Monday, 15 December 2014

Liability-Driven Investing during Retirement for the Individual

Traditional investing strategy seeks to maximize returns considering the risk involved. Asset classes are selected and weighted according to how well they fit together, for the amount of diversification they provide along with their risk and return relative to the risk tolerance of the investor. The time horizon of expected withdrawals shapes the asset allocations but the overall goal of the portfolio is to provide an adequate total return. This investing approach in retirement leads to the determination of a safe withdrawal rate that protects the portfolio from depletion before death, epitomized by the standard 4% rule (see our original here and a recent update). A portfolio may not even change at all between the savings phase of life and retirement, as we discovered when we wrote about a feasible Lifelong Portfolio consisting of a 50-50% stock-bond mix.

Liability-driven investing (LDI) takes a completely opposite tack. The goal of the portfolio is to meet future cash spending. As we remarked last week, defined benefit pension plans like the Healthcare of Ontario Pension Plan (HOOPP) are prime exponents since their sole purpose is to provide pension income as promised. The idea of LDI is to match the portfolio cash flows to the required spending - the liabilities - in terms of dollar amounts, timing and risk. We work backwards from the spending to the portfolio.

In terms of retirement income planning, the 4% rule and LDI are the ends of a spectrum of possibilities, recently brilliantly described and impartially assessed by Wade Pfau and Jeremy Cooper in The Yin and Yang of Retirement Income Philosophies.  It is well worth reading for the non-technical discussion of the practical pros and cons of the gamut of income and investing strategies.

The best way to show the differences is with some examples.

Test Case
- 65 year old man or woman,
- starting retirement, no part-time job
- portfolio worth $1 million,
- eligible for full Canada Pension Plan ($12,450/yr) and Old Age Security ($6765/yr), a total of $19,215 per year
- portfolio in a RRSSP/RRIF or other registered account, so it is all income subject to taxation (thus the portfolio allocation between dividends or capital gains from stocks vs interest from bonds doesn't matter)
- basic needs require $50,000 annual income, i.e. $30,785 after CPP & OAS, plus
- wants or discretionary luxury spending

The 4% Rule
$1,000,000 x 0.04 = $40,000
... for any and all spending needs to be adjusted upwards each year for the previous year's inflation so that spending power aka standard of living is maintained, hopefully as long as required, but historically the portfolio always lasted at least 30 years. In most historical instances, the portfolio ended up with a substantial balance, many times higher than at start of the retirement period.
... total $59,215 including CPP & OAS, or
... $9,215 above the basic needs

The big disadvantage is that though it always worked out in the past, there is no guarantee. Since nowadays future returns don't look so rosy and since many countries haven't fared as well as the USA, on which the 4% rule was based, it might be more cautious to take out less, like only 3.5% per year:
$1,000,000 x 0.035 = $35,000
... total $54,215 or
... $4,215 above basic needs

LDI Strategy
To match spending with income, it is first necessary to distinguish really essential spending with discretionary luxury spending. An image from The Yin and Yang shows it thus:
(click image to enlarge)

The Age Pension layer is CPP and OAS. On top of that, to meet needs there must be regular, no-variation, inflation-adjusted, lifetime, no-default, no-reduction income. Above that, the luxury spending can depend on more volatile assets, in the probability-based blue zone.

As a result, the portfolio gets divided between the Liability-Matching Portfolio (LMP) to meet needs and the Return-seeking risky portfolio (RP) to meet luxuries.

Option 1 - Buy an annuity to implement the LMP
Using Cannex's proprietary (pay-only access) website, to which this blogger has been graciously granted temporary access, we have obtained current rates for lifetime annuities. Professional planners and/or insurance agents normally would provide real quotes to investors. It's not a DIY online purchase possibility.

The Annuity / LMP:
- Single-premium,
- No guaranteed period of payments if you die early, in order that the best value of lifetime income is gained through higher mortality credits aka the money of people who die earlier than you,
- Single life, (income is lower for a couple that chooses joint life, where some or all of the annuity continues after the first spouse dies)
- Lifetime so that there is no need or desire to guess how long you will live
- Providing $30,785 income for needs spending
- Rising 2% per year, the best estimate today of future inflation, since no Canadian annuity providers actually offer annuities that directly guarantee CPI-indexing. Here we have a small but potentially significant disadvantage if inflation should unexpectedly rise above 2% for an extended period a la 1970s.

