Are Canadians on the brink of a retirement crisis? Private sector pensions have all but disappeared, and one in three Canadians are nearing retirement without any savings. A growing number of seniors are not only carrying mortgage debt into retirement, but also represent an increasing number of bankruptcy filings.
Add longevity risk – the prospect of outliving your money – into the equation, and it’s no wonder the financial news media can’t stop harping on about these emerging threats to our retirement.
Enter Fred Vettese, chief actuary at consulting firm Morneau Shepell, and author of a new book called Retirement Income for Life. Mr. Vettese has long argued that Canadians are not facing a retirement crisis – in fact, far from it. Why is that?
What Retirement Crisis?
Let’s start with the standard financial advice that you need to replace 70 percent of your final average earnings to have a comfortable income in retirement. The real retirement income target for most people is much lower than 70 percent.
A recent study showed that the vast majority of middle-income households who retired with enough income to replace 65-75 percent of their final average earnings ended up with a much higher standard of living in retirement. Four out of five households improved their standard of living by 20 percent or more, and in some cases the amount they had to spend doubled.
Vettese champions a retirement income target closer to 50 percent. The reason is three-fold: One, it allows people to smooth out their spending, saving, and consumption throughout their lives; Two, many expenses incurred during your working years (including saving for retirement) simply disappear once you’ve retired; And three, seniors start spending less in real terms once they reach their early 70s.
The drop in spending has little to do with insufficient income. A 2001 study by actuary Malcolm Hamilton showed that seniors in Canada save enormous amounts of money. Senior couples aged 75 and over either saved or gave away as cash gifts an average of 16.1 percent of their income.
The study looked at seniors from all income levels, not just the wealthy. The average income for couples 85 and older was just $31,300.
“Taking all the foregoing studies into account, I believe it is safe to conclude that the spending of seniors in real terms keeps up with inflation until age 70 or so, and after that it will usually fall at the rate of:
- 1 percent a year throughout one’s 70s,
- 2 percent a year in one’s 80s, and
- 0 percent from age 90 and on.
There would also be a one-time drop of 30 percent or so when a spouse dies.”
Okay, so we don’t have to save so much as to replace 70 percent of our income in retirement. We’ll likely be quite comfortable living on 50 percent of our income. Terrific.
Let’s say you earned an average of $80,000 a year during your final working years. Your retirement income target in year one of retirement would then be just $40,000.
CPP and OAS benefits might cover one-third of that amount or more. The average CPP amount for new beneficiaries is $7,700 per year, while the maximum OAS benefit is $7,040 per year. The rest of your income would have to come from a workplace pension plan or from personal savings.
Five Strategies To Enhance Your Retirement
With the retirement crisis out of the way, let’s focus now on the five strategies or enhancements that Vettese recommends to ‘get more retirement income without saving more.’
Strategy #1: Reducing Fees
The MER on the average equity mutual fund in Canada is 2.35 percent, and in some cases can top 3 percent when you add other fees typically charged by financial advisors. The first step to building and preserving your retirement nest egg is to reduce your investment fees – ideally to 0.50 percent or less.
This can be achieved by abandoning retail mutual fund products and switching to low cost, passively managed ETFs.
Going it alone and constructing a portfolio of ETFs through an online discount broker would save you the most money, but DIY investing does come with some pitfalls – namely knowing how to navigate your discount brokerage to add new money, buy and sell the right products, and when to rebalance.
Another option is to invest online using a robo-advisor, where you can expect to pay a little bit more (still much less than 1 percent) but the buying, selling, and rebalancing is taken care of for you.
Strategy #2: Deferring CPP Pension
Fully indexed to inflation and sure to be paid for life. That’s what makes CPP such a great benefit for retirees. What if you could increase your CPP pension by 50 percent? Sounds like a no-brainer, right?
To get the larger payments you’ll have to forego receiving CPP pension benefits until age 70. The trouble is, almost no one like the idea of waiting that long to start taking CPP. Only 1 percent of all recipients postpone the start of their CPP payments until age 70.
