What are the Retirement Income Planning Options?

Retirement Income Planning Options

Excerpts from the Book – Preserving Wealth – written by Jack Lumsden, MBA, CFP®

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“There are five main options to achieve the cash flow you desire from your own assets:

1. income only investing
2. income-focused investing.
3. guaranteed income: life income annuity/guaranteed income products
4. total return investing: a diversified portfolio
5. combination of the above

 

“Let’s start with income-only investing first,” Uncle Wayne continued. “With this option, you would only invest in bonds or GICs, and the income they provide is what you use for spending. This is often the starting point in creating a retirement income and cash-flow plan. The challenge with this approach is that with the current low-yield environment, the income earned may not be enough to fund your cash flow needs annually. Over time, the asset growth may not allow you to keep up with inflation, as your cash flow needs increase.”

“So,” Alice asked, “low yield means low-interest rates, and with the current interest rates so low, it could be difficult to create income from the money you invest? We couldn’t really increase our income each year in retirement, sort of like when we received a raise while working?”

“You got it, Alice.”

“What about the second option? How is income-focused investing different from interest-only investing?” Alice continued.

“With income-focused investing,” Uncle Wayne said, “not only would you invest in income-oriented investments such as GICs and bonds, but you’d also invest in dividend-paying stocks, either directly or within mutual funds, and live off the income they provide.

“As with the income-only investing, the challenge with this approach is that with the current low yield and interest rates, as Alice mentioned, the income and dividends earned may not be enough to fund your income and cash flow needs. Over time, the asset growth may not allow you to keep up with inflation as your cash flow needs increase.”

“That makes sense to me,” David commented. “Next on the list is annuities. I’ve heard about them, but how exactly do annuities work?” 

“Well,” Uncle Wayne started, “a life annuity isn’t really an investment but a tool to create income. It’s like purchasing your own pension. With this option, you would purchase an annuity from a life insurance company and then receive a guaranteed income for life or for joint life with your spouse or partner. Annuities can be purchased with registered investments (RRSPs and RRIFs), and the income is fully taxable each year. Annuities purchased with non-registered funds may have a tax advantage.

“A key advantage of annuities is that they eliminate the risk of outliving your savings and market risks, which are transferred to the life insurance company.”

Sandra commented, “I take it to mean that with life annuities, as long as you’re alive, you’ll get paid, so that takes care of outliving your savings.”

“And when you say market risk, Uncle Wayne, I assume you’re referring to when the markets have terrible years, like 2008,” said Alice. “What happens to your capital when you purchase an annuity?”

“Both of you are correct, Alice. As long as you’re alive, you’ll receive your income, and market risk is exactly what happened in 2008. An advantage to annuities is that once purchased, no more decisions are made. However, the trade-off is that for the lifetime guaranteed income, you no longer have access to your capital. Some life insurance companies do offer cash back annuities, which means that at death if payments you received haven’t equalled the original purchase price of the annuity, the difference goes to your estate.”

“So, if you don’t have a pension like me, Jack could buy an annuity and sort of replicate a pension for lifetime income?” asked Sandra.

“Absolutely,” grinned Uncle Wayne. “Some people don’t like the thought of using their capital to purchase an annuity, so another option for guaranteed income is guaranteed income products offered by life insurance companies through their segregated funds, which are pooled investments like mutual funds. These products provide a lifetime guarantee of income regardless of how the underlying investments perform within the segregated fund contract. 

“Most often, the guaranteed income will be less than what an annuity would provide; however, you do have full access to your capital at any time at the current market value. If you do redeem your money, you no longer have the income guarantees. These products are flexible enough that if your needs change, you can get your money back. I have friends who retired prior to the 2008/2009 financial crash, and they found these types of income products to be very helpful in providing guaranteed income for part of their income and cash-flow strategy.^[1]

“Sounds complicated,” I added, “but I can see that having some guaranteed income in retirement on top of the Canada Pension Plan and Old Age Security would help with the sleep-at-night factor.”

Mark added, “I’ve been talking to some of my friends who have already retired, and to a person they’ve said that those who have more guaranteed income worry less about their own investment portfolios. So how does the next option work, investing using a globally diversified portfolio?”

“This approach is like what you would do prior to retirement,” Uncle Wayne explained. “You’d invest in a globally diversified portfolio that will generate income, dividends, and capital gains, so that you don’t totally rely on only one source of income. The inclusion of capital gains allows you the potential of keeping up with inflation over time. This is called a total return portfolio.

“To create a monthly income, like your pay cheque when working, you withdraw the cash flow you require. The withdrawal amount can be changed to adjust for an increase or decrease in your retirement expenses. For example, during the Great Recession (December 2007 to June 2009), I reduced my ‘do what I want, when I want’ spending that year until the markets rebounded in the following years. With a total return portfolio, many retirees may end up with an asset allocation in the range of between 40% to 60% growth investments and 60% to 40% defensive investments. 

“Often with this strategy, a ‘bucket’ approach is used, where the first two to three years of spending is placed in the ‘income bucket’ and allocated to very conservative investments, such as a high-interest savings account or short-term bonds, and the cash flow is redeemed from this location first. The balance is allocated to the longer-term portfolio, the diversified portfolio bucket.” At the end of each year, the income bucket is filled up from the diversified portfolio bucket if the market growth has been positive.”

“I think this would help with the sequence of return risk. Is that correct, Uncle Wayne?” asked Alice.

“Absolutely,” Uncle Wayne answered. 

“This all sounds very complicated,” Mark commented. “How do you review the various tax strategies?”

“First of all, you need a great accountant and CFP, and there are some great financial planning software packages that good financial planners can use to model the different options.”

 Uncle Wayne then added, “Many retirees like me will develop a plan where they may utilize a combination of the above options to create their lifelong income and cash-flow plan. For example, retirees may decide to cover some of their essential expenses with an annuity or a guaranteed income product and then invest the balance in a total return portfolio, perhaps using a bucketing approach.

“A key part of this approach is the coordination from a timing, sequencing, and tax standpoint, as retirees may have numerous income sources, such as:

• Old Age Security and Canada Pension Plan.
  • Company pension plans.
  • RRSPs, RRIFs, locked in RRSPs.
  • Tax-free savings accounts (TFSAs).
  • Annuities and guaranteed income products; and
  • Non-registered investment accounts.  

 

“So, there’s a great need to develop an optimal de-accumulation strategy, and this is where a great financial planner can help.”  

For more information on the retirement income and cash-flow planning you can refer to  Chapter 3: Protecting and Preserving your Wealth  from the book Preserving Wealth The Next Generation – The definitive guide to protecting, investing and transferring wealth by Jack Lumsden, MBA, CFP®

[1] These products protect retirees’ income and cash flow from financial market declines, like during the COVID-19 Pandemic.

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