More days, fewer dollars

Her 99-year-old client had had an investment portfolio that was sufficient to support an active lifestyle but, rather than deplete his assets, he chose to live with his son, continue to grow his money and bequeath the portfolio to his son.

The other elderly client had sold his house and invested the money, but the income generated wasn’t enough to meet his needs and he had depended on his two sons for support.

Harnum’s client roster still includes one person who is well over 90 and another who is 89.

“More and more clients are living to an older age,” says Harnum. “The issues that I’m dealing with as some of my clients move into their 90s are just a glimpse of what’s to come in the financial planning industry. Retirement is becoming a longer time period, and the amount of money that must be saved during the income-earning years is increasing. Freedom 55 is becoming less and less attainable.”

Baby boomers have already started to retire, and this trend will accelerate as 2011 approaches and the oldest boomers hit the official retirement age of 65. Pressure on governments will increase as demand soars for medical benefits and old-age supplements, and it’s probable that those who want anything more than a basic level of health care will have to pay for it out of their own pockets.

In addition, life expectancy is increasing. According to Toronto-based Manulife Financial Corp.‘s mortality tables, a 65-year-old male has a 56% chance of living until age 85 and a 22% chance of living until 95. A 65-year-old female has a 69% chance of living until 85 and a 32% chance of living until 95. For a couple aged 65 today, the chances of at least one spouse living to 90 are almost 50%.

While living longer is one of the benefits of modern medicine and a healthy lifestyle, having the money to finance an ever-lengthening lifespan is one of your clients’ greatest challenges. Living to 95 means a retirement of at least 30 years, and for those retiring earlier than 65 or living to 100, retirement could be as long as 40 years. For many people, their retirement years may last longer than the time they spent in the workforce. As baby boomers make the conversion from putting away money for retirement to living on their accumulated savings, advisors will need to alter drastically their approach.

“There is a pile of risks when the client moves to the income-disbursement side, and the only formula is that there is no formula,” says Daryl Diamond, president of Winnipeg-based Diamond Retirement Planning Ltd. “Nobody wants to outlive their capital, and there is not a lot of room for error. Unlike the accumulation phase, which is where most advisors have focused their attention, after retirement most clients don’t have the flexibility to work a couple more years or save a little more to reach their goals.”

A long life is just one of the dangers seniors face. They can also fall into what Moshe Milevsky, associate professor of finance at York University in Toronto, calls “retirement ruin” through a variety of other means. Inflation, lower than expected investment returns, death of a spouse, unexpected health-care expenses or an overly generous withdrawal rate can also wreak financial damage on a retirement portfolio.

“People plan for the first day of retirement, but not for the last day of retirement,” says Marcia Mantell, retirement specialist for Fidelity Investments Canada Ltd. “We are on the cusp of enormous change as the aging baby boomers change the complexion of Canadian society. Over the next 10 years, this will become very visible, with a lot of old faces walking the street. There are a lot of wild cards that many people don’t want to think about, including the length of their life and the possible need for extended medical care — something that will be required by one in two people.”

@page_break@Clients May Live To 100

If your clients have assembled sizable investment portfolios during their working years, the first step when they cross the threshold to retirement will be rearranging their portfolios to deliver paycheques for the rest of their lives. Advisors need to have frank discussions with their clients about the state of their health, their spouse’s health and the family’s history of longevity. If there are no reasons to assume an early demise, it’s best to assume a long life, and many advisors are now basing their calculations on their clients living until 100. That’s a much safer route than estimating a life to 95 and being off-target by five years. If the client dies younger, nobody will be angry with you if they have too much money left over.

Also assume that your clients will be living a full life through much of their early retirement. After 80 years of age or so, they may slow down, but health-care costs could increase. If they find themselves in a long-term care facility, it may cost $4,000 or $5,000 a month for quality care, or they may want to spend an equal amount on private care in their own homes.

Canadians typically live the last 10 years of their lives with disabilities, with 80% of those 65 and over having a chronic health condition, according to the National Advisory Council on Aging. Common problems include arthritis, high blood pressure, heart conditions, back problems and diabetes. According to Fidelity’s research, almost half of retirees will be admitted to LTC facilities, with 25% staying one year or more, and one in 10 staying five years or more.

Beyond Fixed-Income

Most people can’t afford to limit themselves to interest-paying investments such as term deposits and bonds. In addition to capital preservation, retired investors need some protection from inflation. In about 24 years, an inflation rate of 3% a year can double the cost of living. While Canadian government bonds lie at the safe end of the risk spectrum, there’s an assortment of potentially richer income-producing alternatives for people who can handle more volatility in their portfolios. Alternatives include foreign, provincial and corporate bonds; preferred shares; dividend-paying common shares; and income trusts. An array of conservative mutual funds — investing in a mixed bag of income-producing securities — are designed to provide regular monthly income. Most people will also need to have an equity component in their portfolios, to provide the growth necessary to preserve their assets from the corrosive effects of inflation.

