How to make the right pension decision when longevity is so variable

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Q. I am presently 64 and will be 65 in July 2019. My wife is 63. We are both in good health as we approach pension years. We are mortgage free and have approximately $200,000 in RRSP’s to draw on.

I have a defined benefit pension due at 65 totalling about $4,000. I have option 1 of taking 100% of the pension amount starting in August 2019 and will receive that amount until I pass away. The pension then stops. Option 2 is to take 60% of the $4,000 pension, starting in August 2019, so around $2,400, until I pass away and then my spouse will receive the same 60% pension until she passes away.

Should I pass away first then Option 2 would make the most sense. If my wife passes away first then Option 1 would make the most sense. Should my wife only live a relatively short time after I pass away then Option 1 would be best. Should my wife live many years after I pass away then option 2 would be best.

How does one make an informed decision on financial affairs when life expectancy is so variable and unpredictable? Any information given in making a decision would be helpful.

—Thanks, Richard

A. Great question, Richard—and the way I see it, you have two ways to think about how to answer it: like a pension actuary, or like a financial planner.

It seems like you’re approaching the problem like a pension actuary, by starting to speculate about how long you and your spouse might live in retirement.

At the age of 65, Statistics Canada tells us that a male has, on average, 18.9 more years of life to go (to age 84), while a Canadian woman can expect 21.9 more years of life (to age 87). (Notice how both of these numbers are higher than life expectancy at birth, which is 79.5 years for men and 83.8 years for women. That’s because as people age, their life expectancy actually increases: each year you live means that you have survived all sorts of potential causes of death.)

But life expectancy is a statistical measure of the average time someone is expected to live—or the “50% probability”—based on the year they were born, their current age, and other demographic factors including their sex. Some people will die before those ages and some will live to be older.

In order to help reduce the risk associated with using average life expectancy in financial planning, the Financial Planning Standards Council (the standards-setting and certification body that awards the Certified Financial Planner designation) and the Institut québécois de planification financière (the not-for-profit organization that awards the Financial Planner diploma in Quebec) have prepared guidelines for financial planners to use.

These guidelines recommend that planners use the 25% probability of survival in estimating longevity, not the 50% probability provided by average life expectancy—as “forecasting a longer life expectancy offers protection from future improvements in mortality and accounts for the greatest financial risk to an individual: longevity risk.”

If we follow the Guidelines and adopt the 25% probability, Richard, we would project to your age 95 (or age 97, if we wanted to be more conservative and use the 10% probability), and, for your spouse, to her age 95 (or age 97 using the 10% probability).

There’s a problem with using this approach, however: although it gives us a sense of how long someone aged 65 might live in retirement (and note that it can be a very long time), your question is not really about understanding your respective potential lifespans, but about dealing with the uncertainty associated with your remaining lifespans. That is, you are not primarily concerned with assessing just how long you or your spouse might live, but with what we might call the “volatility of longevity.”

For example, what happens if you take Option 1—the “single life” pension option, paying 100% for as long as you are alive—but you only live a short time? Alternately, what if you take Option 2, which pays less, but you outlive your wife by many years? In both cases, the alternate choice would be “better”—but only if we define better as “maximizing the pension payout.”

This brings us to the second way to think about how to answer your question: like a financial planner. This approach shifts the focus from projections and probabilities to risks, dependencies, and contingencies.

From a financial planning perspective, your goal would not be to maximize the funds paid out of the pension but to reduce the risk on your household balance sheet. That is, the “best” option is not the one that may pay out the most, but the option that reduces the most risk. And in order to find this option, you first need to figure out where those risks lie.

This is the point at which a financial planner could model some scenarios and identify the planning strategies that might be available to you. For example: would the 60% survivor pension be required to meet your wife’s financial needs if you predecease her, or does she have sufficient additional income and assets for your household to “take the risk” of opting for the single-life pension? Think of budgeting, cash flows, and balance sheets as your starting point, that can then be matched with strategies, plans, and options.

You ask, “How does one make an informed decision on financial affairs when life expectancy is so variable and unpredictable?” For financial planners, this is the real value of financial planning: it helps reduce uncertainty—not by making highly exact predictions, but by identifying financial vulnerabilities and dependencies, and ways to effectively address them.

Richard, you are in the enviable position of having a defined benefit pension, which removes a lot of the financial risk retirees often experience. By taking the next step and developing a financial plan that is geared to your specific concerns and circumstances, you can put in place an even more secure future.

Alexandra Macqueen is a Certified Financial Planner and retirement expert providing advice through Pension Acuity Partners.