Gauging the Risk of Retiring Too Soon

"Someone who wanted to take into account withdrawal rules for locked-in plans, other income sources, taxes and fluctuating market returns could try a new version of software from Apeiron Software Ltd. [...] RetireWare software called Monte Carlo, which simulates volatile capital market returns." — James Daw, The Toronto Star

Full Review

A man we'll call Russell faces a common problem: how to gauge the risk of retiring too soon, with too little money.

When he switched employers in his early 50s, Russell transferred the cash value of an inflation-protected pension plan to a locked-in retirement account. An insurance man had shown him how well he could do if he earned an average return of 10 per cent — an aggressive and misleading assumption.

So far, his insurance-company segregated funds have only risen in value an average of 4.83 per cent a year: minus 3 per cent the first year, followed by 11.5 and 6 per cent. Russell fears he will not be able to retire as soon, or as well off, as he expected.

Russell, 56, is transferring his $500,000 in pension money to a new adviser who has recommended a mixture of stocks, bonds, income trusts and mutual funds.

"I believe if I had stayed put with (my current adviser) I would be broke in my 70s," he complains. "I believe the dismal returns are due to the high management-expense ratio (3.5 to 3.75 per cent of assets per year) and the (insurance company's) investment plan."

One gauge of Russell's situation is the amount the pension plan for Ontario teachers must set aside for someone to retire at age 56. The sums are staggering.

Spokesperson Lee Fullerton said the Ontario Teachers' Pension Plan must reserve about $850,000 to pay a teacher's pension of $40,000 a year, and about $1.2 million for a principal's pension of about $60,000.

The teacher would receive $40,000, adjusted each year for inflation, up to age 65. Then the payment would drop to the equivalent of about $34,500 today once the teacher was eligible to collect a Canada Pension Plan benefit without an early-retirement reduction.

The estimated reserve fund for such a pension would fall from $850,000 to $750,000 if the yield on real return (inflation-adjusted) government bonds were to rise from about 2 per cent today to about 3 per cent, where they were a couple of years ago, said Fullerton.

Clearly, Russell is some years away from a teacher's pension. When he does retire, he could still run short of money if he does not allow for fluctuating returns and a longer-than-average life expectancy, warns Jim Otar of Otar & Associates Inc. in Thornhill.

Otar, an engineer who became a certified financial planner, sells a $39.99 retirement calculator at retirementoptimizer.com that estimates the "probability of survival" of a person's savings. For about $160, he will do a one-page report for someone who completes an online questionnaire.

Otar's software tests the odds of a mix of investments becoming exhausted by different ages, based on the pattern of annual returns generated by an index of blue-chip stocks and government bonds (deducting for inflation) at different starting points since 1900. If nothing else, the program shows how variable the past has been.

It's impossible to predict how well a stockbroker will do investing Russell's money, so Otar takes total market investment returns and subtracts a typical amount for management costs.

He assumed Russell would put half of his $500,000 into equity mutual funds and half into bond funds. He took off an annual management-expense ratio of 3 per cent from stock returns and 1.5 per cent for bond returns.

Otar calculated that, if Russell wanted the equivalent of the average Ontario teacher's pension (as set out above, plus CPP and Old Age Security benefits), he would need to let his savings grow until he reaches age 66.

There would still be a 9 per cent chance of his money running out before age 85, and a 34 per cent chance of running out by age 90. To reduce the chance of running out to 10 per cent at age 90, he would have to delay retirement until age 69.5.

Alternatively, he could start saving an extra $8,000 a year in order to have a high probability of drawing a teacher's income to age 90, said Otar. Or he could opt to buy a guaranteed life annuity, depending on interest rates at the time.

Provincial rules governing annual withdrawals from former pension funds would prevent Russell from ever exhausting his savings. His withdrawals would simply get smaller, or lose their buying power, if his returns proved inadequate.

Someone who wanted to take into account withdrawal rules for locked-in plans, other income sources, taxes and fluctuating market returns could try a new version of software from Apeiron Software Ltd. [our emphasis added]

President Marc Des Rosiers is now offering an enhanced version of his RetireWare software called Monte Carlo, which simulates volatile capital market returns. [our emphasis added]

If you work with a financial planner, you could ask for the sort of stress testing of retirement and investment plans that Otar and RetireWare try to provide. [our emphasis added] Before cashing out of a pension plan, see an actuary.

James Daw writes a daily column on personal finance and investing in the National Edition of The Toronto Star.

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