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In my last commentary I wrote about the advantage that DB pension plans have in providing for higher pension payments to retirees from accumulated assets than can be purchased through an insured annuity.  The seemingly ‘free money’ comes from the fact that a DB pension plan is backed by a third-party that is guaranteeing payments if the pension fund proves insufficient.  When assets are transferred to an insurance company there is no longer a third-party guarantor of investment losses and as a result the insurance company must be cautious not to over promise on a pension that it cannot deliver.  The result is less investment risk which means a lower investment income to fund the monthly pension.

What can DC members do to level the playing field?

Equity Investing

The most common solution I have seen to the problem is for DC plan members to continue to invest a percentage of their funds in equities.  The general theory is that with a possible 30- or 40-year retirement, moving all investments to fixed-income investments or an annuity is walking away from the equity market too quickly.

One clever financial advisor I spoke with builds a 10-year laddered bond portfolio for clients to take care of near term expected cashflow needs and then invests the balance of the client’s assets in equities (I am looking at you Sean).  But this only works when you have enough assets to have such a customized approach and is generally a good idea for those that have enough assets that they never have to worry about running out.

The problem for most retirees is that the possibility of outliving their nest-egg is real.  Managing your own funds individually and risking running out of money if you live too long or risking leaving money behind that you could have used to live a little more comfortably if you die sooner than ‘expected’ is not an easy problem to solve.

Roughly speaking, only a quarter of males 65 years old will die within three years of their expected lifetime of 86.5.  I use three years because as someone managing money for my 85-year-old mom, missing by three years can be painful.  Assuming a retiree targets their expected lifetime, about 35% of retirees will leave 3+ years of money on the table and about 40% will run out of money more than three years before they die.

Many financial advisors are dealing with this problem by telling DC plan members to save enough money to last until age 90.  All this strategy does is increase the number of retirees that leave money on the table (even if the advisor doesn’t understand it is self serving advice) and unnecessarily depresses their lifestyle in their golden years.

Index Linked GICs

Banks now offer indexed linked GICs where your investment return is tied to an index such as TD Bank’s “Canadian Banks GIC” which is linked to the S&P/TSX Banks Index.  Layered onto this market investment is a minimum guarantee and in exchange for this protection there is a maximum return that the GIC holder can earn.

These products help retirees balance the need to invest in equities through retirement with the need to avoid ‘downside losses’.  Unfortunately, as with pure equity investing described above, there is no ability to manage the longevity risk and retirees are left to worry about under-spending or over-spending neither of which is a friendly option for those that aren’t planning legacy giving as part of their financial plan.

Guaranteed Minimum Withdrawal Benefits

About a decade ago, the insurance industry figured out that DC plan members faced the conundrum of taking a risk and investing in equities or avoiding risk and buying an annuity.  Few retirees were buying annuities making it clear a different type of tool was needed.

In a nutshell, the GMWB plan is a hybrid investment/annuity policy sold by an insurance company.  The twist is that the insurer guarantees that the premium deposited in the policy will earn a minimum rate of return.  In exchange for this guarantee, plan members had to commit to holding the investment for 10+ years before starting their retirement income.  At retirement, if the investments can outperform the guaranteed rate, then a higher pension can be paid.

I am no expert in all the nuances of the GMWB design, but my general understanding is that they are complicated to explain to plan members, come with relatively high management fees, and as of late are not that popular with financial advisors seeking to guide clients in retirement.

Longevity Insurance

Late-life deferred life annuity contracts just doesn’t roll off the tongue as nicely as longevity insurance.  Of course, actuaries like to be really clear and late-life deferred annuities gives you everything you need to know about how longevity insurance is designed.

The strategy behind longevity insurance is to let savers continue to manage part of their nest-egg for the first 10 or 20 years of retirement to allow for continued investment in equities and to provide flexibility in withdrawal rates in the early phases of retirement while at the same time locking in some protection against outliving the income needed to fund the basic necessities of life for as long as life continues.

So why don’t more DC plan members and individual savers just buy longevity insurance with a portion of their funds and then invest/spend the rest leading up to the age where they have deferred their guaranteed income?  The easy answer is that in Canada the product doesn’t currently exist.

A group of industry experts including the Association of Canadian Pension Managers, the Canadian Life and Health Insurance Association, and my friends at the Canadian Institute of Actuaries all agree that longevity insurance is important and an easy win for government.  A September 2018 submission to the federal government outlines that view as well as some other helpful hints about improving the system.

Here is the good news.  In the March 2019 Federal Budget {Dean’s commentary here}, our government figured out that this was an important tool for retirees and is introducing ‘advanced life deferred annuities’.  This is clearly a win for the industry and for DC plan participants.  There are limits on the amount of money that can be deferred, but we have a start.  In my view, the limits are based upon a misconception the government has about the ‘cost’ of deferred taxes, but that is a discussion for another day.

The DC Advantage

Managing retirement income through a DC plan is always seen as more difficult than doing so with a DB plan.  But that view is largely based upon the recent history of DB plans as for most of the world’s history there were no DB plans and workers either had to keep working, rely on family, or save their own money to fund retirement.  DB is a relatively new idea even though our industry is quickly evolving to the frame the defined benefit plan as the old way of doing things.

The key feature of DC plans is that it places the individual as the guarantor of their own future rather than asking any other party to do so.  Some (employers) see this as an advantage while others see this as a disadvantage.  For DC to be a success for plan members there is work to be done to improve the system.  The advanced life deferred annuity is one step in that direction.