Retirement Income for Life (Third Edition)

Actuary Frederick Vettese has a third edition of his excellent book, Retirement Income for Life: Getting More Without Saving More.  He explains methods of making your retirement savings produce more income over your entire retirement.  These methods include controlling investment fees, optimizing the timing of starting CPP and OAS pensions, annuities, Vettese’s free Personal Enhanced Retirement Calculator (PERC), and using reverse mortgages as a backstop if savings run out.

This third edition adds new material about how to deal with higher inflation, CPP expansion, new investment products as potential replacements for annuities, and improvements to Vettese’s retirement calculator PERC.  Rather than repeat material from my review of the second edition, I will focus on specific areas that drew my attention.

Inflation

“We can no longer take low inflation for granted.”  “An annuity does nothing to lessen inflation risk, which should be a greater worry than it was before the pandemic.”  “We could have practically ignored inflation risk before COVID hit but certainly not now.”

It’s true that inflation is a potential concern for the future, but it’s wrong to say that it was okay to ignore inflation in the past.  Not considering the possibility of inflation rising was a mistake many people made in the past.  We were lulled by many years of low inflation into being unprepared for its rise starting in 2021, just as many years of safety in bonds left us unprepared for the battering of long-term bonds when interest rates rose sharply.

Inflation risk is always present, and financial planners who have treated it as a fixed constant were making a mistake before inflation rose, just as they would be wrong to do so now.  This underappreciation of inflation risk is what causes people to say that standard long-term bonds (with no inflation protection) are safe to hold to maturity.  In fact, they are risky because of inflation uncertainty.

People’s future spending obligations are mostly linked to real prices that rise with inflation, not fixed nominal amounts.  The uncertainty in future inflation should be respected just as we respect uncertainty in stock market returns.

Maximizing retirement income

Vettese does a good job of explaining that things like CPP, OAS, and annuities provide more income now because they offer your estate little or nothing after you die.  To make full use of this book, you need to understand this fact, and “you have to commit to the idea that your main objectives are to maximize your retirement income and ensure it lasts a lifetime.”

Spending shocks

Retirees should “set aside somewhere between 3 percent and 5 percent of their spendable income each year, specifically to deal with spending shocks.”  “This reserve might not totally cover all the shocks that people … might encounter, but it will definitely soften their impact.”

It’s easy to plug a smooth future spending pattern into a spreadsheet, but real life is much messier than this.  I’ve seen cases of retirees choosing to spend some safe percentage from their savings while also expecting to be able to dip in anytime something big and unplanned for comes up.  This is a formula for running out of retirement savings early.

Retirement income targets

In this third edition, Vettese assumes that retiree spending will rise with inflation until age 70, then rise one percentage point below inflation during one’s 70s, two percentage points below inflation from age 80 to 84, then 1.8% below at 85, 1.6% below at 86, 1.4% below at 87, 1.2% below at 88, 1% below at 89, and rising with inflation again thereafter.

This plan is based on several academic studies of how retirees spend.  I don’t doubt the results from these studies, but I do have a problem with basing my plan exclusively on the average of what other people do.  The average Canadian smokes two cigarettes a day.  Does that mean I should too?

The academic studies mix together results from retirees who spent sensibly with those who overspent early and were forced to cut back.  I don’t want to base my retirement plan partially on the actions of retirees who made poor choices.  Similarly, I prefer to base my smoking behaviour on those Canadians who don’t smoke.

I suspect that Vettese has already tried to take this into account with his assumed retiree spending reductions, because some studies I’ve read show retiree spending declining earlier than Vettese’s plan.  It’s hard to know what would happen to study results if we excluded early overspenders, but I suspect that spending declines would tend to start later and be less severe than Vettese’s plan.

Part of the reason I believe this comes from the fact that societal spending actually rises faster than inflation; it tends to rise with wage inflation rather than regular (price) inflation.  Wage inflation has averaged about 0.75 percentage points more annually than price inflation.  So, even if your retirement plan assumes your spending will rise with price inflation, your spending will decline relative to your younger neighbours.

In fairness to Vettese, though, his free tool PERC embeds other assumptions that are conservative, so the fact that I find this assumption somewhat aggressive doesn’t diminish the usefulness of PERC.

Monte Carlo simulations

“Monte Carlo simulations might be good at modelling investment returns between the 5th percentile and the 95th percentile, but when you go deeper into the tails of the distribution, it is a different matter.”

This is a good point.  When a simulator says your retirement plan gives you a 97% chance that you won’t run out of money before you die, it sounds wonderfully scientific, but it’s just marketing.  Black swan events make it impossible to make such assessments accurately.  Models of investment returns are never completely accurate, and the further we go toward lower probability outcomes, the worse these models are.

CPP survivor pension

The rules for calculating a surviving spouse’s additional CPP payments after the other spouse dies are quite complex.  Vettese explains them well, except that I think one part is inaccurate, as I explained in detail in an earlier post.  

