Planning for retirement is hampered by not knowing how long to plan for. One approach is to assume you are going to live forever and restrict withdrawals from investments to living off the income and preserving the capital. Preserving the capital could mean preserving the nominal value (today’s dollars) or preserving the real value so the principal grows with inflation. In either case this is a very restrictive use of the retirement nest egg. Living off dividends is a variation of this theme, but the expected dividend yield for the Canadian stock market is 2.1% so $1 million of retirement funds would generate an annual income of only $21,000[1].
An alternative is a planned decumulation so that investments are exhausted on death. Since death is unpredictable this is a difficult trick to pull off and raises the risk of outliving your investments (shortfall risk).
A middle ground is provided by government benefits, annuities and a defined benefit pension plan. In all these examples payments are made as long as you live and may even incorporate increases linked to inflation. There are limitations: government benefits are insufficient for a comfortable retirement, annuities are unpopular for a variety of reasons including the irrevocable loss of capital and the fees, and open defined benefit pension plans are like unicorns outside the government sector.
Risk Pooling
All the options described above rely on risk pooling. While the life span of an individual is uncertain the distribution of mortalities becomes more certain as the number of participants increases. Consequently, it is less risky to predict future payments and the pool earns mortality credits (also known as survivorship credits). If a pool member dies their capital remains in the pool for future distribution to those alive. The consequence is a higher return for survivors, hence survivorship credits.
The modern tontine is a pooled fund that offers an investment return in addition to survivorship credits. Unlike an annuity, payments are not guaranteed by an insurance company but depend on market performance.
Case Study
In a recent research paper, we explored the potential of the modern tontine. A practitioner paper that expands on pension planning options and the concept of the modern tontine is available here.
The objective of the research was to determine the impact of a modern tontine in a realistic setting. The investment scenario was:
- A simple investment portfolio with two assets: a diversified stock index (the risky asset) and short-term bond index (the risk-free asset).
- A 65-year-old Canadian male who plans to have his $1 million portfolio last to age 95.
- We used an optimization strategy that adjusted the asset allocation during retirement to maximize the total retirement income while minimizing the risk of shortfall.
The model examined three scenarios:
- Our base case. An initial withdrawal of 4% of the capital ($40,000), with subsequent annual withdrawals indexed to inflation. The asset allocation was fixed, so there was no optimization. No tontine.
- Variable withdrawals between a minimum of $40,000 and a maximum of $80,000 and optimal asset allocation. No tontine.
- Variable withdrawals, optimal asset allocation with a tontine.
The measure of success was the average annual withdrawal during retirement and the measure of failure (risk) was the expected shortfall (ES)[2]. An expected shortfall of -$250,000 indicates that in the worst 5% of cases the portfolio needed on average an additional $250,000 to fully fund the withdrawals. A good outcome is for ES values closer or even positive or a higher average withdrawal for the same ES
More income, less risk
Our main observations were:
- An initial portfolio of $1 million does not guarantee that inflation-adjusted withdrawals can be sustained over a 30-year period. The ES is significantly negative. This contrasts with the popular notion that a 4% withdrawal is without shortfall risk.
- Allowing flexible withdrawals and an optimal adjustment of portfolio weights improves the average annual withdrawals but the ES is still significantly negative.
- Adding the tontine overlay shows strong improvement. Real annual withdrawal rates close to 7% (or 9% including 2% for inflation) with a positive ES. The combination of flexible portfolio weights and withdrawals with the tontine overlay provides effective insurance against shortfall ris.
How is it possible for the tontine overlay to offer a higher income at lower shortfall risk? The additional income comes from the survivorship credits from the pool of participants. This is the benefit of risk pooling; those that need extra income (because they are still alive) benefit from those who do not need income (because they are dead). This is not the whole story. While dynamic asset allocation is most effective in the early stages of retirement when it has a long enough investment horizon to make an impact, the tontine overlay is most effective in the later stages when survivorship credits are greatest. Dynamic asset allocation and the tontine overlay have a complementary impact on reducing the risk of shortfall.
The tontine overlay does not preclude passing wealth to future generations. That can be done through gifting while still alive if the benefits from survivorship credits are not required for retirement expenses, or planned for separately by distinguishing assets as an estate asset and investing them appropriately. This is surely preferable to the fatalism of letting the market decide.