Retiring baby boomers are in an era of decumulation anxiety, as they convert their pension assets into income that they fear won’t hold up over the entirety of their retirement.
The decumulation problem is complex for defined contribution pension plan sponsors because it involves transferring lump sum pension assets to retirees who may lack investment expertise and who may not know how to distribute their savings to cover their entire retirement horizon. It’s not obvious how to calibrate between having the desired standard of living while controlling expenditure to avoid outliving savings and, if possible, leaving an inheritance.
Compounding the issue is the extended life expectancy of retirees today, which means that pension assets have to be distributed over an uncertain time horizon. As well, following the coronavirus pandemic, prices have increased by an unprecedented 15 per cent in Canada since 2020, with the U.S. and other countries seeing similar trends.
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In terms of available services, retirees have always been able to buy a life annuity from an insurance company that will provide a steady stream of retirement income for life. The problem is that not many people choose this option in what is termed the ‘annuitization puzzle’ by financial academics. Reasons include the high cost of life annuities, the absence of inflation protection and the pre-determined nature of annuity payments, which makes it difficult for individuals to insure against unexpected medical expenditures or leave a bequest.
Instead, most retirees choose to invest and decumulate their capital on their own. But because they’re afraid to outlast their savings, this leads to a pattern of living poor and dying rich, as seen in studies of wealth decumulation patterns in Australia and the U.S.
The question is, what other services are there to help retirees invest and decumulate their capital more efficiently? For starters, the Canada Pension Plan and the Quebec Pension Plan already offer inflation and longevity protection because they provide payments fully indexed to price inflation for life. This means the longer retirees delay withdrawing from their CPP or QPP, the more they’ll receive in their monthly payout and thereby increase their longevity insurance.
Read: 2023 DC Plan Summit: How Australia, the U.S. are tackling decumulation challenges
Another approach to consider is a strategic phasing of the decumulation period of retirement. Retirement at age 60 is very different from retirement at age 80. In the early years, retirees tend to be more active in managing their portfolio and spending as they take advantage of entertainment or travel goals. There’s the retirement mid-phase, where spending levels out as retirees become more static. Then in the third phase of retirement, retirees need to be able to cover health costs as they face cognitive decline and need personal assistance. It’s this final phase that gives retirees particular anxiety and this is precisely when the steady and indefinite stream of payments from a life annuity becomes extremely valuable.
Purchasing an advanced life deferred annuity, which has recently become available in Canada, presents a cost-effective way to access steady income later in life. ALDA payments don’t start until the age of 85, which means this new product is considerably cheaper than a traditional life annuity in which payments start immediately. A retiree can purchase an ALDA and continue to invest in a broad portfolio of assets. This gives retirees the opportunity for investment growth and flexibility in spending during their earlier phases of retirement.
A combination of CPP/QPP and a cost-effective ALDA can provide retirees peace of mind and relieve their fear of running out of income in their later years. Retirees can enjoy their retirement and decumulate their hard-earned savings more effectively.
Read: My Take: Tackling decumulation today will lead to retirement-ready workers tomorrow