WHY RETIREMENT IS COSTING CANADIANS MORE THAN EVER
Life expectancy is increasing as pension coverage decreases, writes Jason Heath.
Retirement is getting more expensive for Canadians and it has been for quite a while. But despite soaring prices for some popular items at the grocery store, the broader cost of living is not the prime culprit.
Rather, retirement is costing more due to four primary factors, namely, longevity, pension trends, interest rates and investment fees. And it’s not just a Canadian issue, either. A recent study in the Journal of Financial Planning entitled Planning for a More Expensive Retirement found that for a 65-year-old U.S. retiree, the cost of funding a “real” dollar of income — that is, a dollar of future income in today’s dollars, adjusted for inflation — has doubled since 1980.
To say that it is a global epidemic would be fearmongering, but it is certainly a global concern. For Canadians preparing for retirement and the professionals advising them, it is important to consider the four key elements that are making retirement more expensive for retirees.
LONGEVITY
According to Statistics Canada, in 1992, Canadian life expectancy at age 65 was 18 years. Currently, a 65-year old can expect to live for about 21 years. By 2050, the Office of the Superintendent of Financial Institutions estimates 65-year old Canadians will have a life expectancy of 23 years.
In fairness, Canadians are retiring later. The average retirement age in 1992 according to Statistics Canada was 62 and after bottoming out at 61 in the mid-1990s has risen since to about 63 currently.
It is worth noting that on a percentage basis, an extra year of work may not adequately compensate for an extra year of life expectancy. Working until age 63 instead of 62 is only a 2.3 per cent increase in working years assuming one enters the workforce at age 18. An extra year of life expectancy over a 23-year retirement is a 4.3 per cent increase in retirement years — nearly double that of an extra year of work.
PENSION REDUCTIONS
Another contributor to the increased cost of retirement is the decline in guaranteed defined benefit (DB) pension income. It is a well-known fact that DB pension coverage has decreased for retirees over the years as fewer companies offer such plans. It is not a well-appreciated fact that DB pension income comes from forced savings — contributions from employees and employers — such that those without DB pensions must save proactively. Unfortunately, when tasked with saving independently, workers often forgo optional savings in favour of the urge to spend.
In 1977, 52 per cent of employed Canadian men were covered by registered pension plans (defined benefit and defined contribution plans), compared to 37 per cent in 2011. Over the same period, employed women’s coverage increased from 36 to 40 per cent. DB pension plans also declined over this time, both in terms of coverage and in income replacement for those covered, meaning an increase in optional retirement savings and the temptation of optional immediate gratification.
INTEREST RATES
We all know that interest rates have been on a long downtrend in Canada. Canada Savings Bonds peaked at 19.5 per cent in 1981. This compares to just 0.5 per cent currently.
But it is also worth considering the relative return that bonds offer compared to stocks. Over the 20-year period ending Dec. 31, 2016, Canadian 3-month treasury bills generated a risk-free return of 2.4 per cent. That was very respectable given a 1.8 per cent inflation rate over that period meant that even T-bills more than kept pace with inflation. Over the same period, the Toronto Stock Exchange returned 7.3 per cent including dividends.
Currently, 3-month T-bills are yielding 0.7 per cent and total CPI inflation is 1.3 per cent, meaning low-risk bonds are falling short of inflation. Estimated long-run stock returns are still in the 6 to 7 per cent range according to the Financial Planning Standards Council (FPSC), but today’s T-bills are paying less than one-third of the return they have earned for investors over the past 20 years.
Bonds no longer offer as competitive a return relative to either inflation or stocks. For a conservative investor, this means you need to have that much more saved to fund retirement. And as people age, it is not only frequently recommended that they increase their exposure to bonds, but research shows they prefer bonds.
A recent research paper by Michael Guillemette of Texas Tech University entitled Risks in Advanced Age found that older investors have “have a preference for certainty” and tend to “exhibit equity-varying risk aversion.” Furthermore, they “face declining cognitive abilities over time, which corresponds with a decrease in investment performance and financial literacy skills.” This means that the simple solution to ensuring retirees outlive their nest egg may not be more stocks — it may be a larger nest egg in the first place.
INVESTMENT FEES
Another real impediment to retirement funding that is making retirement more expensive for Canadians is investment fees. One of the first spotlights on sky-high Canadian mutual fund management expense ratios (MERs) was Khorana, Servaes and Tufano’s 2002 research paper entitled Mutual Fund Fees Around the World. The average Canadian fund fee at that time, 15 years ago, was 2.7 per cent.
Since then, Canadian mutual fund fees have declined about 0.5 per cent to 2.2 per cent, but given how much gross returns have been compressed due to falling interest rates, mutual funds are taking a larger proportion of an investor’s return. This is even more pronounced for retirees who are shown to have an increased exposure to lower yielding bonds as they age. These days, there is not much left over for a bond mutual fund investor after fund fees negate so much of your return.
So, what is the moral of the story?
Since retirement planning models and even rules of thumb are very sensitive to assumptions like projected returns and longevity, investors and advisers alike may need to reconsider their asset accumulation targets and decumulation plans if interest rates remain low and asset prices remain high. It’s also important to consider that a 65-year old husband and wife have a 25 per cent chance that one of the two spouses will live to 97 years of age.
The increased reliance on private savings makes also makes it incumbent on investors and advisers to focus on retirement planning much more than on product or security selection. Continued investment fee compression and investment options are also critical in a low-return environment as retired investors increase exposure to low-risk investment options that could further contribute to a more expensive retirement.