A New Tool in the Fight Against Longevity Risk
What is Longevity Risk?
“Nothing is more difficult than retirement income planning.” I have heard or read variations of that phrase multiple times in the last few years. Why is it so difficult? After all, people are retiring every day in Canada. Hasn’t this been figured out by now?
Saving for retirement is fairly straightforward. Live on less than you earn and invest the balance for the long term. At a certain point you will quit working and that is likely when you will quit investing new dollars into your retirement savings. There is a beginning and there is an end. It might not be easy to manage your income and expenses so that you can save that regular portion of your income but the strategy itself isn’t that difficult.
However, planning your spending in retirement is a different kind of challenge. Unless you have one of those rare inflation-adjusted defined benefit pensions, your guaranteed income is limited to government sources. These include the Canada (or Quebec) Pension Plan (CPP/QPP), Old Age Security (OAS), perhaps the Guaranteed Income Supplement (GIS), and potentially a provincial benefit, depending on the province in which you live.
Depending on your lifestyle before retirement, these government sources may not be enough. The CPP retirement pension was designed to replace about 25% of a person’s earnings from employment. The new CPP enhancement will eventually bring that replacement to one third of the average work earnings you receive after 2019. That means the balance of your income needs to come from the remaining government benefits (OAS, GIS), any workplace pension/savings programs, and your own private savings.
Even if inadequate in themselves, CPP, OAS and GIS are from the government and are unlikely to be eliminated. However, typical workplace savings like a defined contribution pension plan or a group registered retirement savings plan (RRSP) do not have guaranteed income streams associated with them, nor do our private savings in personal RRSPs or tax-free savings accounts (TFSAs).
Alas, also not guaranteed is the age at which we will die. Some childhood classmates of mine died the summer following our high school graduation. Others have died along the way from accidents or illnesses both physical and mental. On the other hand, an uncle of mine died recently at age 102.
This inability to know when we will die is known as longevity risk. Risk generally refers to the uncertainty of an outcome, but from the perspective of individuals, it refers to the risk that we will outlive our money. It’s all well and good to retire at age 65 and have sufficient assets to give you a high probability of funding your lifestyle to age 90. But what if you live to 100? How do you deal with that unknown?
Two Standard Approaches to Longevity Risk
Two approaches to dealing with longevity risk immediately come to mind. But each has its own drawbacks.
Save a Lot, But Spend Almost None of It
Retirement experts have observed that many retirees die with almost as much in assets as when they began their retirement journey. Two reasons are often cited. First, after spending a lifetime saving for retirement, it is not easy to suddenly turn around and begin spending that accumulated money. Habits established over 30 or 40 years are hard to change.
The second reason is uncertainty. Specifically, it is the uncertainty of one’s remaining lifespan. So, not knowing how long you have to live, it is easier to continue to restrict your spending than spend too much now and not have enough later on when you need it.
Buy an Annuity, But Lose Control of Part of Your Money
An annuity is an insurance product that is designed to address longevity risk. Insurance is all about paying an entity to take on a risk that you would rather not have to deal with on your own. That’s why annuities are products of insurance companies. With an annuity you purchase a contract that will pay you a guaranteed amount of money, typically on a monthly schedule, for the remainder of your life. Annuities have multiple options available but the simplest version is one in which you give the insurance company a lump sum, and in return you receive monthly payments for the remainder of your life.
The worst fear of such an arrangement: that you will leave the insurance agent’s office just after signing the paperwork and get hit by a bus, losing both your life and a good chunk of your life savings.
Enter the Longevity Pension Fund
At the beginning of June 2021, Purpose Investments launched the Longevity Pension Fund, a mutual fund with a lifetime income target of 6.15% per year. This is a much higher distribution than the amount you are likely to receive from rolling over a 5-year ladder of Guaranteed Investment Certificates (GICs). It also appears to be slightly better than you will get with a straight life annuity. However, guarantees are not available for the longevity fund. Nevertheless, it is an interesting product that has already generated a fair degree of commentary.
Here are some general points to highlight:
First, as its name indicates, this fund is intended for income generation in retirement. Do not invest in this fund if you are looking for capital gains that will be used to fund your estate after you are gone.
Second, the payment stream is tied to the life of the fund holder. If your health is such that longevity is not likely in your future, this fund is not for you.
Third, the income target is different depending on your age cohort. The following table shows the class D funds, those that are intended to be sold through a discount brokerage directly to clients, not through an investment advisor.
Let’s look at the bottom row first. The Accumulation class does not provide a payout. The intention is to build up a position over time so that you can receive income payments from the fund once you reach 65.
In the left column, you can see that there are four different Decumulation cohorts. You can expect that new cohorts will be added as time marches on and people turn 65.
Why are there age cohorts? “In order to appropriately pool the longevity risk, the Longevity Pension Fund groups investors into cohorts of people with three-year age brackets—for example, people born from 1954-1956.” In essence, the probability of you living to a certain age depends on your age today. The older you get, the greater the probability that there will be fewer of you around. More about risk-pooling later.
How does the Longevity Pension Fund generate its income?
Component 1: Investment Return
First there is the investment component. As the graphic below indicates, the investments put the fund into the global neutral balanced category. This is a relatively conservative category, with investments in equities making up between 40% and 60% of the overall portfolio. The management fee for the D-series, that is the series available to be bought directly through a discount brokerage, is 0.60%. The final management expense ratio (MER) will be somewhat higher, but regulations prohibit the statement of an MER for a new fund.
