When helping boomers plan for retirement, it’s important for financial advisors to know that “longevity risk ultimately becomes bigger than investment risk,” said Don Ezra, co-chair of global consulting at Russell Investments. Ezra is the author of four books, most recently The Retirement Plan Solution: The Reinvention of Defined Contribution (2009). He was speaking at the Annual Wealth Management Conference sponsored by CFA Society of Toronto, which was held in Toronto on May 2, 2013.

“I hate the R-word,” confided Ezra, adding that his own recent transition into retirement had given him a changed perspective. A person should retire to a lifestyle, he emphasized, not from a lifestyle. “It’s a psychological transition. Too many retirees never get out of it,” and thus, according to Ezra, the best financial advisors “are psychological counsellors too.”

When advisors speak to clients, Ezra recommends that they use a discussion platform based on Ed Jacobson’s “Life Abundance Portfolio©,” which incorporates family and friends, work and play, mental and physical health, and finances. “Happiness over a lifetime is a U-shaped curve,” Ezra said, quoting a study by Blanchflower and Oswald of 500,000 people in 72 countries. The stress of the middle years “makes the happiness bottom out,” but then in retirement years, wisdom, experience, and perspective make happiness levels rise again. “So the best is indeed yet to come,” Ezra told the audience.

At Russell Investments, he explained, the framework for a retiree’s wealth has three tiers: enough money for essentials, lifestyle, and estate. “Most people have not saved enough to get from the lifestyle zone into the estate zone, and that tension between lifestyle and leaving an estate can be uncomfortable.” The key to finding out the retiree’s position is to connect assets and goals, said Ezra. A financial advisor helps the retiree cost out essential goals, desired lifestyle goals, and estate goals. The advisor also determines the value of all the assets: current assets, the discounted present value of future savings, and pre-annuitized wealth (such as CPP/QPP and defined benefit pensions). The ratio to which each of the goals is funded is examined, and a goal requires a ratio of 100 percent or more in order to be deemed feasible.

Three dials

In a retirement context, “there are only three dials to turn: change goals, save more, or change investment risk,” he said. In thinking about risk, a distinction between risk attitude and risk capacity must be drawn. The former is psychological; the latter is how much the retiree can actually afford.

Ezra prefers to calculate the present value of future goals instead of using annuity purchase rates. A lifetime income annuity will provide a guaranteed distribution of income over time (for example, via fixed payments) until the death of the person. According to a 2004 survey by Cannon and Tonks, typical annuity purchase prices (in the U.K.) are slightly more than the protection provided, which amounts to about 90 percent of the purchase price. However, inflation-indexed annuities offer protection corresponding to only 70 to 75 percent of the purchase price and are thus overpriced and should be avoided.

In his 2011 paper, “How Should Retirees Manage Investment and Longevity Risk in a Defined Contribution World?” Ezra observed that, “being 100% funded to your life expectancy is not enough. Fifty percent of people will outlive the expected longevity, by definition.” He contrasted two worlds: fixed longevity combined with uncertain investment return, versus fixed investment returns combined with uncertain longevity. The risk distribution with the greater width depends on one’s age. At age 60, longevity risk is smaller than investing 100 percent in bonds; at age 75, longevity risk is bigger than even investing 100 percent in equities. “At some stage, therefore, buying longevity protection is probably sensible,” he added.

“The average retiree is five times more risk-averse than a worker,” said Ezra, because he or she does “not have a human capital element to generate more wealth.” The retiree’s portfolio has three objectives: growth, risk aversion, and protection against longevity risk. Thus, by Tinbergen’s principle, which states that achieving the desired number of targets requires the use of an equal number of instruments, there should be a minimum of three instruments in the portfolio.

Some time before the point when retirement occurs and the decumulation phase begins, Ezra said, the financial advisor needs to sit down with the family to discuss the funds required for essential spending, desired lifestyle spending, and how much is available each year from pre-annuitized wealth. Three scenarios can be fleshed out: total risk aversion, with all future spending locked in; some risk, but with at least five years of essential and lifestyle spending locked in; and more risk, but still with five years of essential spending locked in. The last two scenarios are built using a cap for the five-year amount that must be protected and then permitting investment risk on the remainder of the assets. Ezra said that clients respond favourably when numbers are presented in this fashion. They reinterpret it as: “Give me five years of warning—beyond that, I will take the equity risk.”

In response to audience questions, Ezra said that the five-year warning model could be tweaked to have a longer or shorter warning period, whatever the retiree feels comfortable with, provided the advisor calculates the balance as supportable if the equity risk premium materializes. Studying the progress of the funding ratios over time would give good insights. He also suggested a behavioural twist: set an annual spending limit for clients and then give them a bonus if they keep their spending below the limit.

Hypothetical example showing funding status for different goal priority levels. The left-hand column depicts current assets, the discounted present value of future savings, and “basement” or pre-annuitized wealth (such as CPP/QPP and defined benefit pensions). The right-hand column depicts funding required for essential goals, desired lifestyle goals, and estate goals. Here, essential and lifestyle goals are 112 percent funded and thus are feasible. Adding estate goals results in only 85 percent funding level, and thus estate goals are not feasible. (An asterisk [*] means discounted present values are used.)