Retirement Income Planning

Long time reader Garth asked for my opinion on Wade D. Pfau’s essay Eight core ideas to guide retirement income planning.  Pfau is a smart guy and it’s no surprise that his article is excellent.  I do have some thoughts around the edges, though.

“Play the long game”

Pfau starts with an important point:

“A retirement income plan should be based on planning to live, rather than planning to die.”

This means that making sure you have enough money in old age is more important than trying to squeeze out as much money as you can in early retirement.  But we’re not asking you to sacrifice now.  By taking reasonable steps to protect your much older self, you’re freed up to spend a reasonable amount early in retirement without fear of running out of money.  Pfau lists six steps toward playing the long game which I’ll translate into the Canadian context.

Delaying starting CPP and OAS

As long as you have some savings to live on and you’re in reasonable health, delaying the start of CPP and OAS gives you guaranteed inflation-protected income no matter how long you live.  This can free you up to spend some of your savings early in retirement safely.  Exactly how long you should delay these pensions depends on the details of your finances.

Buying a single-premium immediate annuity

I’m not as positive about this step as Pfau and other experts are because of inflation risk.  Many researchers and financial advisors run retirement simulations where they treat inflation as a fixed constant known in advance.  They might test a plan by trying a few different inflation levels, but this doesn't capture the risky nature of inflation.

Historically, inflation has flared up unpredictably and stayed elevated for long periods.  A future inflation flare-up could decimate the purchasing power of future annuity payments.

Another concern is the fairness of annuity pricing.  Some researchers devise their recommendations based on the assumption that annuities will be fairly priced.  It’s not easy for average people to determine if the annuity they’re considering is priced fairly.

I’m not entirely against buying annuities, but the concerns of inflation risk and pricing risk make me think that people should annuitize a smaller percentage of their portfolios than others recommend.  Another mitigation of my concerns is to annuitize later in life when inflation will have less time to erode purchasing power.

Paying some extra taxes today to save more on taxes later

I’ve been doing this since I retired.  Late each year I estimate my income from all sources, and then I make an RRSP withdrawal to top up my income to the top of a particular marginal tax bracket.  The idea is to pay a small amount of tax now to avoid paying much higher taxes on this income in a future year.

For this to make sense, the tax savings have to outweigh the benefit of continuing to shelter this money from taxes.  Which marginal tax bracket to use for this strategy depends on the details of your finances.

Making renovations and living arrangements for living in place

The challenge I see here is that no matter how well you prepare a home to accommodate you as you age, if you live long enough, a time will come when you can’t safely stay any longer, unless you can afford multiple people providing round-the-clock expert care.  It’s hard on families when elderly people won’t leave homes they can no longer manage.  

You need a plan for making your home work for you as you age, but you also need a plan for the next step when you must leave.  Whenever I hear someone say they don’t want to be a burden, there’s a good chance they’re about to become a maximum burden by insisting on staying in their long-term home.

Planning for managing your finances through cognitive decline

My own plans involve simplifying my investments and cash flow in stages and bringing my sons in to oversee my finances.  Some financial advisors use the possibility of cognitive decline as a selling point for their services.  However, I think it’s unlikely that a financial advisor will be your most trusted person.  If I had a financial advisor, I’d still want my sons to oversee my finances.  Financial advisors can tell many stories of corrupt family members, but there are also many stories of corrupt financial advisors.

Planning to get a reverse mortgage

When your assets are gone, and your income is inadequate, a reverse mortgage can be the best option.  However, there is one concern with reverse mortgages that I rarely see discussed: you must keep your house in reasonable condition and keep up with property taxes and insurance.

It’s tempting to brush this off as a technical concern, but I’ve known many people who reach the point where they don’t maintain their homes properly, particularly as money becomes tight.  Some of these people have been members of my extended family.

The concern here is that the reverse mortgage lender could force you out of your home if you’re not maintaining it properly.  Has the pool had green water for a few years?  Have you stopped cleaning the dog dirt off the carpets in the rooms you don’t use?  Is the deck you no longer use falling down?

Some might look at statistics on reverse mortgage foreclosure and decide the risk is low.  However, such statistics don’t tell us much.  The real test comes when a lender finds itself with many underwater reverse mortgages (where the borrower owes more than the house is worth).  This could happen with a mature portfolio of loans, or it could happen after a sharp reduction in house prices.

