jeudi 25 octobre 2018

Retirement risk

There are two main ways to handle decumulation: annuities, self-managed(DIY) decumulation. The main advantage of annuities products is the guarantee by the sponsor. DIY decumulation have no guarantee and thus is more risky. On the up side, DIY are very flexible.

The Single life Annuity promise a stream of payment which stops at death. By design, it leave nothing to the heirs. Obviously, you could combine it with a life insurance, or guarantee in order to leave money to heirs, spouse or dependant.

By having tens of thousands of member, the sponsor will face on average the expected mortality. Member who dies later will be offset by the one who dies young. Sponsors are still at risk expected mortality to rise in the future. Future increase can be mitigated by having higher mortality based on the latest trend.

The DIY decumulation does not benefit of such risk reduction. The expected mortality is roughly age 85. However, the oldest man on earth is age 115. If you retire at age 55, that's a 20-60 years life spends. About 50% of the population will die however between -5/+5 years of the life expectancy. An 80 years old life expectancy is 86 for a Canadian female. If you survive up to 85, it grows to 89. We cannot be sure in advance if we will die early or not. In addition with you have a spouse, the chances that one of you goes on to live to 90 are great. To counter this, we need to protect for an extended life spends.

However, mortality is not the only risk. The biggest risk of DIY and annuity product is investment returns. Assuming constant rate of return is overly optimistic and naïve. The standard deviation over equity is about 18% and 7% for bonds. The classic strategy to deal with this risk is to have a conservative asset allocation with lots of bonds which have lower volatility. Going one step further, you can immunize against the bonds interest volatility using duration matching and cash flow matching. These options however, all suggest dropping the rate of return from what the equity offer to what short term bonds offers. This can means to reduce return by 2x and more over time.

Next, there is the sequence of return risk. This is the risk that a negative sequence of return prior to receiving a positive sequence of return. The annuity products are less affected by this risk as they have annuity starting each years. The law of average applies. Half will face negative sequence and half will face positive sequence. For DIY, the problem can be quite significant. The classic way to mitigate is to have a higher bonds allocation. That will reduce the volatility that you will face, but it will reduce your rate of return. Some have now recommended to have higher equity allocation after a few years though.

Finally there is the inflation risk. This is a lesser risk than the other. However, if inflation start to pick up, this may become a serious issue. Both DIY and annuity products face this risk. The solution in the annuity products is to get some bonds with inflation protection.

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