Protecting Retirees Against Longevity Risk
Retirement marks a momentous transition, a time to reap the rewards of years of hard work and dedication. However, with increased life expectancy, retirees are faced with the challenge of longevity risk – the risk of outliving their financial resources. In this blog post, I explore some of the nuances of longevity risk and suggest solutions to enable retirees to better manage this next phase of life.
Picture this: A retiree, finally bidding farewell to the 9-to-5 grind, filled with dreams of travel, relaxation, and quality time with loved ones. But beneath the surface lies an unspoken concern – insecurity about the adequacy of financial resources in the face of a potentially long life.
As we investigate the issue, the question arises: Why do many retirees find themselves unprepared for the challenges posed by longevity risk?
Factors Behind Inadequate Retirement Preparation
The challenges of preparing for retirement are complex, rooted in a variety of behavioural, societal, and psychological factors.
Behavioural Patterns: The Procrastination Conundrum
Behavioural economics (the study of how psychological factors and social influences affect individual economic decision-making) sheds light on the human tendency to avoid decisions involving complex scenarios, including retirement planning. This procrastination can be attributed to various biases:
- Present Bias: Individuals often prioritize immediate rewards over future benefits. Retirement, a distant event for many, may not attract the same attention as more immediate concerns, leading to delayed or neglected planning.
- Optimism Bias: Many people believe that they will be the exception to statistical norms. This bias can lead to an unwarranted sense of security, with individuals assuming they will not face financial challenges in retirement.
- Decision Paralysis: Sometimes referred to as “analysis paralysis,” the multitude of retirement options and financial products available can overwhelm individuals. Faced with numerous choices, some retirees may opt for inaction rather than get on with the task.
Societal Norms and Expectations
We like to think we are unique individuals, and indeed we are, but societal norms and expectations play a pivotal role in shaping our perception and behaviour concerning retirement. However, the traditional retirement scenario may not align with the evolving reality of longer lifespans and changing economic landscapes.
- Outdated Retirement Models: Traditional retirement models often emphasize a fixed retirement age, typically 65, maintaining the idea of a period of leisure following a lifetime of work. This model becomes challenging as life expectancy rises, requiring us all to anticipate an extended financial planning horizon.
- Stigma Around Financial Discussions: There is a reluctance in our society to openly discuss financial matters, including retirement planning. This stigma may discourage individuals from seeking guidance or discussing their financial concerns, leading to a lack of awareness and planning.
For many, retirement is distant and intangible. It therefore poses unique psychological challenges that further contribute to inadequate preparation for retirement.
- Temporal Discounting: The temporal aspect of retirement, often decades away, makes it difficult for us to feel an urgent need to make financial plans. This temporal discounting results in postponed actions and delayed decision-making.
- Overestimation of Resources: Some individuals may overestimate the resources they will have in retirement, assuming that their current savings and investments will be sufficient. This overestimation can lead to complacency and a failure to engage in proactive financial planning.
Understanding these factors helps paint a picture of why retirees may grapple with preparing adequately for the reality of increased life expectancy. Addressing these issues requires not only individual awareness but also shifts in the larger Canadian society, financial education, and support structures that will foster practical and informed retirement planning.
Embrace Delayed Gratification
In the realm of retirement planning, a crucial resolution to the challenges highlighted earlier involves embracing the concept of delayed gratification. Delayed gratification is more than a financial strategy; it is a shift in mindset that acknowledges the value of sacrificing immediate rewards for greater future benefits. This approach is a clue to resolving the challenges retirees face in adequately preparing for a retirement that is potentially more than three decades long.
Embracing Delayed Gratification: Delaying gratification involves making choices that may not yield immediate benefits but contribute significantly to long-term financial well-being. It counters the natural inclination towards present bias, where individuals prioritize short-term rewards over future security. By adopting this mindset, retirees can align their decisions with the realities of an extended retirement horizon.
Financial Disciplines and Delayed Gratification: Financial disciplines such as regular savings, prudent investment strategies, and conscious spending fall under the umbrella of delayed gratification. Instead of succumbing to impulsive financial choices, individuals can prioritize building a robust financial foundation that extends far into their retirement years.
Tailored Strategies for Longevity Risk
When delayed gratification is in place, we gain the financial room to address longevity risk. Here, I suggest actions that can be taken in response to the challenges outlined earlier. I hope that these strategies will offer retirees an approach to enhance their financial futures.
Before we proceed further, however, let me remind readers of the three “pillars” of retirement income in Canada.
