Why you should consider pensionizing your nest egg
“…the majority of working Canadians – about 68 percent of the workforce – are currently pensionless.” – Pensionize Your Nest Egg.
Regardless of what you think about any looming retirement crisis in Canada, the facts are, more and more Canadians are without a formal workplace pension plan. That doesn’t bode well for those individuals saving for retirement, and our broader taxpayer base.
Another fact is – over the last few decades, the proportion of companies offering defined benefit pension plans to new employees has steadily dropped. Even if you had or have a pension plan with your employer – there are no guarantees – hello Sears. (You might recall Sears is no more (bankrupt) and sadly, pensioners are now fighting for their pension lives. The Sears pension plan was severely unfunded for thousands of employees for years on end. With Sears no more, as a consequence, Sears pensioners are now stuck with a significant decrease in their monthly pension cheque.)
Will there be more Sears-like case studies in the future? Undoubtedly. That’s part of the reason why the authors of Pensionize Your Nest Egg want you to take matters into your own hands.
I’ve had a copy of Pensionize Your Nest Egg in my personal finance library for a few years now – and I’m finally getting around to posting a review of this book.
In the coming weeks, I hope to have one of the authors (Alexandra Macqueen) interviewed for my site to answer a bunch of questions about “pensionizing” your nest egg – answers about annuities and more you probably need to consider for your retirement plan at some point.
For now, here are some great takeaways Pensionize Your Nest Egg – How to use product allocation to create a guaranteed income for life.
Pension plans 101
Authors Moshe Milevsky and Alexandra Macqueen want to remind you there are stark differences, if you’re lucky to have any pension plan at work, between defined benefit (DB) and defined contribution (DC) pension plans. Here is a summary and my examples:
|Defined Benefit (DB)||Defined Contribution (DC)|
|Income is determined by a formula – a foundational amount of earnings history and years of service. (example: payout during retirement = 2% x 30 years of service x best, average 5 years of salary)||Income is determined by the amount the employee contributed, the amount the employer contributed, and performance of the investments over time. (example: payout during retirement = the employee contributes 5% of salary; with employer contributions of 7.5% of salary; performance of contributions over 30 years of service)|
|The employer guarantees a certain benefit amount at retirement (hence the name).||There is no guaranteed benefit amount at retirement.|
|The employer is responsible for the pension benefits.||The employer’s liability ends after their money is contributed.|
|The employer absorbs the risk.||The employee absorbs the risk.|
What should be noted here as well, DB pensions in the public sector are the only pensions that come with a government guarantee. Because not all workplace pension plans are created equal, there is a case to be made to “pensionize” your nest egg at some point.
What is meant by “pensionization” of your nest egg?
The premise that you can (and should consider at some point for many reasons beyond lack of a workplace pension plan), take a portion of your retirement savings/retirement nest egg and turn that into guaranteed income for life – via an annuity.
The authors cite three very important reasons:
- Longevity risk.
Do you think you know how long you might live in retirement? Nobody does. While information in Pensionize Your Nest Egg cites the average time some folks might live in their so-called retirement stage is 18 years, nobody can predict that. So, by taking at least some of your assets and converting them to a pension that pays a guaranteed income for the rest of your life – that income can protect you from any uncertainty about life expectancy in retirement and many other risks you probably don’t think about enough (such as inflation, sequence of returns, cognitive decline and general ability, and much more).
- Sequence of returns.
Can you predict the stock market or the performance of your portfolio? Same answer – nobody can. While many investors might consider the sound, time-testing balance of a balanced fund (with stocks and bonds) to be “good enough” to finance any retirement, the reality is, you have no idea how long your money might last. While some systematic withdrawal plans offer some downside protection (like this one I’m a fan of here: the Variable Percentage Withdrawal (VPW)), unless you have a very healthy nest egg value, it may be difficult to sustain constant withdrawals for necessary income if stock or bond markets don’t cooperate long-term. While the basic laws of arithmetic can easily tell us how long a nest egg will last with fixed withdrawals, we don’t live in a fixed world. This means your portfolio must be able to withstand various financial withdrawals, at various times, during various market cycles – up, down or flat – who knows. You are most vulnerable in retirement when you’re no longer working, you experience some significant, negative sequences of returns, with minimal (if any) capacity to recover your portfolio value from stock market downturns.
