How to avoid the fear of outliving your money

“Retirees don’t want to think about later life planning. It is daunting, confusing, complex, and expensive. LIFE would offer a simple, understandable, equitable solution. Administered as a national program, it would be widely accessible. It would give retirees freedom of choice, help overcome behavioural biases, and encourage proactive preparation for advanced age…”

Bonnie-Jeanne MacDonald, PhD, FSA

National Institute on Ageing, Ryerson University

The quote comes from a recent study titled “Headed for the Poorhouse: How to Ensure Seniors Don’t Run Out of Cash before They Run Out of Time” published by the C. D. Howe Institute. Author Bonnie-Jeanne MacDonald makes a strong case for a national LIFE solution (Living Income for the Elderly) to avert this problem. Why is an ‘income-for-life’ solution needed? Because with advancing old age, running out of money becomes the major preoccupation for many middle-income seniors not lucky enough to be members of a defined benefit (DB) workplace pension plan. Aside from the stress of worry, a common consequence is precautionary underspending by these seniors, even on the necessities of life.

Related: A RRIF or an annuity. How about both?

Once people reach their 80s, it is too late to acquire longevity insurance. MacDonald points to the burden this places on family members. And just as this ‘advanced aging’ burden is set to grow due to demographics (retirement now spans beyond age 85 for over half of retiring 65-year-olds), the ability of family to carry it is declining. Families are smaller, more mobile, and women (the historical care-providers) are more likely to be engaged in the formal workforce.

Yet, the steady transition towards various types of capital accumulation options for generating retirement income is leaving growing numbers of retirees with insufficient longevity insurance. While the national OAS/CPP/GIS pension programs cover much of this risk for low income workers, that is generally not the case for middle-income workers without DB plans. Yet, these middle-income workers are averse to buying longevity insurance through life annuities offered by the insurance industry. That seems a puzzle until you consider the following:

The packaging is confusing because it combines a longevity insurance product with an investment product. Yes, life annuities do eventually provide surviving purchasers with longevity insurance, but as an investment product it provides a highly uncertain investment return from day 1 (“what if I die tomorrow?”).
A second concern is losing control of one’s money. With a life annuity purchase, gone are options to leave a legacy, do a home renovation, or pay for unforeseen contingencies.
Then there is the pricing question. Not only are interest rates low by historical standards, but there are also the cost impacts of adverse selection, commission payments, and the insurer’s requirement to earn a return on its capital.
Finally, employers are hesitant to make life annuities the default option for DC plan retirees. While it may be the best option for their workers in theory, who knows whether that theory would stand up in a class action court case?

So maybe the lack of enthusiasm for life annuities is not such a puzzle after all. Maybe we have a design problem on our hands.

Solving the life annuity design problem

The design flaw in life annuities is that they try to deliver insurance and investment goals within the same instrument. It is far more effective to split a pension pot at, say, age 65, into separate insurance and investment components. For example, a 2015 U.S. study showed how to convert a $300K pension pot at age 65 into:

A longevity insurance contract which would pay $21K/yr. for life starting at age 86 for a current cost of $36K, and
An investment account of $264K, which the retiree continues to own.

Related: An Annuity that pays off —if you live long enough

If splitting pension pots into separate investment account and deferred annuity components is such a great idea, why is this not common practice? A simple lack of appreciation of the value of doing this seems to be one problem. For example, MacDonald reports that while quarterly sales of deferred annuities in the U.S. have been increasing, they still only represent a small fraction of the U.S. annuity market. Another problem is unfriendly legislation and regulation. For example, Canada’s Income Tax Act does not allow tax deferral in deferred annuities. So there is both missionary messaging and government lobbying to be done to increase the proper use of deferred annuities.

**The LIFE proposal**

All this gets us to MacDonald’s LIFE proposal. It envisions a national voluntary program through which Canadians could purchase longevity insurance through a deferred annuity at a specified age (e.g., 65), with the payout also starting at a specified age (e.g., 85). Under reasonable return and mortality assumptions at those ages, she estimates that a 65-year-old person today could purchase a 20-year deferred annuity at 1/10^th the cost of a life annuity starting today. So out of a $300K pension pot, it would leave $270K under the retiree’s control. Interestingly, this is very close to $264K estimate in the 2015 U.S. study.

Here are the key LIFE proposal features:

Widely advertised and easily accessible national program;
High trust level and credibility through government sponsorship as well as strong governance and management expertise;
Low expense levels through scale, not-for-profit model, reduced anti-selection bias, and no outside guarantors (including government);
Reasonable predictions of annuity amounts starting at age 85 for a LIFE purchase payment made at age 65;
Reduces retiree choice paralysis by having clearly set-out purchase age and payment start age (e.g., 65 and 85);
LIFE would accept any purchase amount between reasonable lower and upper limits;
No commuted value cash withdrawals options for LIFE purchases;
Two separate investment pools for 65-84 year-olds and 85+ year-olds, with Pool 1 having a return-seeking policy and Pool 2 a more conservative liability-matching policy; investment returns and mortality premiums (i.e., capital redistributions from deceased participants) distributed equitably within each of the two pools.

Surely the LIFE proposal deserves serious consideration by Canada’s federal and provincial governments if they acknowledge the importance of ensuring that aging seniors “don’t run out of cash before they run out of time” in an effective manner. Equally important, the implementation of the LIFE proposal would not require any material new expenditures or guarantees from the public purse. It is effectively a ‘free good’ providing material enhancements in lifetime income security for many Canadians. Carpe diem!

Keith Ambachtsheer is Director Emeritus of the International Centre for Pension Management, and a faculty member of the Rotman School of Management, University of Toronto.