Highest income quotes (as of 12 December 2014):
  • Male - $6483 income per $100,000, or about $577,000 to buy $30,785 of total annual income
  • Female - $4761 income per $100,000, or $647,000 (more expensive since women live longer than men)
The RP portion
The RP is the remaining difference after the lump sum to buy the annuity is taken from the portfolio. It can take the same return-risk optimizing structure as and be withdrawn according to the same 4% rule as for a normal portfolio.
  • Male - $1,000,000 - $577,000 = $423,000 x 0.04 = $16,900 more per year, i.e $66,900 in total. Looks pretty good especially since basic needs are covered by the most solid lifetime guarantees available. 
  • Female - same calculation gives $14,100 income extra from the RP and $64,100 in total
Readers who want to fairly accurately estimate what a quote for an indexed annuity would cost can do this by first getting un-indexed quotes from the free Globe and Mail daily updated annuity rates table, then apply an estimate for 30 years worth do-it-yourself inflation protection as described by

Probably the biggest negative for this option is having to give up control, access to and ownership of the annuity lump sum. Once the annuity starts, there is no flexibility or way to back out.

Option 2 - Make your own annuity-like cashflow with Real Return Bonds in a ladder or an ETF
Real return bonds issued by the Government of Canada have the desired features for our needs - default-free AAA-rated, long term (with maturities out to 34 years from today, which handles almost all life expectancies for 65 year-olds), steady payment (twice a year like any bond) and inflation-indexed (unlike the above annuities, RRBs are linked directly to CPI increases).

The iShares Canadian Real Return Bond Index ETF (TSX symbol: XRB), or a selection of its holdings an investor could buy to create a bond ladder, can be used to create the LMP. XRB's Yield to Maturity is presently 2.33%. Reducing that gross amount by the fund's MER of 0.39%, we get a net expected yield, which if you simple buy and hold the ETF is what you will almost exactly get, of 1.94%.

The XRB Holding - A holding that is to be consumed over 30 years with that return works out to $695,000 (it's an amortization problem - 1.94%, 30 years, payments of $30,785). For a 35 year retirement duration / life expectancy, e.g. for a woman instead of a man or an earlier retirement date, the sum to invest in XRB is $777,000.

The uncertainty over life expectancy and the amount to invest is a disadvantage compared to a lifetime annuity but at least erring on the conservative side only results in more money being left in a legacy. As well, the funds remain under the control of, and accessible to, the investor at all times.

The RP portion
The two life expectancies we have used give an RP and discretionary fund withdrawal at a 4% rate of:
  • 30 years - $305,000 capital value, $12,200 income, for a $62,200 total
  • 35 years - $223,000 capital value, $8,900 income, for a total of $58,900
Bottom Line: The contrast between the 4% rule and the LDI approach presents a choice - the 4% rule allows the investor to retain complete control but no certainty of lifetime retirement income; the LDI approach allows higher and guaranteed income but loss of control over a big slice of assets. As the Yin and Yang document itself concludes,  "While neither a probability-based [the 4% rule] nor a safety-first approach [LDI] is definitively right or wrong, different people will align more easily with one or the other".

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.


Andrew said...

Since the Test Case subject is now 65 years old, and will have to convert his RRSP to a RRIF in only about six years (if he has not already done so), consideration of the "4% rule" seems to be largely pointless. The subject will have to default to a 7.38% withdrawal on conversion. That annual withdrawal requirement will relentlessly increase every year to a maximum of 20%.

The only real options seem to be to either buy the annuity, or construct a portfolio which throws off as much reasonably safe income as possible (to slow the inevitable encroachment on capital).

The two can be combined, but in today's interest environment the annuity option is best left until at least age 75 when mortality expectations outweigh the interest element.

CanadianInvestor said...

Thanks for the comment.

Re the 4% rule, if we take the 4% as what can be spent safely, then the additional portion of the forced withdrawal would need to be reinvested. Of the 3.38% extra difference, or $33,800, some 70% of that might be left after taxes, of which $5500 a year could be put into a TFSA to grow tax-free while the rest could only be kept in a regular annually-taxable account.

It does get more complicated from age 71 onwards since now the tax efficiency of different types of returns (divs, interest, cap gains) needs to be managed in the taxable account but with still sizeable amounts in RRIFs or LIRAs the total asset allocation should not need much bending for many years.

Exploring the best timing and market conditions of the annuity purchase may well be worthy of another post. It is true as you say that mortality credits (the benefit of getting other people's money if they die before you) rises with age. And it is also true that current low interest rates mean lower annuity payouts ... but if you are going to fund the annuity with bond holdings, when interest rates rise, the value of those bond holdings will fall too, so you may not be able to buy as large an annuity. It's an interesting topic.