Money Smarts Blog

If you follow the business media, you will notice that they tend to exaggerate everything and take things out of context. Stocks don’t drop one percent, they “drop sharply”. Recent market declines are usually measured from the most recent peak – regardless of how recent or short-lived that peak was.

If you left the design of elevator buttons to the financial media, there would be no “Up” and “Down” buttons – they would read “SOAR!” and “PLUNGE!”.

Let’s look at the American stock market this year

The S&P500 hit a high on April 29 of this year. Over the next five months, it proceeded to shed almost 20% of it’s value before bottoming out on October 3rd.

If you were watching the news on October 3rd, you probably would have heard how the stock market is down almost 20% from the peak, which brings it close to bear territory.  And in only five months. Scary stuff! It would be tempting to panic after hearing those numbers.

However, that time period is somewhat arbitrary and very short term.  Since October 3rd, the S&P500 has gone up again and is only down 9% from April. That still doesn’t sound very reassuring, although it’s a lot better than being down almost 20%.

Let’s look at the return over a slightly longer time period. From the beginning of the year, the S&P500 performance including dividends is roughly zero percent. Does it still sound like it’s time to panic?

But wait, there’s more! Canadians who invest abroad in unhedged investments also experience currency changes. This doesn’t always work out well – check out any 5-10 year American investment returns in Canadian dollars for an example. But this year is different – the Canadian dollar has lost ground against the U.S. dollar since the beginning of the year and that means your U.S. investments have an automatic currency gain.

For example if you owned the Vanguard US stocks ETF (VTI), you might notice that the price in US$ has gone from $64.93 at the beginning of the year down to it’s current price of $64.51 – a drop of about one half of one percent.

However, if we convert US$ to Cdn$, we find out that the current price of VTI is $65.67 Canadian dollars.  The price at the beginning of the year was $64.84 in Cdn$

This means that your VTI return year-to-date in Canadian dollars is 1.3% not counting dividends. Ok, so that return might not win any stock picking competitions, but it’s no reason to panic.

Don’t let the media analyse your investment performance – figure it out on your terms.

Workers who don’t have access to a defined benefit pension are often quite jealous of workers who do. We wish we had something similar, so that we wouldn’t have to worry about our retirement income.

A defined benefit pension is where a worker makes regular mandatory contributions during their working career and then receives a guaranteed paycheque in retirement.

Annuities are a pretty good solution for people who want a defined-benefit-like income stream in retirement. Moshe Milevsky and Alexandra MacQueen took a detailed look at how to incorporate annuities into your retirement plan in their excellent book – Pensionize Your Nest Egg.

But for some reason, annuities aren’t very popular. There are many retirees who would benefit from converting some or all of their retirement portfolio into annuities, but most don’t.

An annuity is an insurance product where you pay an upfront fee in exchange for guaranteed payouts until you die.

The mystery of why more seniors don’t buy annuities is referred to as the annuity puzzle.

Why people don’t like annuities

The problem is that people who have been saving money for a long time and have accrued a nice little nest egg, have a hard time handing over a big chunk of cash for an uncertain return. What if they die two weeks after buying the annuity? What if their investments get really good returns after they convert them into an annuity? What if they change their mind? (annuities can’t be “unbought”).

Another issue is lack of knowledge – not many retirees know what an annuity is or how they work.

Some people don’t like annuities because they usually don’t payout any money to their heirs.

Buying an annuity is too difficult a decision for most people and that’s why most Canadians that should buy some annuities, don’t.

Why do people with defined benefit pensions not have the same issues?

On the flip side – someone who works for an institution that offers a good defined benefit plan gets used to the idea from the very beginning of their career that they are making contributions in exchange for a future income stream in retirement. They don’t have to worry about making a wrong decision about their life expectancy, because there is no decision to make.

Leaving their “pension pot” to heirs is not a decision that someone with a defined benefit plan has to deal with, because in most cases it won’t happen.  It’s not uncommon for a spouse to be eligible for a reduced survivor’s pension, but once that surviving spouse dies, the pension dies with them.

Unless their defined benefit plan contains a survivor’s benefit, they have no concern that those contributions won’t be able to be passed on to the next generation.

Another factor is that defined benefit workers are buying their future income stream one paycheck at a time in small palatable dollar amounts.  Buying a pension with an $800 deduction from your paycheque each month is psychologically a heck of a lot easier than buying the equivalent annuity at age 65 for $650,000.

Most people with defined benefit plans don’t have an appreciation of the amount of money their pension is worth. It’s not uncommon for a retiring government employee to have a pension “pot” that is worth between one and two million dollars. But that employee never sees that money total in an account. They just see their retirement income stream in the form of cash payments once or twice a month. Perhaps they get $45,000 per year from their pension. Most retirees don’t equate their pension money with a large nest egg, so the thought of losing that money if they die early isn’t really a problem for them.

How to solve the annuity puzzle?

More knowledge about annuities would help. People without defined benefit pension plans have to understand that defined benefit pensions and annuities means no inheritance for that money. You can’t have your cake and eat it too.

Retirees have to learn that in order to get a decent guaranteed income stream, you have to fork out a lot of money.

If a retiree wants to leave money after their death, they have the option of only converting some of their money into annuities.  The remainder can stay invested in traditional investments and will be available to be passed on when the retiree dies.

There aren’t really a lot of differences between a defined benefit plan and an annuity. If you could buy an annuity starting at an early age (ie with monthly contributions) that doesn’t pay out until you are 65 (or some agreed upon age), then guess what – you have a defined benefit plan. In reality an individually purchased annuity will likely cost more than a defined benefit plan, but on the other hand – a person who saves their retirement money in an RRSP has more flexibility in terms of when they buy an annuity and what percent of the portfolio they convert to an annuity. They can also buy multiple annuities over time.

Conclusion

We tend to look at the good parts of defined benefit pensions and ignore the bad parts.  Kind of like admiring your neighbours lawn and wishing your lawn looked as green as his, but ignoring the fact that he spends three hours every weekend working on it.

If you have a decent-sized retirement portfolio and no guaranteed pension, annuities likely should be part of your investment plan.

Do you know anything about annuities? Would you consider them for your retirement plan?