Retirement planning models are now commonplace.
With a standard planning tool, we can plug in RRSP savings of a million dollars and an assumed investment return of 5% a year and determine that we can generate an income of about $76,800 per year, including government benefits, indexed to 2% inflation, and our money will run out in about 20 years. So if we know that our investments will return 5% each year, with inflation at 2% each year, and we will only live 20 years, and we only need a budget of $6,400 a month to support our desired retirement lifestyle, then our $1 million ought to be enough to support us in retirement. But it’s not that simple.
The problem is uncertainty
These models mainly provide best estimates, often glossing over the huge range of potential outcomes. The one thing we know for certain is that all the estimates plugged into the planning model will be wrong. A 5% per annum return is not an unreasonable average guess, but your investments will not earn 5% each and every year. They may earn 10% or 25% one year, and 0% or -20% the next year.
And the pattern of returns will greatly affect your ability to fund your retirement. An example provided by Milevsky and Salisbury shows a gap of almost 14 years between when the money runs out if you retire and achieve a repeating investment return of 27%, 7%, -13% versus the reverse sequence (-13%, 7%, 27%). Not only the expected return but also the pattern of returns—especially right before and after retirement—can have a huge impact on whether or not you have enough money to achieve a desired retirement lifestyle.
Similarly, if you are a 60-year-old male, you might expect to live, on average, around 20 more years. But you could live to 110, or you could get hit by a bus later today.
Retirement planning is all about contingencies—what might happen rather than what is expected to happen. And the range of what might happen is exceedingly broad. Yet the solution for most people is not to eliminate the uncertainty. Purchasing an annuity is a much less popular option for most than converting to a retirement income fund, even though annuitization could eliminate much of the longevity and investment risk.
There may be a lot of good reasons for not wanting to lock in with an annuity, including opportunity costs associated with what is perceived to be an expensive product and beliefs that, in future, stocks will likely outperform bonds and/or interest rates are likely to rise. Perhaps pension reform that is pushing pooled registered retirement plans should also be ensuring a more competitive annuity market. However, I suspect most would still not want to lock into an annuity, preferring the flexibility that comes with continuing to have control over the money—to be able to spend more if needed, to be able to leave a bequest, to be free to make choices.
The solution is flexibility
For the increasing number of individuals without defined benefits, the solution to a successful retirement appears to be one of compromise. Each person is left to find suitable trade-offs between the management of retirement assets, the timing of retirement and the lifestyle in retirement.
Notionally, we all start our working career with a personal balance sheet, on which the major asset is human capital, supporting living expenses and offsetting mortgages and/or other personal debts. We hope, over time, some of the human capital is converted into retirement savings. When the retirement savings exceed the present value of expected future retirement expenses, we can retire.
A recent Toronto Star article pointed out that Canadians over 60 have been taking a disproportionately large share of the new jobs since the economic meltdown in 2008. In a lot of cases, phased retirement, postponed retirement and even return to work from retirement are examples of human capital being used to offset disappointing investment results.
Unfortunately, the current job market is not sufficiently flexible to provide a safety net for everyone’s retirement plans. A market downturn may lead to a greater supply of retirement-aged labour, but it is unlikely to signal a greater demand. And not all jobs are interchangeable. It is doubtful that a senior manager at a bank will want to retire with a contingency plan of being able to be a barista at Starbucks.
So there will continue to be a demand for investment strategies that better manage the volatility. While we may be unwilling or unable to accept the lower income provided by a fully locked-in solution, some compromise is required so that we don’t have to rely too heavily, or too long, on our human capital.
Target date funds (TDFs) have failed to provide the promised protection. In 2008, some “retiree” TDFs, which are supposed to be the safe options right before retirement, experienced losses of up to 10%. Various techniques, including dynamic glide paths, allocations to stable value funds or funds with guaranteed minimum returns, and periodically annuitizing small amounts, need to be available for a planned retirement date to be considered a fixed landmark rather than a receding horizon.
In the absence of an annuity, we still need ways to insulate our assets from market volatility after retirement. For those able to use a customized solution, a typical portfolio might include assets cash-matched to expected spending for the first number of years with equities or other more volatile assets earmarked for expenses in the more distant future. Over time, the cash-matched portion of the portfolio is replenished, we hope, after periods in which the riskier assets have outperformed.
But in general, in a world where investment risk and longevity risk have been shifted to individuals rather than pooled in DB arrangements, there needs to be a great deal of flexibility built into the retirement plan, the investments, the retirement lifestyle and the timing and extent of retirement.