- Inflation – a portfolio wealth killer.
The same dollar you start with will buy much less over time. We all understand this I think. Milk, gas, utility bills and more, cost more, over time.
So what does this mean for retirees?
It means two big things as the authors suggest: retirees must think in real terms and they must invest in real products.
What they mean is, for real terms – when you estimate your retirement spending needs make sure you account for inflation. If you need to live on $5,000 per month after taxes, make sure you increase this amount by 2-4% next year, and the year after, and so on.
For real products, invest in things where possible that keep up with the cost of living. With some benefits as a Canadian, you’re already very lucky – CPP (Canada Pension Plan) and OAS (Old Age Security) are indexed government benefits.
In other cases, not so much. Stocks for example, are weakly-linked to inflation since while you expect price increases in stocks (i.e., growth over many years of investing), stock market growth is never guaranteed in the short-term.
So what about annuities and why use them to create your own pension/to “pensionize”?
An annuity is actually an ancient Roman product – I didn’t know that! Life annuities were paid to Roman soldiers in exchange for their military services; wealthy Romans could bequeath an income for life to their heirs.
Today, we have translated those ancient times into giving an insurance company a lump sum of money in exchange for monthly income for life. Annuities can be bought with registered funds from individual RRSPs, locked-in RRSPs, defined contribution pension plans, and more. Annuities can also be purchased with “after-tax” (non-registered money).
In fact, you can see a case study here for an elderly parent where an annuity with some assets can work:
So can I purchase an annuity and change my mind?
No – an annuity purchase is a one-way contract. You get income in exchange for the lump sum insurance company payment. As per the authors: “With an annuity, there’s no cashing-out-possibility; there’s just income during your lifetime.”
Is an annuity just my money?
Yes and no. While annuities are contracts for life, the cash flow you’re entitled to is actually made up of other people’s money. The cash flow you’ll receive is the sum of your money, interest, and other people’s money in terms of their own mortality credits. Essentially when people die, and leave money on the table (so to speak), the remaining participants benefit.
Are there various types of annuities – such as joint-life?
You bet. Many people consider buying a joint-life annuity, which will pay out income as long as one of the two members of the couple are living – which also offer some guarantee periods. Both of these features reduce mortality credits though (i.e., income then) until advanced ages.
Should I consider “pensionizing” the entire nest egg?
The authors didn’t state that – in fact – the authors routinely suggested pensionizing some of your nest egg instead of all of it because if you have both pensionized assets AND a healthy investment portfolio, you can actually withdraw more from your portfolio in the early years of your retirement (all things being equal). Meaning, converting just some (say 25% or so) of your retirement nest egg into a stream of lifetime income by “pensionizing it” increases the chance you can spend your wealth at all ages.
How to pensionize – step-by-step?
Authors Moshe Milevsky and Alexandra Macqueen offer this step-by-step process in the book to guide your thinking:
- Identify your desired retirement income
- Calculate your existing retirement income
- Determine your pension income gap
- Calculate your retirement sustainability quotient – (basically the degree of success of earning the income you need for 1. The more secure, the more pensioned-like income you can spend, the better!)
- Assess your plan – is it sustainable?
- Calculate your financial legacy – if any
- Consider pensionizing your nest egg – as you need to.
Summary – should consider pensionizing your nest egg?
In my opinion, yes – since Pensionize Your Nest Egg was an eye-opener for me that presented some major retirement risks for many Canadians without a secure workplace pension plan. In reading this book however, it also enlightened me to to some other benefits of annuities that have nothing to do with a workplace pension, including your plans to leave a legacy; protecting yourself against cognitive decline in your super-senior years, and more.
I look forward to having co-author of Pensionize Your Nest Egg, Alexandra Macqueen on the site soon. Stay tuned!
Last but not least – win a copy of Pensionize Your Nest Egg! Enter the draw below and if you win, Alexandra will send you an autographed copy in the coming weeks. Good luck!
In the meantime, got questions for Alexandra for her upcoming interview with me?
Got questions for me? Always open to input and suggestions. Thanks for being a fan.