How to avoid outliving your money

Buy annuities, employ a dynamic withdrawal strategy, and be tax-smart.

Paul Kaplan 27 January, 2016 | 6:00PM

Note: This article is part of Morningstar's January 2016 Five keys to retirement investing special report.

One reason why retirement planning is particularly challenging is because you don't know how much longer you are going to live. A retirement income plan that lasts until your life expectancy is inadequate because you might outlive it. These days, people in North America are living longer than they did in the past with a growing number of people making it past 100, as did my paternal grandmother, who lived to 106.

So when you are retired, you not only face market risk (the risk of your portfolio losing value due to falling security prices), but also longevity risk, which is the risk of outliving your money.

To measure longevity on average for Canadians, I obtained data on mortality rates published by Statistics Canada. The document is titled Life Tables, Canada, Provinces and Territories, 2009 to 2011, indicating the period of study as well as the fact that it contains data for each province and territory as well as Canada as a whole. As with most tables of mortality rates, there are separate tables for males and females, reflecting the fact that women generally live longer.

Based on Statistics Canada data, I calculated the longevity risk of 65-year old singles and couples:

Percentile Single
50th (median) 84 88 91 89 92
25th 90 93 95 94 97
10th 95 98 99 98 100
Source: Morningstar

The table shows that for a single 65-year old male, there is a 50% chance of living to at least 84, a 25% chance of living to at least 90, and a 10% chance of living to at least 95. For a single 65-year old female, the ages are three to four years older. While a 10% chance may seem small, it is certainly enough to be worth preparing for.

The last three columns in the table are for couples, both heterosexual and same-sex, as indicated by the column headings. For couples, the number indicated means that at least one member of the couple lives to that age. Therefore, a couple has greater longevity risk than either of its individual members because there's a greater likelihood that at least one of the two people will reach a certain age than any one person. As the chart shows, a couple consisting of two 65-year females needs to be prepared for the one in 10 chance that at least one of them will live to 100.

You can't eliminate longevity risk, but there are ways to mitigate it. Here's how:

Buy annuities to lock in income for life. A fixed-payout annuity provides a fixed amount of income for the rest of your life. If you are married, it can continue to provide income so long as at either you or your spouse is alive.

Employ a dynamic withdrawal strategy. First, calculate how much you need to cover necessities such as food and housing, beyond what you are getting in government benefits and annuity income. This is your non-discretionary withdrawal. Then prioritize what you would like to spend money on but can get by without. These are the discretionary items in a dynamic withdrawal strategy. You make these discretionary withdrawals when your portfolio has performed well. The better your portfolio is doing, the more discretionary spending you can make. Conversely, cut back on spending when returns are poor. By varying your spending according to market conditions, you will extend the life of your portfolio and reduce your longevity risk. This approach differs from a systematic withdrawal plan, in which you withdraw the same amount regardless of how your portfolio is performing. The problem with systematic withdrawals is that you could be taking money out when you most need to be invested.

Be a tax-efficient investor. You can make your portfolio last longer, thus mitigating longevity risk, by making tax-efficient decisions on where to hold assets. When saving for retirement, try as much as possible to keep the least tax-efficient investments, such as bonds and bond funds, in tax-deferred accounts such as RRSPs. Investments that are more tax-efficient, such as stocks and stock funds, are better held in non-registered accounts. Then during retirement, keep your tax-deferred holdings as long as possible by first making withdrawals from your taxable accounts. Withdrawals from registered accounts should be made only if you need the money, or if required by law as is the case with registered retirement income funds (RRIFs). Tax-efficient investing not only makes your savings last longer by reducing your tax burden, it also shifts your overall portfolio from stocks to bonds. This, in turn, lowers your investment risk as your risk capacity is shrinking.

About Author

Paul Kaplan

Paul Kaplan  Paul Kaplan is Director of Research for Morningstar Canada.