don’t know what we don’t know and this inhibits us from doing anything dramatic with our precious retirement monies.

Even if we were to concede that a better blend of annuity income and lump sum savings exists, who knows what that blend is? It is hard for the uninitiated to obtain clear information on the subject from an unbiased source. Whom can you trust? Absent such information, we tend to feel more comfortable doing nothing.

I would suggest that most retirees can do better. Let’s start by acknowledging that neither of the extremes – 100-per-cent annuity income or 100-per-cent savings – is optimal. The first extreme provides no flexibility while the latter offers no long-term security. It follows then that some blend of annuity income and savings must be better. In the absence of knowing the best possible blend, it seems reasonable to conclude that just nudging that blend toward the middle would be better than staying put.

To show what I mean, consider a couple, both 65, who have $600,000 in registered retirement savings plans (RRSPs) plus some Canada Pension Plan and Old Age Security pension income. They have no workplace pensions and no other investable assets. If they put all their monies into registered retirement income funds (RRIFs) and draw a steady income from them, my computer model shows that they could safely draw about $56,000 a year from all sources including government pensions. This calculation assumes they increase their draw a little each year to reflect a modest level of inflation. This result is possible even if investment returns are very poor. If their investments enjoy middling returns, they could withdraw up to $70,000 a year.

Our new retirees might think the range of $56,000 to $70,000 is perfectly acceptable but let’s see whether they can do better. What if they use 25 per cent of their RRSP monies ($150,000) to buy a life annuity at the age of 65? This nudges their retirement assets toward more annuity income. Their income range is now $60,000 to $69,000.

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Assuming they had rock-solid faith in the computer modelling, what would most retired couples choose: a strategy that yields an income range of $56,000 to $70,000 or one that produces a range of $60,000 to $69,000? My guess is that most retirees would find the narrower range more acceptable. It provides more predictable income and in the event of terrible investment results, substantially more money. The big stumbling block, though, is coming to grips with the annuity paradox.

By the way, the idea of nudging one’s blend of assets toward the middle tends to work only in the case of retirees whose assets are mainly in the form of investable savings. Retirees who have only defined benefit pension (e.g. civil servants) usually don’t have the choice of converting some of their pension into a cash lump sum. If they did have that choice, they should probably give it some serious consideration.

Frederick Vettese is former chief actuary of a national consulting firm and the author of Retirement Income for Life: Getting More without Saving More. He derives no financial benefit from the sale of annuities.

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