- Pillar 1. Public Pensions. This includes the Canada (or Quebec) Pension Plan and Old Age Security. CPP/QPP is a contributory (contributions from both employees and employers), earnings-related social insurance program while OAS is a residency-based income supplement available to most Canadians aged 65 or older.
- Pillar 2. Employer Pensions and Savings Plans. This includes employer-sponsored registered pension plans (RPPs) and group RRSPs. Participation in the plan may be mandatory, and as a further incentive to participate, the employer may match employee contributions. Since the employee contributions are deducted before income tax is calculated, the tax deferral impact is immediate at every paycheque.
- Pillar 3. Personal Savings and Assets. The third pillar includes personal savings, investments, and assets accumulated during one’s working years. This may include personal and spousal RRSPs, TFSAs, non-registered accounts, real estate, and possibly other investments.
While CPP and OAS are essential for most Canadian retirees, they are seldom sufficient by themselves. There are also many jobs where employer pensions are not available. In that case, without the second pillar, it is up to the individual to “pick up the slack” by being more diligent in saving for their retirement on their own. In other words, the third pillar has to stand in for the second pillar as well.
Now that these pillars have been established, what can we do to adjust them to optimize protection against longevity risk?
Delay Canada Pension Plan (CPP) and Old Age Security (OAS)
CPP and OAS are fundamental components of Canadians’ retirement strategy. Delaying receipt of these income sources aligns with the concept of delaying gratification now for greater security later. CPP benefits increase by 0.7% for each month of delay after the age of 65, up to 42% by the age of 70. Similarly, OAS benefits can be deferred for up to five years after the age of 65, resulting in an increase of 0.6% for each month delayed, up to 36% by age 70. This move not only ensures a more substantial income stream but also acts as powerful protection against the challenges of inflation since these income sources are adjusted annually (CPP) or quarterly (OAS) to account for changes in the cost of living.
Balancing Guaranteed Income and Investments
Retirees can strike a reasonable balance between guaranteed income sources and a diversified investment portfolio. This approach mitigates the impact of market volatility while providing a steady income stream. We have already mentioned CPP and OAS. Annuities are another source of guaranteed income. Defined benefit pension plans are one form of annuity and the accumulated capital in defined contribution pension plans can also be used to buy an annuity, which is an income stream from an insurance company. Indeed, depending on your risk tolerance, you can also use assets in RRSPs, TFSAs, and non-registered accounts to buy additional annuities. Having said that, it is generally considered appropriate to limit annuity purchases to approximately one-third of your retirement savings, perhaps purchased in multiple “tranches.”
The rest of your retirement assets can be dedicated to carefully chosen, appropriately diversified, low-cost investments. This balance can allow retirees to create a financial foundation capable of withstanding the economic uncertainties of a lifespan with an unknown limit.
Long-Term Care Insurance (LTCI) and Emergency Fund
Acknowledging the potential need for long-term care insurance and establishing an emergency fund are integral components of preparing for potential longevity. Long-term care insurance acts as a protective shield, ensuring retirement savings remain intact in the face of unexpected healthcare costs. However, long-term care has proven to be a difficult product for insurance companies to offer. Premiums have increased because initial terms have been found uneconomical. Many insurance companies no longer offer it, or if they do, the terms may no longer be attractive for most people. While I certainly recommend investigating LTCI as an option, it may make more sense to fund this risk yourself. For example, if you have a home, it can be sold to help cover the cost.
An emergency fund is essential, in my view, regardless of age. It serves as a financial safety net, covering unforeseen expenses and reducing the need to withdraw more than intended from a tax-deferred account. For example, withdrawing more than originally intended from a Registered Retirement Income Fund (RRIF) will cause a bigger tax bill in the year of the emergency.
In taking these steps, retirees move from the status of passive recipients of financial information to become active participants in shaping their retirement story, adding stability and security to their retirement.
Turning to the Future
The question shifts from “What if?” to “What now?”
The consequences of taking these steps to address longevity risk are positive and empowering.
- New Possibilities: Retirees are no longer shackled by the fear of outliving their resources.
- Envisioning Financial Well-Being: The suggested solutions provide opportunities to create financial plans that will align with evolving circumstances.
- Actionable Steps: From delaying CPP and OAS to maintaining a balanced portfolio and establishing emergency funds, retirees can take concrete steps to secure their financial future.
Protecting Canadian retirees against longevity risk is not just a necessity; it’s an opportunity for a redefined retirement experience. Retirees can begin retirement knowing that they have addressed their financial concerns.
This is the 233rd blog post for Russ Writes, first published on 2024-01-29
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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.