“It’s essential to take a balanced approach, but there is still a lot of old-school thinking on the part of advisors when it comes to asset mix,” says Dan Richards, president of Toronto-based consulting firm Strategic Imperatives Ltd. “The formula of 100 minus the client’s age for determining an equity component may have been fine in the past, when life expectancies were shorter. But in today’s environment, in which both lifespans and lifestyles are expanding for retirees, a higher component of growth may be necessary.”

Harnum says no matter how risk-averse her clients are, she recommends they have at least 30% in equities. She then “layers” their portfolios, so they have at least two years’ worth of living expenses in short-term funds, and two years’ worth in a balanced, conservative portfolio. As her clients make their way through retirement, she cashes out enough investments each year to add another year’s worth of spending money to the cash account. The two-year “safe money” cushion and layering strategy provides the flexibility to hold off taking money out of the equity account if markets are down. She also recommends that her clients focus on the bottom-line performance of their overall portfolio, and not the volatility of the individual components.

“My philosophy is to direct attention to the things we can control, including portfolio allocation and tax reduction,” says Harnum. “Then you have to let the markets ride and do what they do. You won’t win consistently, but the client’s fear of taking money out of something that’s going down is mitigated by always having two years’ worth of cash on hand.”

Principal Guarantees

For retirees with a low tolerance for risk, a variety of products provide exposure to equity markets but with some kind of principal guarantee. These include segregated funds, equity-linked guaranteed investment certificates and principal-protected notes with returns tied to a variety of underlying investments, including stock market indices, customized stock or income trust portfolios, gold or managed futures. Most of these products charge additional fees that limit the potential upside. But, for many clients, a reduced return is worth the peace of mind that comes with the guarantee that they will not lose money if they hold the investment until its maturity date.

Any advisor using segregated funds for clients, however, should keep in mind that any withdrawals from the segregated funds can reduce the death and maturity guarantees on the product by the amount withdrawn, so seg funds may be best used for the portion of a retirement portfolio that is left alone to grow.

Some investment fund companies have also issued “life cycle” funds that shift the asset allocations in balanced portfolios toward secure fixed-income over a 10-year or 20-year time frame that can be chosen to match retirement schedules.

Timing of Withdrawals

Two clients with the same asset allocation may end up with entirely different results over the same number of years if they retire on a different date. A client who suffers losses in an investment portfolio in the early years can be irreparably damaged, while one who enjoys gains can achieve an extra cushion of security. There is no way to predict what kind of market conditions will be at play during any particular time period.

To drive this point home at a recent conference on retirement income planning sponsored by Morningstar Canada, Paul Kaplan, vice president of quantitative research for Chicago-based parent Morningstar Inc., advised running through several simulations of hypothetical asset allocations and investment return scenarios to show clients various outcomes over time, depending on whether the first year or two of retirement see a gain, loss or neutral scenario. These “Monte Carlo” simulations are best done when clients are still in a position to delay withdrawals or to contribute a little more before retiring.

“Real returns are not constant every year, and most models are based on an average annual withdrawal rate,” says Kaplan. “If you lose money early in retirement, it has a profound effect on long-term compounding, and there may not be time to recover.”

Withdrawal Rate

Traditional models assume a balanced portfolio can generate an average annual return over time of 7%-8%. That may be a safe assumption during the accumulation years, but many experts are advising withdrawing retirees to be more conservative to avoid outliving their money. The withdrawal rate can significantly affect the length of time that assets will last. Clients must also decide if they want to dip into their principal or leave it intact to pass on as a legacy to heirs or charity.

Fidelity’s research cites the example of an imaginary 65-year-old couple that retired in 1972 with a $500,000 portfolio, divided into 50% stocks, 35% bonds and 15% cash. If they withdrew 6%, or $30,000, in the first year and then adjusted upward annually for the actual inflation rate, their portfolio would have been depleted by 1990, based on the historical performance of market indices. Statistics show there was an 83% probability that one of them would have been alive at 83 years of age at the end of that 18-year period. Alternatively, at a 4% annual withdrawal rate, Fidelity estimates the portfolio should last for 52 years under average conditions for markets and inflation.

Cutting back on expenses or taking on part-time work are ways that clients can cut back on withdrawals, particularly in the early years of retirement, leaving more money to grow and compound over time.

Taxes

When calculating an annual withdrawal rate, it’s important to remind clients that they will be paying taxes on withdrawals to some extent. Taxes can vary, depending upon whether funds are withdrawn from a registered account such as a RRIF, in which case they are fully taxable, or whether they are in non-registered funds that can benefit from the favourable tax treatment accorded to dividends and capital gains.

Various strategies can be applied to reduce taxes, including spousal RRSPs, income-splitting with spouses and controlling income so that old-age security clawbacks are avoided. IE