Key risks to retirement income – Part 1

• Key risks to retirement income – Part 2

The debt crisis in Europe, slowing growth around the world, uncertainty surrounding the U.S. deficit – I think we can all agree that there are plenty of client questions out there to keep us busy. In all parts of life, there are things that we can control and there are things that we can not, and financial planning is no different. Showing your clients how to differentiate between the two helps move the conversation from questions to solutions.

This is part one of a two-part series on the key risks to retirement income that financial advisors should consider, according to Fidelity Investments Canada’s research, when they are helping their clients develop retirement income plans. Fidelity first published a paper on this topic, entitled Lifetime income planning, in 2005. Our research at that time illustrated that longevity, inflation, asset allocation, annual inflation-adjusted withdrawal rates and out-of-pocket health care costs were real risks for those drawing income from their investments. We believe that these five key risks require special attention when it comes to retirement planning. The original paper has remained very popular with advisors. I know this because we’ve fulfilled over 35,000 requests for it since it was first published!

In part one of this series, I will focus on the risks that are beyond the control of investors: longevity and inflation. The second part will look at the risks that are within the control of investors: asset allocation, withdrawal rate and out-of-pocket health care costs. While some of the risks might be not fully within our control, there are always actions we can take to ensure that our clients are not left unprepared.

A lot has happened since our retirement income paper was first published, not the least being the global financial crisis, the subsequent recession, the recovery (which at times seems wobbly at best) and the ongoing market volatility. We thought it was important to revisit the five key risks in light of what has happened in recent years, and to answer two questions about each risk. One, does it remain a “key” risk to retirement income? Two, if so, what did the events of recent years teach us about the risk? We published the answers to these questions in our updated report, After the global financial crisis – The five key risks to retirement income, which you can find on our website.

The results leveraged responses to our annual Fidelity Retirement Surveys. The survey has now been carried out for six years, by the well-respected firm The Strategic Counsel. One of the important features of our retirement survey is its consistency. We do occasionally discard questions that we think have become irrelevant, and we don’t hesitate to add questions to reflect changes to the economic, financial or market environment. However, by asking a set of core questions each year, we develop an historical data set and a deeper understanding of attitudes and concerns and how they are changing. So what does our “revisit” reveal?

Longevity

Not surprisingly, the global financial crisis didn’t affect longevity, in the sense that it didn’t have any effect on life expectancy – although some financial planners may believe the stress caused by the crisis had negative effects on their own life expectancy!

Statistics shows that there is a 50% chance that at least one member of a couple both 65 will live to age 90, and a one in four chance that at least one member will live to 94. As active, healthy lifestyles and medical advances continue to extend life expectancy, Canadians will have to consider how early they can afford to retire and plan for the real possibility that they’ll need 20 years or more of post-retirement income.

What did perhaps change, at least for those investors who ignored well-thought-out investment plans, could be substantial. Those investors moved their investments to cash or money market instruments at or near the bottom of the last market cycle, and either stayed out of the markets or invested much more conservatively through the correction. These investors now face their longer life expectancy and retirement with a diminished portfolio. This will require them to take corrective action. They must adjust something, either their retirement plans or how the portfolio is invested compared with their goals.

It is our conclusion that longevity risk remains a “key” risk; moreover, it is somewhat more elevated than before the crisis because of the portfolio behaviour many investors displayed. We cannot control how long we are going to live. What can be controlled is ensuring that portfolios reflect the percentages and are invested accordingly.

Inflation

During the global crisis, the subsequent recession and even some of the recovery, the risk of inflation appeared to be replaced by that of deflation. Since the word “deflation” has been so often misused, I will remind readers that deflation exists only when almost all consumer prices are falling constantly.

The threat was seen as sufficiently high that it engendered some highly stimulative monetary policies, such as the second round of quantitative easing by the U.S. Federal Reserve. But as the recovery established itself, the discussion shifted to the possibility, or in the opinion of some commentators, the probability, that the very stimulative monetary policies used to deal with the crisis – increased government spending, lower taxes in some cases, rock-bottom interest rates and strong doses of monetary stimulus such as the quantitative easing – would drive up post-crisis inflation rates dramatically. Interestingly, we do have several examples of much higher inflation in the world, but they are all in the developing world, which avoided most of the financial crisis.

Closer to home, there is still some concern that the U.S. may be susceptible to higher inflation down the road, though it is highly likely that deft policy-making by the Federal Reserve can avoid it. Even closer to home, the Bank of Canada remains committed to maintaining a domestic inflation rate of two per cent per year. The likelihood that the Bank will succeed means that future inflation may be no worse than that of the past 20 years.

Our conclusion is that internationally, the risk of inflation is more elevated than it was before the crisis. The best-case scenario is that Canada will experience inflation no worse in the future than it has for the past 20 years – an average of about two per cent per year. Since even that rate would wipe out approximately 40 per cent of an individual’s purchasing power over a 25-year retirement, the best that can be said is that inflation remains a “key” – and often underappreciated – risk for investors. Simply put, investors requiring growth must look to products that have the potential to outpace inflation.

As you have read, two of the five key risks identified in 2005 remain just as, if not more, relevant today as they were in 2005. It’s important to remind investors that just because certain elements are beyond their control, that does not mean that they can’t, and shouldn’t, be planned for. Next month, we’ll look at the remaining, controllable risks to retirement income: asset allocation, withdrawal rates and out-of-pocket health care costs

One final note. Most of us wear our seatbelts, just to be safe. This is the attitude required for investors when it comes to retirement income planning. There is no doubt the global financial crisis and the economic recession of 2008–2009 caused both financial and emotional distress for Canadian investors, and older Canadians in particular. But it hasn’t changed the risks to retirement income that all Canadians should consider. Rather, it has highlighted the need for greater individual risk assessment, as well as the need for a written retirement income plan that incorporates strategies to mitigate the key risks to retirement income.

Peter Drake is vice-president, retirement & economic research, for Fidelity Investments Canada. With over 35 years of experience as an economist, he leads Fidelity’s research efforts in examining retirement in Canada today.