As we saw in the first article in this series, most pharmacists can expect to receive retirement income from several sources. The most common sources are the Canadian Pension Plan (CPP) and Old Age Security (OAS), employer pension plans and personal saving accounts. In this article you will learn that not all retirement income sources are created equal. All income sources have their strengths and weaknesses, so the key is to find a combination of sources that works best for your personal situation and risk level.
To recap the first article, retirement income planning has two basic parts (the rest of this article will focus on Step 2):
1. Determining where your income will come from: This step looks at all the income sources available to you during retirement, like government benefits, pensions, personal savings etc.
2. Examining the pros and cons of your different income sources: This step looks at the sustainability of each income source.
So, in addition to figuring out where your income will come from , a good retirement plan will also look at the advantages and disadvantages of each source. For example, some income sources are guaranteed to last you a lifetime, while others are designed to keep up with inflation. To figure out the differences between each income source, we need to look at the different challenges you’ll face during retirement.
Generally speaking, the challenges pharmacists face in retirement can be grouped into two categories: external risks and internal preferences. External risks to your retirement income are events that are mostly out of your control, like inflation, stock market returns and (to some extent) your life expectancy.
Internal preferences for your retirement income are factors that are influenced by your needs and tendencies, like the amount of money you need in “liquid” investments, your reactions to the ups and downs of the market, and any estate goals you may have.
External risks to your retirement income
Let’s begin with external risks to your retirement income. There are three major risks in this category: inflation risk, sequence of returns risk and longevity risk.
1. Inflation Risk:
Inflation is a serious risk in retirement because over the long term, money tends to loose its purchasing power. For example, between 1992 and 2004, the Consumer Price Index (CPI) rose 26.1 percent for Canadians 65 years of age and over (Source: Statistics Canada, Survey of Household Spending, May 2005).
The erosion of purchasing power makes it dangerous to hold cash, GICs and bonds over the long haul. Sure, your principle is mostly guaranteed, but the low rate of interest that is paid has historically not kept up with rising consumer prices.
Fortunately, there are a number of assets that have held up well against inflation, like real estate, stocks and some precious metals. Also, certain income sources are designed to keep pace with inflation, like the CPP, OAS, and some defined benefit (DB) pension plans.
2. Sequence of Returns Risk:
Many pharmacists have personal savings accounts like RRSPs that they plan to use during retirement. These savings accounts are a great way to plan for retirement, but they also create another type of risk known as “sequence of return” risk. Basically, this risk is the connection between the your withdraw rate and the return your remaining money earns during the first few years of retirement.
For example, a market downturn in the early years of retirement can have a dramatic effect on your portfolio’s ability to last. That’s because your portfolio has to work extra hard to recover those early losses. Stock market losses in the first few years of retirement can increase the risk of your savings running out early.
There are ways to defend against sequence of returns risk, like building up three to five years worth of cash before you plan to withdraw your money. Drawing from a separate cash reserve gives your investment portfolio time to recover if you run into early market losses.
Some investment products are also designed to protect against sequence of returns risk. Guaranteed Minimum Withdrawal Benefit (GMWB) plans are hybrid investments that provide some protection against sequence risk.
3. Longevity Risk:
Longevity risk, or the danger of outliving your savings, is another significant risk facing retirees. Canadians are living longer than ever before. According to the Office of the Chief Actuary, five out of ten Canadians who are 20 years old are expected to reach age 90. One out of ten is expected to reach 100 years of age. That means some pharmacists will have to fund a retirement of 25 years or more.
Annuities have always been a good hedge against longevity risk. Annuities are contracts with life insurance companies that provide guaranteed income for life in exchange for a lump sum. To illustrate, a 65 year old male could pay $100,000 in exchange for guaranteed payments of $550 per month for life. The major downside to annuities is you forfeit the your principle, and the contract is non-reversible. Most annuities are also exposed to inflation risk.
Internal preferences for your retirement income
Let’s move on to preferences for your retirement income. No two pharmacists are exactly alike, so in addition to the external retirement risks, there are also Retirement Preferences that need to be considered. For example, one pharmacist may want to leave a large estate to their heirs, while another may want open access to all their retirement funds.
Your retirement income preferences will influence the types of retirement products you will choose, which adds another layer of pros and cons. In general, there are three major retirement preferences: liquidity needs, behavioural effects and estate needs.
1. Liquidity Needs:
In its simplest terms, liquidity is your ability to immediately access an asset and convert it to cash. Some pharmacists may want all their retirement assets to be highly liquid, maybe to cover any emergency health expenses that may arise. Others may forgo some liquidity in exchange for guaranteed income.
Some retirement income products score high when it comes to liquidity, while others score low. For example, annuities are non-reversible so they have very low liquidity, while a portfolio of stocks and bonds can be converted to cash fairly easily so it has high liquidity.
2. Behavioural Effects:
Human beings are hard wired to always do what feels good, but when it comes to investing, what feels good is not always the right thing to do. For example, many investors during the dot-com boom bought shares in technology companies because “everyone else was doing it.” It felt good to invest like everyone else at the time, but the technology crash and losses that followed was disastrous for many.
Some pharmacists know their limitations, so a retirement plan that eliminates any behaviour or emotional meddling may be appropriate for them. Income sources like annuities and pension plans completely remove the retiree from the investing process, so its protection against behavioural effects is high.
Other pharmacists are highly capable and confident with managing their own investments, so a hands-on retirement plan may be appropriate for them. A self-directed portfolio of stocks and bonds is highly flexible, but of course vulnerable to behavioural effects and emotional risks.
3. Estate Needs:
An estate is the money you leave behind after you pass. Some pharmacists have specific estate plans, like leaving their children an inheritance, or donating a lump sum to a charity. It’s important to note that some retirement vehicles have a residual value after you pass away, while other retirement products do not.
For example, defined benefit pensions plans are excellent sources of income for pensioners and their spouses, but these plans typically leave nothing to the pensioner’s children or estate. By contrast, any assets that are left over in personal savings accounts when a retiree passes away can form part of an estate plan.
Putting it all together. The key is to match income sources to your unique situation.
Again, all retirement income sources have their strengths and weaknesses, so the key is to find a combination of sources that works best for your personal situation and risk level. Some income sources compliment each other, so there are some benefits to diversification.
The following is a useful tool developed by the QWeMA Group to help summarize the pros and cons of various retirement income products. The low, medium and high score is a qualitative ranking of the ability of each category of investment or product to meet a specific need, compared to the other two categories.
For example, annuities score low when it comes to liquidity needs, but high when it comes to protecting against longevity. Withdrawal plans tied to RRSPs score high on estate needs, but low when it comes to protecting against human behavioural tendencies.
Source: QWeMA Group
So what do you think? Are there other retirement risks facing pharmacists today? Are there other retirement income sources that you can think of? Join in the conversation.
