Understanding risk in 2 key retirement planning decisions
When it comes to investing, investors understand risk and return tend to be connected – the higher the risk, the higher the return, on average. Conversely, if you do not want any risk, you are essentially stuck accepting a risk-free rate of return, such as those offered by GICs.
Wouldn’t it be nice to get the return that goes along with risk, but while not taking the risk that is commensurate with that return? In fact, there are a few cases where that is possible. While risk is still being taken in order to generate returns above the risk-free rate, who is accepting that risk and who is getting that return is not always the same person, which can lead to opportunities for some.
Before I dive deeper into two such situations, let’s first define some of the key risk factors.
Understanding key risks for retirees
When facing key decisions, retirees should consider the risk trade-offs inherent in their various options. One key question that is often overlooked is who is accepting the risk in the first place.
While there are many sources of risk, retirees should be especially concerned about 3 key risk factors:
- Investment Risk (including Sequence Risk): This is the risk that average investment returns will be lower than expected, or that the sequence of those returns will not be favorable vis-à-vis the timing of your withdrawals.
- Inflation Risk: This is the risk that inflation will be higher than expected, thereby eroding your purchasing power.
- Longevity Risk: This is the risk of outliving your money due to a longer than expected life expectancy.
Below I have described two key retirement planning decisions where one should consider who is accepting the risk – the risk is present in either option, but who is accepting that risk is different.
Key decision #1: Deciding between the pension or commuted value on a defined benefit pension plan
Many people are faced with the decision of taking the commuted value on their defined benefit pension plan or just taking the annual pension instead. While looking at the potential return these two options can generate makes sense, one should also consider the risk trade-offs that occur in this decision.
Related article: Understanding your Defined Benefit Pension Options
While there are many risks, we will focus on 3: Investment (including Sequence), Inflation, and Longevity.
Who accepts these risks are summarized below:
|Risk||Deferred Pension||Commuted Value|
|Investment Risk (including Sequence Risk)||The pension plan accepts this risk||You accept this risk|
|Inflation Risk||The pension plan may accept some, all, or none of this risk||You accept this risk|
|Longevity Risk||The pension plan accepts this risk||You accept this risk|
Related article: Should you take the commuted value on your pension?
One benefit of having a defined benefit pension plan over a retirement or investment account is that with the defined benefit pension – the plan is accepting the investment risk. If returns are low, the plan sponsor generally has to top-up the plan. Once you take the commuted value, you have to make the investment decisions (or hire an advisor), and you also have to accept the investment risk yourself. If returns are low, there is no plan sponsor to come in and top you back up.
Defined benefit pension plans may or may not have inflation protection. Some plans have a tiered structure, where pension credits earned before a specific date are eligible for inflation protection and pension credits earned after that date are not eligible for inflation protection. This is because the trend is toward less generous defined benefit plans, and fewer plans overall as well. It really comes down to the specifics of each plan and each person’s credits to determine the level of inflation protection offered to them by their defined benefit plan.
However, determining the amount of inflation protection offered by the commuted value is simple as there is none – unless, of course, you put the entire balance in real return bonds or some other inflation-protected investment vehicle.
Another key benefit of defined benefit pension plans is that they pay benefits for life, no matter how long that life is. With the commuted value, you are taking all the longevity risk. You could potentially run out of money, especially if you live a longer than average life. Fear and anxiety as you draw down your investments and get close to your last dollars would be avoided with a guaranteed income.
The biggest risk of the deferred pension is that you do not live a long life, and end up receiving less money through the monthly cheques than you would have received through the commuted value. There is a break-even age at which these two options are equal, and that age is generally in your 80’s. So, if you live past this break-even age, the deferred pension would have been better, and if you do not survive to at least the break-even age, the commuted value would likely be best.
In other words, the commuted value manages the risk of dying young, while the deferred pension manages the risk of outliving your money.
While you should certainly consider which option would provide the most money (i.e. the best return), you should also consider which option has the lower risk for you – because who accepts the risk that generates your return is not always the same under both options. The deferred pension is usually a way of getting a return commensurate with risk-taking – but the plan is the one taking the risk and you are the one getting the return. Whereas, with the commuted value, you still get the return, but are now accepting the risk yourself.
Key decision #2: CPP/OAS and RRIF start dates
Deciding when to start your CPP and/or OAS is a top consideration for many people in or approaching retirement.
Related article: When is the best time to start CPP?
A related decision is often what to do with your RRSP/RRIF (or LIRA/LIF). For example, delaying your CPP/OAS may allow you to draw down from your RRSP at lower rates in your 60’s versus what you would pay after age 71 if you delayed the entire balance of your account until then.
While there are valid tax and other considerations to this decision, one should also consider the risk trade-offs that are inherent in this decision. Who accepts the risks are summarized below:
|Investment Risk (including Sequence Risk)||Government accepts this risk||You accept this risk|
|Inflation Risk||Government accepts this risk||You accept this risk|
|Longevity Risk||Government accepts this risk||You accept this risk|
In other words, the CPP/OAS represents government-guaranteed, inflation-protected income for life – no matter how long that life is. Investments inside an RRSP/RRIF or LIRA/LIF, on the other hand, are much riskier to the retiree by comparison.
With this risk perspective in mind, you might prefer to drawing down on your RRSP / RRIF first because it is much riskier and you should want to manage your risks, especially these key risks retirees face.
Related article: Developing RRSP withdrawal strategies
Also, it would give you an opportunity to defer the CPP/OAS. Deferring your CPP from age 65 to 70 would result in a 42% increase in benefits (which is 0.7% per month of deferral) and deferring your OAS from age 65 to 70 would result in an increase of 36% in your benefits (which is 0.6% per month of deferral). Those deferrals would essentially increase the size of your government-guaranteed, inflation-protected, longevity-risk-proof income.
Lastly, you would generally prefer to just get a monthly cheque at later stages in life than deal with managing your RRIF. So, using the RRSP/RRIF to fund the earlier stage of retirement while deferring and therefore increasing the size of your CPP and OAS for later stages of retirement is another trade-off to consider.
While I have provided only two examples of situations where you should consider risk trade-offs of 3 key risks, there are certainly many more situations where you should go through this process and many more risks that may need to be considered as well. Working with a qualified financial planner prior to making key retirement planning decisions is the only way to ensure your unique situation is fully considered. Making such decisions within the context of a comprehensive financial plan is strongly recommended.