At one point, Vettese calculates a quantity C that is the difference between the deceased spouse’s basic retirement pension and the surviving spouse’s basic retirement pension.  Information I’ve seen elsewhere says that this should really be the difference between the maximum basic retirement pension and the surviving spouse’s basic retirement pension.

In an example for a couple Susan and Nick, after Nick’s death, “Susan’s CPP pension would be increased to the maximum CPP pension payable to any one individual.”  This is because CPP rules don’t permit Susan’s total CPP to exceed this CPP maximum.  However, my understanding is that this applies to the case where Susan’s CPP pension was started at age 65.  If Susan had started CPP at 70, her own pension would still be 42% higher, and when the survivor pension is added , her total CPP pension would exceed what we think of as the maximum CPP pension.  Similarly, if she had started her CPP at 60, her total pension would be less than what we think of as the maximum CPP pension.

OAS

If you’ve lived at least 40 years in Canada between the ages of 18 and 65, you’re entitled to a full OAS pension (that may be clawed back if your income is high).  However, if you haven’t been in Canada for that long as an adult (but for at least 10 years), your OAS pension “will be reduced in proportion to the number of years of residency … between ages 18 and 65.”

If you delay taking OAS until somewhere between age 65 and 70, the extra years can be used to either increase your years of residency closer to 40, “or to adjust [your] pension upward by 7.2 percent for each year beyond age 65,” but not both.

Deferring CPP

The best reasons for not deferring CPP to age 70 are that either you don’t have enough savings to bridge the retirement gap before age 70, or that your health is severely compromised making an early death certain.  Beyond that, Vettese explains why most other reasons people give are irrational or invalid.

“Deferring CPP pension to age 70 forces you to draw down your [assets] more quickly before age 70, but those same assets last longer because the CPP pension from age 70 and on is so much bigger.”

This is an important point that I find people have a hard time understanding.  They imagine having to spend down their assets, and then imagine a bleak future.  In reality, they will have higher guaranteed CPP income that will insulate them somewhat from stock market gyrations, and their assets will ultimately last longer.

Most of the book’s analyses are based on getting below median investment returns.  In one chapter where Vettese looks at what happens if investment returns are at the median, he concludes that deferring CPP to age 70 “makes eminent sense whether future returns are poor or middle-of-the-road.”

Reverse mortgages

“With a reverse mortgage, you do not have to make any payments while you or your spouse continue to live in the home.  And you cannot be forced to move out.  You do have to maintain the home, however, including paying property taxes and home insurance premiums on a regular basis.”

This is self-contradictory.  You can be forced to move out if you don’t maintain your home or fail to pay property taxes and insurance premiums.  We tend to think of home maintenance as an annoyance, but something we can handle.  However, I’ve known several old people who simply couldn’t maintain a home properly.  Many old people rely on neighbours and family for help with basic maintenance, and many others simply fail to maintain their homes properly.

We are still in the early stages of Canadians taking on reverse mortgages.  Financial institutions are unlikely to deliberately generate bad press while they are trying to make sales.  But in a decade or two, when they have many clients who owe as much as their homes are worth after the cost of selling, the mood will change.  Financial institutions will be incented to force old people out of their homes if the homes are run down.

PERC built-in assumptions

Vettese explains the assumptions built into his free PERC tool, including that “the primary spouse (the one entering the data) is assumed to die at 90 and the surviving spouse at 93.”  However, in an earlier example, “Graham dies at age 85, the default assumption that is built into PERC.”  I’m not sure if this is an error, or if these are somehow built-in assumptions for different types of cases.

For anyone who finds assuming death at 90 or early 90s not to be conservative enough, PERC also assumes that you want to be left with 10% of your assets remaining at this age, which is on the conservative side.  So, depending on what different assumptions the reader might make, these differences might balance out somewhat.

Another thing to keep in mind is that PERC displays income in pre-tax amounts.  I’ve always done my own planning with after-tax amounts, so it takes some work to compare my outputs with those of PERC.

Decumulation strategy

“Retirees are generally better off drawing down assets from multiple sources on an annual basis (in proportion to how much they have of each asset) rather than drawing down taxable assets first and trying to keep their tax-sheltered assets intact for as long as possible.”

This agrees with my own simulations.  However, I’ve found that it’s generally better to draw down taxable assets before drawing down a TFSA, particularly if the taxable assets don’t have large unrealized capital gains.  It’s RRSPs and RRIFs that are best drawn down gradually throughout retirement.

Financial advisors

Controlling investment costs, deferring CPP and OAS, buying annuities, and even planning to rely on a reverse mortgage all cut into financial advisor compensation.  “I know a growing number of financial planners out there who do accept the ideas in this book,” but Vettese also has stories of advisors whose recommendations help themselves rather than their clients.

Conclusion

This is an excellent book about the complex task of decumulating assets in retirement.  The tone of this review may seem negative, but this is because I included every case where I disagreed with the author.  I highly recommend this book to anyone who is either retired or close enough that they need to consider how to create an income from their savings.