Chapter 14

Progress Report

Nick and Susan have come a long way since they started on the path to a better decumulation strategy. The “before” picture, as given in Chapter 9, was dismal. Under a worst-case investment scenario, Nick and Susan were shocked to discover just how easy it was to burn through $600,000 of RRIF assets. The money was totally gone by the time Nick was 81 and Susan was 78. They were left with only the income they get from CPP and OAS, which puts them about $30,000 a year short of their income target for the rest of their lives.

It would be easy to conclude that the Thompsons didn’t retire with enough money or that they spent it too quickly or invested too recklessly. None of these assertions prove to be true. As the foregoing chapters showed, all they needed was to adopt a better decumulation strategy (and avoid a black swan).

With Enhancement 1 (lower fees), Nick and Susan gave less money to investment managers and kept more of it for themselves. Enhancement 2 transferred much of the investment and longevity risk back to the government by deferring the start of their CPP pensions until age 70. Enhancement 3 involved the purchase of an annuity with 20 percent of their RRIF balance. This effectively transferred more investment and longevity risks, this time to an insurance company. The result of adopting all three enhancements is shown in Figure 14.1.

Figure 14.1. How the enhancements increase total income

A bar graph showing the Thompsons’ income from all sources between Nick's ages of 65 and 90 and captures the impact of each of the 3 enhancements.. In the first year of retirement, the Thompsons have about $60,000 in without any enhancements. Prior to turning 81, the income from all sources are the same before and after enhancements, matching the target income line, which starts at $62,500 and gradually increases overtime. Starting at 81, there’s a gap between Nick’s actual income and the income target, with a nearly $30,000 gap by age 82 without enhancements. Enhancement 1 closes this gap at ages 81 to 83. Enhancement 2 closes the gap at ages 84 and 85 and narrows the gap considerably at later ages. The remaining gap - at ages 86 and up - is closed by Enhancement 3.

E1 to E3 are Enhancements 1 to 3. Chart assumes they are added sequentially. This assumes 5th-percentile investment returns. Income includes reserve fund.

It is hard to overstate the importance of these actions. From the time that Susan is 79 until her eventual death, which could be well into her 90s, the enhancements give her nearly $30,000 a year in additional income.

It is important to remember that this result is based on the worst-case investment scenario, meaning 5th-percentile investment returns each year. Enhancements 2 and 3 provided insurance against such poor returns and the Thompsons essentially cashed in on that insurance. Enhancement 1 is valuable regardless of the investment scenario.

The Enhancements with Median Returns

To anyone who is really concerned about the consequences of poor returns or simply living a very long time, the previous section should provide ample reason to adopt the enhancements. Nevertheless, it is natural to wonder what would have happened if investment returns had turned out better.

What if the Thompsons had achieved median investment returns instead? Would Enhancements 2 and 3 have hurt them or helped them? To answer this question, I assumed that the Thompsons had median returns and had adopted Enhancement 1 (reduced fees). This became the new base case. After all, reducing fees is a no-brainer. It is a very different type of enhancement compared to Enhancements 2 and 3, which are really a form of insurance.

I also assumed that the Thompsons are counting on median returns so, to be consistent, they may as well set their income target a little higher. Consequently, they start off drawing income of $70,000 from all sources instead of the $62,500 we used in the previous scenarios.

As a result, Nick and Susan reach their new, higher income target every year up until Nick turns 90 (and Susan is 87), and it is only in the following year that the RRIF runs out. This may seem impressive, but it is what you would expect with reduced fees and median returns. If they are still alive at that point, however, they will have an income shortfall of about $35,000 a year in their 90s.

Now let’s see what would happen if the Thompsons had adopted Enhancements 2 and 3 when they retired in addition to Enhancement 1. We still have them start out by drawing income at the $70,000 level, the same as the previous scenario. Now, though, there is no income gap until Nick is 95. Equally important, the income gap after age 90 shrinks to only a third of what it would be without Enhancements 2 and 3.

The above analysis should make you feel better about the value of the enhancements, even if you don’t think your investment returns will ever be as bad as the 5th-percentile returns we have been assuming.

Takeaways

  1. Enhancement 1 is a no-brainer.
  2. We already know that Enhancements 2 and 3 should help in a worst-case scenario because both are a form of insurance against poor returns and a long lifespan.
  3. What is a bonus is finding that Enhancements 2 and 3 add value even if one achieves median investment returns.