With the private sector’s move from defined benefit to defined contribution pension plans and rising life expectancies, the issue of retirement decumulation is increasing in importance.
Decumulation deals with converting retirement savings into income that must be managed over the rest of the retiree’s lifetime. It can be a challenge for Canadians who don’t have a significant DB pension because they’re subject to a number of challenges, including longevity and investment risk.
In its March 2019 budget, the federal government announced a significant proposal to assist Canadians with decumulation: changes to the tax rules to accommodate advanced life deferred annuities.
The current tax rules permit the purchase of a life annuity from a capital accumulation plan (i.e., registered DC plan, registered retirement savings plan, registered retirement income fund and deferred profit-sharing plan), but require that the annuity payments start no later than the end of the year that the individual reaches age 71.
Beginning in 2020, the federal Income Tax Act will be amended to permit the purchase of an ALDA. This option is similar to the life annuity but its payments can begin as late as the end of the year the individual reaches age 85. No more than 25 per cent of the amount accumulated under a single CAP can be applied to purchase an ALDA. As well, there’s a dollar limit of $150,000 (indexed to inflation) from all qualifying plans used to purchase the ALDA.
The following example illustrates how an ALDA can help address some of the challenges associated with decumulation. Joe is retiring at age 65 and has accumulated $500,000 of savings in an RRSP. He doesn’t have a spouse, but would like his savings to provide a meaningful inheritance for his two children in the event he doesn’t live to a very old age.
Joe is considering three strategies for using his savings to provide income during his retirement. The first is to use his entire RRSP savings to purchase an immediate life annuity from an insurance company. Because Joe would like to provide an inheritance to his children, he’ll purchase an ILA with a 15-year guarantee — in the event he dies within 15 years of his retirement, the present value of the payments he would have received for the balance of the 15 years will paid to his children. Based on quotes from insurance companies, Joe determines he can use his retirement savings to purchase an ILA paying $29,300 a year.
His second option is to manage his savings. Joe can transfer his entire RRSP account to an RRIF and periodically withdraw money as retirement income. If the RRIF earns an annual rate of return of 4.5 per cent and he withdraws $29,300 a year, his savings will last until age 96. When he dies, his children will inherit any remaining balance.
Joe’s third option is to use a portion of his savings to purchase an ALDA that provides a lifetime annuity starting at age 85. The remainder of his RRSP savings will be transferred to an RRIF, which will be used to provide income until his ALDA begins.
It’s difficult to predict how many insurers will offer ALDAs and how they’ll price this new product. However, we assume $114,000 of Joe’s retirement savings will purchase an ALDA that pays $29,300 a year beginning at age 85. If Joe transfers his remaining $386,000 to an RRIF, he withdraws $29,300 per year and the annual investment return is 4.5 per cent, the money will last until age 85 when his ALDA starts.
The following table summarizes the expected amounts and sources of retirement income under the above-mentioned three strategies:
|Expected Amounts and Sources of Retirement Income|
|Purchase ILA||Manage Savings||Purchase ALDA With Portion of Savings|
|Ages||Annual Income||Source||Annual Income||Source||Annual Income||Source|
|65 – 84||$29,300||ILA||$29,300||RRIF||$29,300||RRIF|
|85 – 96||29,300||ILA||29,300||RRIF||29,300||ALDA|
The following are some considerations regarding the three strategies:
- Longevity protection: Both the ILA and ALDA provide Joe with longevity protection. If he lives beyond age 85, both options guarantee his annual retirement income for as long as he lives. However, if he manages his entire savings using an RRIF, the savings are expected to be reduced to nothing by age 97, which will be a problem for Joe in the event he lives to a very old age.
- Death benefit: If Joe doesn’t live to a very old age, the strategies of managing his entire savings and purchasing an ALDA with a portion of his savings provide for a more meaningful death benefit than the ILA option. For example, under the ILA, if he dies at age 75, the only death benefit payable would be the present value of the remainder of the 15-year guaranteed payments, which amounts to $137,000. If he manages his entire savings and dies at age 75, the expected amount remaining in his RRIF, payable as a death benefit to his children, is $408,000. Finally, if he purchases an ALDA with a portion of his savings and it provides a death benefit in the event Joe dies prior to age 85, the combination of the expected amount remaining in his RRIF and the ALDA death benefit would be $379,000. All the above death benefit amounts are subject to income tax.
- Investment risk: The purchase of an ILA completely eliminates investment risks for Joe during his retirement years. The purchase of an ALDA doesn’t eliminate investment risk, but reduces risk compared to the approach of managing his entire retirement savings. For example, if Joe manages his own savings and the RRIF returns negative five per cent during the year in which he turns 80 (and earns 4.5 per cent per year during all other years), his RRIF will reduce to zero at age 94 instead of 96. However, if he purchases an ALDA, he’ll have to withdraw a slightly lower amount from his RRIF between ages 81 and 85, but he’ll still receive a guaranteed lifetime pension of $29,300 beginning at age 85.
- Benefiting from investment upside: Since the strategies of managing his own savings and purchasing an ALDA result in Joe investing at least a portion of his savings in an RRIF during retirement, he can benefit in the event that financial markets perform well and actual investment returns on his savings are better than expected (i. e., higher on average than the expected return of 4.5 per cent per year). However, if Joe purchases an ILA with his entire savings, there’s no upside potential from strong financial market performance during his retirement years.
- Retirement income flexibility: During retirement, it’s important to maintain income flexibility so more income can be withdrawn periodically to fund special expense items, such as travel, family celebrations or special health-care expenses. A person managing their own savings has flexibility and, in this example, purchasing an ALDA provides income flexibility until age 85. On the other hand, if Joe bought an ILA with his entire savings, he’d have no retirement income flexibility.
As a decumulation approach, purchasing an ALDA with a portion of a person’s retirement savings falls between the extremes of managing all their savings and using all their savings to purchase an ILA.
As a result, some of the ALDA’s potential advantages include: providing longevity protection when it’s needed the most (i.e., at very old ages); facilitating the provision of a meaningful death benefit in the case of a retiree who doesn’t live to a very old age; reducing investment risk while still maintaining some upside potential from strong market performance; and enabling a retiree to maintain some retirement income flexibility.
In the cases of people retiring without a DB plan, the ALDA should lower their tendency to underspend in their retirement years out of fear of outliving their investments.
Hopefully, insurance companies will offer this new product to Canadians and Canadians will understand its value. After all, its addition to the retirement decumulation tool kit is a complement to the traditional immediate life annuity.