To replace the gap left by deferring CPP until age 70, you’ll need to make up the difference from personal savings. That means drawing down your RRIF or TFSA more rapidly than expected between ages 65 and 70.
However, the enhanced CPP benefit is worth the wait and can greatly improve your financial situation, even preserving your RRIF and TFSA balances once CPP payments kick-in. Deferring CPP also reduces longevity risk by increasing the portion of your income that is guaranteed for life.
Strategy #3: Buying an Annuity
Speaking of income for life, the next retirement enhancement aims to do exactly that. Take a small portion of your savings, likely from your RRIF, and convert it into an annuity. Specifically, the type of annuity that is payable as long as either spouse is still alive – called a ‘joint and survivor annuity.’
How much of your savings should you allocate to an annuity? The example in Retirement Income for Life shows a couple with $500,000 saved in their RRIF and they converted 30 percent of that amount – or $150,000 – into an annuity.
Vettese argues against buying an indexed annuity because they tend to be over-priced. Given the research that spending declines in real terms as we get older, an annuity that provides inflation protection would appear to be unnecessary.
Furthermore, whether you buy an annuity at retirement or not, Vettese says you should consider buying another annuity around age 75 if you still have substantial tax-sheltered assets.
Strategy #4: A Dynamic Spending Approach
Most people assume your retirement income target stays static throughout retirement. Blame the 4 percent rule or a hard-dollar target amount that you’re aiming to achieve. But it’s a mistake to keep your spending more or less the same every year because there’s a good chance your assets will either run out or grow into a sizeable surplus that never gets used.
With a dynamic spending approach you will spend more if your financial situation improves (i.e. stock markets perform well), and spend less if your situation worsens. Rather than a static percentage or number, think of your retirement income target as a range of numbers between your safe income target and your best-estimate target.
Don’t forget about taxes. The amount of income you draw will usually be more than the amount you can actually spend: the difference is the income tax you have to pay.
Note: If you’re between 50 and 80 check out this online tool that will help anyone who is at the point of retirement (or who has retired) to calculate their personal income range.
Strategy #5: The Nuclear Option
The first three strategies help reduce risk and increase retirement income. The fourth strategy helps you keep your spending on track no matter what happens. If you do all four there’s a good chance you’ll avoid financial catastrophe during your lifetime.
But, Vettese concedes, not everyone is going to defer CPP until age 70, nor will everyone buy an annuity. And if you need the services of a financial advisor then it’s likely your investment fees will be much higher than if you managed an ETF portfolio on your own.
Perhaps you’ll fall victim to a rogue advisor who makes off with a portion of your life savings, or your spouse tragically dies early. Under these conditions, your income in your 60s might be lower than you ever anticipated and the strategies described above will be rather ineffective.
So now what do you do?
Options under these circumstances might include:
- Accepting a drastic cut in spending for the rest of your life.
- Downsize and move into a smaller home, perhaps in a less expensive community.
- Take out a reverse mortgage or home equity line of credit
While reducing spending by 30 percent or more is unappealing, the other two options have their pitfalls as well. Downsizing might unlock a sizeable amount to top-up your nest egg, but it might not be enough to save your retirement. Besides, moving in your 70s or 80s can prove to be difficult.
Finally, a reverse mortgage should be considered as a last resort. Something to provide necessary income late in retirement, not to enhance one’s lifestyle.
The five retirement strategies presented above go against the grain – especially CPP deferral and purchasing an annuity. As a result, Vettese says, you might be inclined to look for a reason to reject them.
For instance, if this decumulation strategy is so effective, why don’t we hear much about it in the financial news media or from more advisors? Vettese suggests that could be because many academics and other leading pension thinkers who endorse these ideas do not tend to communicate with the general public.
The key takeaway is that these enhancements or strategies, when taken together, can significantly reduce the amount of savings one needs for retirement, while at the same time reducing investment and longevity risk. None of these enhancements is new, as they have been endorsed by many academics, actuaries, and pension industry groups for years.
Vettese’s book, Retirement Income for Life, is an attempt to change public perception and make these strategies more commonly accepted practice.