Control and risk in retirement

July 10th, 2017

Life Annuities 3
People with defined contribution pension plans or group RRSPs may face a “good news, bad news” situation when they retire.

The good news is that many people will receive 6-figure (and sometimes even 7-figure) cheques from such plans.

The bad news is that this money has to fund their lifestyle for the rest of their (and their spouses) lives regardless of what financial markets and inflation are doing.

My wife and I are in precisely this position and therefore I have a personal, as well as a professional interest in determining exactly how you go about doing this.

In my research, I have determined that there are only two strategies available: life annuities and systematic withdrawal plans.

You purchase a life annuity from a life insurance company with a lump sum. In return, they pay you a monthly amount for the rest of your life.

In systematic withdrawal plans, you decide what percentage of your assets you withdraw from your savings annually. The percent most talked about is 4%. This amount is increased annually to take into account inflation.

It is useful to analyze these two strategies from the point of risks in retirement. There are three categories of risks: externally imposed risks, controllable risks, and behavioural risks. This article focuses on the third category of behavioural risks.

The first behavioural risk is the ability to self-execute and resist the human tendency to buy high and sell low. Life annuities score low on this risk because the insurance company is managing the investment process, while systematic withdrawal plans score high on this risk since you are managing the investment process.

The second risk is the temptation to spend today. The life annuity pays a fixed amount monthly and hence the risk is low. For a systematic withdrawal plan, the decision is in your hands and the risk is therefore high.

Third, there is the risk of cognitive decline with aging, impairing your ability to make sound decisions when dealing with complex financial issues.  A life annuity, in effect, puts you on autopilot and this risk is therefore low, while implementing a systematic withdrawal plan in your 80’s and 90’s could be a real challenge and this risk is high.

Fraud is another form of risk because everyone knows that seniors have a lot of money. For a life annuity, the insurance company holds all the funds and there is no risk because no one can touch your money. For a systematic withdrawal plan, you hold all the funds and you are susceptible to fraud, a high-risk situation.

Another behavioral risk is poor or biased advice. The news is full of stories about bank employees forcing unwanted services and inappropriate products on customers. This cannot happen with life annuities while it is a very real risk with SWP’s.

People are very uncomfortable with the idea of turning control of their money over to an insurance company, but from my perspective, once the risks are understood, it makes a lot of sense to put some portion of your retirement savings in a life annuity.