## Tuesday, May 21, 2019

### The Cost of Longevity Risk

One valuable part of CPP, OAS, and defined-benefit pensions is that they keep paying you even if you live a long life. In more technical language, these pensions take care of longevity risk. When you have to manage your own investments, you’re forced to spend conservatively in retirement in case you live long. Here we consider example cases to illustrate the cost of longevity risk.

Shawna is 65 years old and is entitled to a \$1000 per month pension, indexed to inflation, for the rest of her life. She is offered the choice of keeping this pension or withdrawing its commuted value to invest in her locked-in retirement account.

To keep this example simple, we’ll assume the pension plan expects Shawna to live 20 more years, and her commuted value is calculated with a discount rate of inflation plus 1.5%. The commuted value of her pension works out to \$207,436. We’ll also assume Shawna won’t have to pay any income taxes immediately as she would have to if her commuted value was too much larger.

If Shawna takes the commuted value, she is then hoping to invest her lump sum well enough to all withdrawals of at least \$1000 per month, rising with inflation, for the rest of her life. If she just assumes she’ll die at 85, she only needs to generate annual returns of inflation plus 1.5%.

However, Shawna is worried she might live past 85. To be safe, she plans to make the money last for 30 years. The question then is what return does she have to get to produce \$1000 per month rising with inflation for 30 years? The answer is inflation plus 4.16%.

Even with an all-stock portfolio, there is significant risk that Shawna’s portfolio won’t produce this return, on average, for 30 years. Taking the commuted value leaves Shawna with a lot more risk than if she just takes the pension.

The situation changes for a younger person. Consider Carla who is 45 and is entitled to a \$1000 per month pension, rising with inflation, starting at age 65 for the rest of her life. With the same assumptions as in Shawna’s case, Carla’s commuted value is \$154,015.

To make her self-generated pension last for 30 years starting at age 65, Carla needs to generate investment returns of inflation plus 2.52%. This is more realistic than Shawna’s case. Carla is still taking some risk if she takes the commuted value, particularly if she is working with an expensive advisor. But with discipline and low-cost investments, Carla has a reasonable chance of generating more income than she would get with her pension.

It’s easy to get lost in the numbers when trying to decide whether to take a pension or withdraw its commuted value. Any analysis that leaves out longevity risk is flawed.