You need a ‘true’ pension

Consider using part of your wealth to buy a life annuity from an insurer. It will provide you with monthly payments for the rest of your life—just like a defined benefit pension.


Why you need a ‘true’ pension plan for retirement

Most Canadians lack workplace pension plans. The number of Canadians belonging to one keeps dropping as few private-sector employers offer them. As a result, Dr. Moshe Milevsky and Alexandra Macqueen advise you to build your own pension in their book, Pensionize Your Nest Egg. Dr. Milevsky is a Professor of Finance at the Schulich School of Business in Toronto. Ms. Macqueen is a Certified Financial Planner in Toronto.

They write that a ‘true’ defined benefit (or DB) pension “promises a lifetime of income to each retiree when he or she stops working, with the potential for a survivor pension for your spouse after you die”.

But DB pensions are now rare. Dr. Milevsky and Ms. Macqueen write, “if you work in the public sector, chances are you (still) have a DB pension plan. But if you work in the private sector, your chances aren’t so good—if you have a pension plan at all, it is likely a defined contribution (or DC) plan.”

Dr. Milevsky and Ms. Macqueen do not consider DC plans true pensions. They write, “There’s no promise of lifetime income. Instead, your retirement future is subject to the random ups and downs of the stock and bond markets.”

Defined benefit plans are true pensions

Even DB pensions in the private sector depend on the fortunes of the company. When Nortel Networks went bankrupt, for instance, many retirees were left in the lurch. The public sector can raise taxes—despite isolated bankruptcies such as American cities. Even solid private-sector employers are turning away from DB pensions. A friend who works at Canadian Imperial Bank of Commerce has a DB pension. But in recent years her new co-workers are enrolled in riskier DC pensions.

Dr. Milevsky and Ms. Macqueen go further. They write “a defined contribution workplace pension plan, tax-deferred or tax-free savings account, a permanent or whole life insurance policy, or any large sum of money in a mutual fund, unit fund, segregated account, separately managed account or discount brokerage account is not a pension”.

“Our quantitative analysis indicates that a prospective retiree—who could be you—might have 20, 30, or even 40 times their annual income needs in investable wealth (what we would call a wealth-to-needs ratio of 20, 30, or 40). These assets could be sitting in the most diversified of mutual funds, investments, retirement savings accounts or even in a DC pension plan, and yet the retiree still runs the risk that the portfolio will not last as long as he or she does. This is the nature of random and unpredictable human longevity combined with financial volatility. In the language of retirement income planning, retirement income streams without guarantees are subject to a high ‘lifetime ruin probability.’”

Retirees face specific risks

Canadians are living longer than ever. Scientific advances should further extend lifespans. The one risk is that long retirements are costly.

A second risk retirees face is the sequence of returns. After the market crash of 2008-2009, for instance, many workers delayed retirement. But those who were already retired lost a chunk of their wealth with little time to recoup the money. That’s likely to occur in 2022 as well.

A third risk retirees face is inflation. Since central banks aim for inflation rates of two per cent or so, inflation will persist. An inflation rate of only two per cent doubles prices over 35 years. Of course, inflation is now far above two per cent.

Dr. Milevsky and Ms. Macqueen suggest you use part of your wealth to buy a pension. This involves buying a life annuity from an insurance company. In exchange for a lump-sum payment, you’ll receive monthly income for as long as you and your spouse live—no matter what financial markets do. You should opt for inflation protection. Shop around as terms can differ significantly from one insurance company to the next particularly when interest rates are rising quickly. Higher interest rates make annuities more lucrative for retirees.

With your income needs covered, you can do what you want with the remainder of your portfolio: spend it, bequeath it, or donate it to charity.

This is an edited version of an article that was originally published for subscribers in the October 14, 2022 issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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