According to the prospectus, the fund will invest in “equities, fixed income, inflation sensitive securities and cash, with the goal of generating income in diverse environments while reducing portfolio volatility.” It may also use “derivative instruments” and other alternative investment strategies.
Component 2: Return of Capital
In addition to returns from the investments, the fund may also include “return of capital” in the cash distributions to those who hold the Decumulation class. To understand what this means, think of capital as the amount you have contributed to an investment. Return of Capital is not income to you, then. Instead, it is returning your own money back to you. You may have seen Box 42 on a T3 slip. That records Return of Capital. It is not something you need to report on that particular year’s tax return, but it has an impact on a capital gain or loss.
Imagine you invested $5,000 in an income fund. These funds often seek to maintain a particular distribution per unit. The bonds in the fund will pay out interest and the stocks will pay out dividends. If assets within the fund were sold there may also be some capital gains. If the fund is seeking to pay out more in distributions than the income from these various sources, it may return some of your invested capital to you. Since it is your own money, there is no tax on this because it is not income as such. However, the effect is to reduce your own contributed capital.
Over the years you received multiple T3s. Let’s assume that the accumulated value in Box 42 has added up to $1,000. You then sell the mutual fund for $5,000, the exact amount you paid for it. If you’ve been ignoring the meaning of Box 42, you may have thought, well, the sale will not cause a capital gain because I sold it for the same amount I paid for it. Not so. Those returns of capital have effectively reduced your purchase price, or more properly, your Adjusted Cost Base (ACB) to $4,000 ($5,000 invested capital – $1,000 return of capital = $4,000 net invested capital). You have a $1,000 capital gain you need to account for on your tax return.
Note that this is not necessarily a bad thing. There is an element of tax efficiency here because capital gains are taxed at 50% of the rate of interest income. If you are investing in a non-registered account you may appreciate that part of your distribution includes a return of capital.
Component 3: Other People’s Money
Pooling Longevity Risk
This phrase from the fund facts may pique your interest: “The Fund’s ability to meet its investment objectives is dependent, in part, on the mortality of unitholders within each class and the investment returns achieved.” When you read mortality think death.
Mortality credits are well-known to those in the insurance industry. These credits come about when people who are in a certain cohort die sooner than expected. In a straight life annuity, unless you have arranged for a guarantee, once you die the money you turned over to the insurance company in return for those steady monthly payments stays with the insurance company. This is a credit that goes into the pool of assets managed by the insurance company. That extra amount offsets the extra expense of continuing to pay those who live longer than the average in that particular age cohort.
The Longevity Pension Fund is not an annuity. It is not an insurance product. It is a mutual fund. Nevertheless, it uses the mortality tables developed by actuaries to estimate the amount of additional income beyond investment returns and returns of capital.
You may have noticed in the table above that the older cohorts (see Cohort 1) can anticipate a larger distribution than those who are younger (see Cohort 4). The reason is twofold. First, the older you are, the sooner you are likely to die, and the less likely it is that the fund will need to pay you for an extended period. The fund can therefore pay out more. Second, if you are within an older cohort and continue to survive, you are still receiving an income while those who have died are not. The money of the deceased is available to pay more to you and the remaining survivors who are still invested in the fund.
This raises the subject of redemptions, that is, selling the fund back to the fund company. Redemptions can occur voluntarily, that is, by your own decision, or they will occur at death. According to the fund company, “when an investor redeems, they will receive the lesser of their unpaid capital (initial investment less distributions to date), or current Net Asset Value (NAV).
An example of a voluntary redemption might be as follows. You invested $100,000 in the fund at age 65 and began to receive distributions that worked out to $6,150 annually. Exactly, three years later you redeem the fund. You have received $18,450 over those three years ($6,150 x 3). The NAV of your investment is $109,000. Your unpaid capital is $81,550 ($100,000 – $18,450). You get back the lesser amount, $81,550.
Let’s consider another example, the difference being that you stayed in the fund until your death at age 90, 25 years after you put down your $100,000. For the sake of this illustration, let’s assume that you continued to receive $6,150 per year. After 25 years, you will have received a total of $153,750 in income. No matter the NAV of the units of the fund, you have received in excess of the amount you invested so nothing will remain to go to your estate.
Finally, if you started investing in the Accumulation class of the fund at age 55, but changed your mind at age 60, then you would receive the NAV, just as though you were redeeming a regular mutual fund because you would not yet have received any distributions from the fund.
Is it a good deal?
This is a new mutual fund blazing new trails in terms of its intention to offer steady income for life through the use of mortality credits. The lack of a guarantee may turn off someone who might look at this fund as an alternative to an annuity, but if you have invested in any kind of securities before, you know that losses are a potentiality that all investors need to contend with.
Because of the nature of this fund, it is probably wise to think of this as a permanent investment. Yes, you can redeem your position but the clawback of your distributions after age 65 is going to make it hurt, especially if its NAV has gone up considerably. Still, the goal of this product is to provide greater assurance that your money will last as long as you do, so don’t think of it as having any other purpose than retirement income for your lifetime.
I’m not in the habit in my blog posts of reviewing a single product, but this really is something new in the mutual fund universe. Dan Hallett of HighView Financial Group, a frequent, and frequently critical, commentator on all things financial thinks that it seems well-designed. If the fund catches on, we may see other companies coming on board to issue their own longevity funds, giving validity to Purpose’s initiative. From my point of view, I’m inclined to take a wait-and-see approach for now, but as I become increasingly aware of the importance and difficulty of retirement income planning, I appreciate that businesses are thinking outside the box to come up with products that might address this need.
This is the 101st blog post for Russ Writes.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.