Factors Contributing to the Retirement Spending Challenge
Investment vehicles – We are seeing a major shift away from defined benefit (DB) pension plans and greater reliance on defined contribution (DC) pension plans and other wealth accumulation instruments. This has lead to greater market risk for retiring individuals.
Healthcare costs – Health and long-term care costs continue to escalate faster than wages and inflation. Some research indicates that healthcare spending will increasingly fall on individuals by 2015.
Longevity – Longevity has been increasing at a remarkable rate. Few understand that there is a significant mortality issue, let alone how to calibrate and manage the risk that they may outlive their money.
Living Longer
In a 2005 study by the Society of Actuaries, it was found that two-thirds of retirees underestimated their average life expectancy, and that two-thirds of that group underestimated it by five years or more.
Despite the improving mortality phenomenon, investors may be asked to choose a fixed payout period for planning purposes, making the risk of outliving their money very real.
Income and Spending
With DB plans being replaced with DC plans and other savings arrangements—which have many positive features—the path to a predictable lifetime income is not as clear as under a DB plan.
One way to increase income security for DC plan members is to introduce an annuity feature within the plan. In the US, we are seeing the emergence of “in-plan annuities” that offer plan members the benefit of a lifetime income stream and the opportunity for investment growth.
Investment returns also play a significant role in income predictability. The years immediately preceding and just following retirement are critical to one’s retirement income, making the transition into retirement key to generating a predictable lifetime income.
Spending Patterns in Retirement
A recent Sun Life study indicates that most pre-retirees anticipate an active early retirement, implying a need for flexibility. While activities wind down in middle and late retirement, spending does not necessarily decrease as many retirees will become major consumers of healthcare—the incidence and intensity of which is unpredictable.
Good Solutions
Longevity, investment returns and retirement spending are unpredictable and volatile elements that must come together for Canadians to enjoy financial security in retirement.
Fortunately, the industry is responding with more sophisticated income security products to help retirees mitigate the risk of outliving their assets. These solutions under development include longevity insurance, target date investments (growing in popularity in Canada), sophisticated forms of variable annuities and ultimately, auto-pilot DC plans.
Challenge
While financial institutions have a significant role to play in helping individuals draw down their assets in an orderly manner, they are not solely responsible for it.
Financial planners need to ensure their models incorporate multi-end point projections. They need to educate their clients on mortality trends and product innovations, and be ready to offer a wider range of solutions.
Employers can introduce more lifetime income options to their DC plans. Easier access to well-designed, cost-effective rollover options will create an equal opportunity for DB and DC members.
Individuals must become more aware of the possibility of outliving their assets and seek advice from those who have access to the full spectrum of solutions.
Given medical advances, changes in nutrition and exercise, and public health improvements, lifespan is expected to increase for years to come. Ensuring a retirement free from financial worries may be a daunting challenge, but is one that we can do a much better job of.
Donald Stewart is the chief executive officer of Sun Life Financial.
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