Want More Retirement Income?

If you are reading this then we both know the answer to the question. The harder question is what options are available and what are the tradeoffs? If you are still working then you have the opportunity to save more or retire later, but if you are already retired then you can seek higher investment returns, change your assumptions about how long you will live, or change your spending pattern within retirement. We use a simple model to compare each option.

The most popular response to seeking more income is to chase higher returns, particularly from investments biased towards generating income. There is the notion that chasing yield (high yield bonds, preferred shares, dividend paying stocks) is low risk and something of a free lunch. The objection to this is twofold. Firstly, the pursuit of yield (i.e. interest payments and dividends) in preference to total returns (which includes capital gains) is driven by the mistaken belief that these sources of income can be isolated from the risk of the underlying investments. Secondly, a bias towards yield in preference to capital gains, leads to concentrated portfolios that are less diverse, and hence more risky, than the portfolio focused on total return.

Diamonds are forever, humans not so much.

There are two other ideas we think consider more attention based on the observations that we are not going to live forever and that the typical retiree spends less as they age.

The consequence of not living forever is that we can consider depleting our retirement assets, rather than living off only the investment return. This is, admittedly, a behavioural challenge because we spend our working life saving, with the focus on portfolio growth not portfolio depletion. The risk of depleting the portfolio prematurely is a serious concern but should be taken in context. The probability of living for ever is zero while the probability of living to age 100 is only 5%¹.

We consider the example of a 65 year old retiree. If we plan to deplete his portfolio over the next 35 years until he reaches age 100 instead of assuming he lives forever then how much more income can he spend? Let’s assume our 65 year old retiree is investing in a portfolio of 60% equities, 40% fixed income with an expected return of 5.15% and an initial value of $1 million. If we further assume that expected inflation is 2.00% then the portfolio can sustain a withdrawal of 3.09% or $30,900 indexed to inflation. This is the “live forever” income².

Based on annuity math which we have discussed here, we can calculate the income for 35 years, to age 100, from the same portfolio. The income is $48,100, adjusted for inflation, an increase of 56% over the “live forever” option. Put another way, would you give up 56% of your income to insure against living to over 100?

The expected longevity of a 65 year old is 18.82 years. In other words, 50% of 65 year olds die before reaching age 83.82. If we planned to deplete the portfolio at age 83.82 then the retiree could enjoy an inflation adjusted income of $72,300 an increase of 134% over the “live forever” option.

The other opportunity to shift spending towards the early years of retirement is to recognize that consumption typically declines with age as shown in the table below.

Age Range	Annual Consuption Decline
65-69	1.25%
70-79	1.75%
80+	2.75%

Source: The Essential Retirement Guide, Frederick Vettese, 2016

To keep things simple we will assume that, on average, consumption declines by 2% annually after age 65. Coincidentally, this is the same as our estimate for future inflation (although this might always be the case) so a decline in consumption of 2% annually is equivalent to keeping consumption at fixed in today’s dollars and allowing inflation to erode real purchasing power. When we repeat our calculations with these new assumptions, the annual income to age 100 increases to $62,200 and the annual income to expected mortality at age 83.82 increase to $84,200. If we allow real purchasing power to decline in the “live forever” scenario we can withdraw $51,500 each year, an increase of 67%.

Let’s compare these changes with taking more portfolio risk by increasing the equity allocation to 80% from 60%. The expected return increases from 5.15% to 6.10%, so the “live forever” annual income rises from $30,900 to $40,200, an increase of 30%. Unfortunately, these figures to not take account the impact of increased volatility in the portfolio that increase the chances of running out of money³.

Conclusion

We summarize our results for a 65 year old with $1 million invested in a 60% equity, 40% fixed income portfolio in the table below.

Scenario	Inflation Adjusted Income	Real Spending Declining at 2%
“Live forever”	$30,900	$51,500
Live to age 100	$48,100	$62,200
Live to expected longevity, 83.82 years	$72,300	$84,200

Thus, for example, we can see that if we are willing to let go of the idea of that our retirement nest egg should never fall in value, and planning to live “only” to age 100 with an income that declines in purchasing power by 2%, the sustainable income rises from $30,900 to $62,200, more than double!

To be clear, our point is to highlight the costs of self-insuring against longevity risk and maintaining a level, inflation adjusted, spending throughout retirement when the evidence suggest that is more than most Canadians actually spend. Retirees who are willing to make trade-offs to boost their income, especially in the early phase of retirement when they are most active, should pause to consider the best strategy for their circumstance before succumbing to a pressure to chase yield by increasing their exposure to risky investments. Our final point is that life is not an annuity: most investors shy away from buying lifetime annuities because they are irreversible. Effective retirement planning is an ongoing, dynamic process that continuously incorporates changing personal and market circumstances.

¹ For simplicity, we assume a single male in all the examples.
² We are ignoring the volatility of returns, fees and taxes in all the examples.
³ In simulations using Returns 2, from Dimensional Fund Advisors, the probability of running out of money before age 100 rose from 4% to 20% when the equity allocation was increased from 60% to 80%.