Such a lender would find itself with a strong incentive to start foreclosing on underwater borrowers.  One way for a respected name in reverse mortgages to do this without damaging its reputation too badly would be to sell certain loans to a more ruthless lender.

I’m not suggesting that people should live in fear of being forced out of their homes.  But they need a plan for how they will maintain their home as they become less physically able to do the work or even oversee such work.

Do not leave money on the table

Pfau explains that some plans are better in all respects than other plans.  We often face tradeoffs, but if a plan is inferior in every respect, we shouldn’t follow that plan.  It’s hard to argue with this point, but it would be good to get some examples of what he means.

Use reasonable expectations for portfolio returns

I find it helpful to think in terms of real returns (which means returns after subtracting inflation).  When inflation was high, it wasn’t unreasonable to expect high nominal returns (which means returns without subtracting inflation).  But if inflation is low, expected nominal investment returns are low.  It’s easier to just focus on real returns instead of thinking about inflation all the time.

Long-term world-wide historical real returns for stocks have been about 5%.  For my own planning, I reduce this to 4%, and I reduce this further with a formula when stock prices are elevated as measured by the Cyclically Adjusted Price-to-Earnings ratio (CAPE).  I call this formula Variable Asset Allocation (VAA).  I’m currently assuming my fixed-income investments will earn a real return of 1%.

Based on these assumptions, a spreadsheet can calculate a spending level.  Of course, it’s possible that stocks and bonds will underperform these somewhat conservative assumptions.  I’ve decided that I have the capacity to reduce my spending if future returns disappoint.

Counting on high market returns

Pfau says that planning to spend more than what a bond portfolio can give is risky.  How much such risk you choose to take on should be determined by your capacity to reduce spending as necessary.

Some reasonable people choose to assume higher stock and bond returns than I do.  For example, some expect stocks to earn a real return of 5%.  As long as they have a high capacity to cut spending as necessary, this can work.  But I fear that some aren’t as flexible as they think they are.

There are others who expect even higher returns.  They point to historical real U.S. stock returns of 7%.  There are strong reasons why we shouldn’t expect future U.S. stock returns to match the past.  The main one is that the U.S. has already risen from being similar to some other countries to being a superpower; it can’t do this again.

Managing risks

Pfau identifies longevity risk, market risk, macroeconomic risks, and spending shocks.  He says you need an integrated strategy for addressing these risks.  I agree with this, although we would have to look at some of his other work to see examples of such an integrated strategy.

I see many examples of bad plans for addressing risks.  Some commentators talk of owning gold in case civilization crumbles, bonds in case stocks crash, blue-chip stocks in case risky stocks crash, and other asset classes for similar reasons.  They see all these risks in isolation.  They’re like dieters who order a diet coke to go with their double-burger and fries as though the diet coke will somehow save them.  Just as we need to look at what we eat as a whole, we need to examine the totality of our retirement portfolios to assess risks.

Investments vs. insurance

“My research shows that the most efficient retirement strategies require an integration of both investments and insurance.”

By “insurance,” Pfau means various types of annuities.  This is another case where I have seen researchers work from the assumption that insurance products are priced fairly.  I see a small number of possibly good insurance products in the world along with a vast sea of terrible insurance products sold with deliberately misleading stories.

To be fair, there are many terrible investments out there as well, but insurance looks a lot worse to me.  I can figure out how to invest my money well, but I haven’t figured out how to find annuities worth owning.

Start with the household balance sheet

“Treat the household retirement problem in the same way that pension funds treat their obligations. Assets should be matched to liabilities with comparable levels of risk.”

Pfau doesn’t give much detail in this essay on how exactly to match assets and liabilities.  He gives some related ideas on distinguishing between technical liquidity and true liquidity.  These seem like good ideas in principle, but it’s hard to say much without more details.

Conclusion

Pfau lays out some excellent principles of retirement income planning in his article.  In the decade since he wrote it, no doubt his subsequent work has filled in some of the details I called for.  This area is complex, and retirees are largely over-matched.  Even most high end financial advisors aren’t great at retirement income planning.  The world would be a better place if people had more options for buying into pension plans that manage this difficult problem for retirees.