Quantifying Risk

Lightning and lotteries

According to the National Oceanic and Atmospheric Administration, the odds of becoming a lightning victim in the United States in any one year is 1 in 700,000. Your odds of winning the jackpot at Lotto 6/49 is 1 in 13,983,816. So you are 20 times more likely to be struck by lightning than winning the jackpot. If you paid $3 for your ticket and the jackpot is $5 Million, your expected gain is $0.36 and your net expected loss for your $3 investment is $2.64.

We tend to think that we will almost certainly will never be struck by lightning, while today may just be our lucky day for Lotto 6/49.

Getting struck by lightning is a risk with known odds and outcome. If you walk in an open field during a thunderstorm with an umbrella pointing upwards, your odds become considerably higher. Knowing the danger, most of us avoid this risk by staying out of harm's way.

There is also a risk of loss with the lottery ticket purchase. The loss is quite small ($3.00), and it may be viewed as a harmless entertainment expense. But the point is that you are trading a small loss for a very unlikely gain that can have a large impact on your life.

By definition, a risk carries uncertainty. In exchange for a potential payoff, we take a chance of incurring a loss. Each risk has its own odds and the impact can be small or large if it occurs.

Why think about risk?

When it comes to retirement planning, we must consider that our livelihood will come from invested assets, public and private pensions. We are no longer counting on indefinite and renewable employment income.

Examining each of the potential risks can help us make decisions on how we can minimize the odds of running out of money under all potential situations that may unfold in the future.

As with lightning and lottery, when assessing risk, we must determine its likelihood and the magnitude of the outcome. Armed with this information we can then decide whether we want to apply techniques to reduce, eliminate, transfer, or retain the risk.

Assessing risk

The likelihood of a risk is the odds it will happen, and its magnitude is the amount or severity of the loss.

There are several approaches to quantifying risk. Numerous different risk formulae exist, but perhaps the most widely accepted formula for risk quantification is:

Risk = Rate of occurrence X Impact of the event

Three approaches can be used to assess post-retirement risks:

1. Determining the odds for the occurrence,
2. Evaluating the impact of a risk to a moderate change in outcome using sensitivity testing, or
3. Gauging the impact of an occurrence with stress testing.

The risk analysis in RetireWare uses a combination of these approaches, with an emphasis on stress testing.

The importance of the longevity risk

"Longevity: The Underlying Driver of Retirement Risk"
 – Society of Actuaries report

The financial aspect of a successful retirement depends on the level of spending, available capital and sources of guaranteed income to finance expenses over the retirement period. Spending, initial capital and guaranteed income are predictable.

Investment returns can be managed to a degree with diversification, conservatism and hedging, but still carry significant uncertainty and can wreck wealth if poor returns prevail at the onset of retirement. Longevity for an individual is completely unpredictable, but life expectancy is rising and this is expected to continue with improvements in lifestyle and medical care.

Appropriate levels of spending ultimately depend on the duration over which they apply. This makes longevity in our view the most important factor to which other risk factors are subordinate.

Looking at the possibilities

“All models are wrong, but some are useful.”
– George Box, Professor Emeritus of Statistics

A risk cannot be evaluated in a  vacuum in the real world. It interacts with other factors and other risks. In other words, more than one adverse risk event can take place at the same time.

We developed a mathematical model to assess and quantify exposure to post-retirement risks. An objective function quantifies the success of the retirement plan with respect to each risk under consideration by looking at demographic and economic scenarios where a particular risk occurs and measuring the impact on the retirement budget.

The quantification of risk follows a stress testing approach that considers the odds of each economic and demographic scenario, and the set reproduces all possibilities to closely match the expected outcome and volatility used for the model.

Risks under consideration are: longevity, market, inflation, sequence of returns, long-term care and loss of spouse. For each risk, the risk success value depends on the degree to which expenses are covered where the risk occurs in  a subset of the economic and demographic scenarios.

Scenarios combine different end points of life expectancy and economic environment for equities, bonds, interest rates and inflation. Each scenario applies to one or more risks. The success measure is based on the present value of the shortfall of assets required to meet retirement income goals.

The degree of success values for each risk is an average of the results obtained for the applicable scenario subset. Results are rated on a scale from 0% to 100%, with 100% being the perfect rating, where the risk is completely managed.

Based on the individual’s retirement financial needs and aspirations, each risk's index value evaluates how the risk is managed. Taken together, the risk measures provide an overall evaluation of the current post-retirement risk strategies in place and highlights areas of weakness that need to be addressed.

Two other measures complement the risk analysis results: the expected estate compared to the estate objective goals and the degree to which sources of lifetime income covers essential and discretionary expenses.

The income coverage measurement provides information on "income coverage" and "essential expenses coverage". If there is a detailed budget, the results include the average percentage that sources of lifetime income (annuities, Government and private pensions) are able to cover the retirement income goal. For example, if the goal is $50,000 per year and lifetime income sources are at $20,000 on average, the income coverage is 40%. 

Risk management plan

Once risks have been assessed, strategies can be adopted to improve areas of weakness in the retirement plan. These strategies fall into one or more of these four major categories:

• Avoidance (eliminate)
• Reduction (mitigate or control)
• Transfer (outsource or insure)
• Retention (accept and budget)

Risk analysis results and management plans should be updated periodically to evaluate whether risk levels have changed or whether the strategies in place are still effective.

By: RetireWare / Equisoft On 12:06 PM

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Retire Happy!

The pursuit of happiness

Researchers at Liverpool Victoria, a UK insurance company, recently assessed the cost of a "happy retirement" at nearly $400,000. Their estimate is for maintaining a fairly ordinary standard of living consisting of essential living costs plus the cost of the "pursuit of happiness".

The calculation assumes a retirement age of 65 and lifestyle expenses lasting for the remaining life expectancy of 17 years. The cost estimate represents funds required in addition to the average state pension payable in the UK.

What is unique about their research is that they conducted a survey to find out what people close to retiring consider necessary to feel content in retirement.

They found a list of recurring themes that led to compiling this list of essential ingredients:

• Holidays outside the country each year,
• Time with children and grandchildren, and periodic gifts to them,
• Socializing with friends,
• Indulging in hobbies,
• Retirement at age 65,
• Living in a house with a garden, possibly outside the city,
• Living close to children and grandchildren, and
• Convenient transportation and walking distance to amenities.

I suspect we Canadians are not so different.

Many of these items are at no cost, but others come with a price tag. While the research focused on the "bare bone" cost of happiness, many will find that they need far more to achieve contentment in retirement. For example, holidays are to be frequent and long, hobbies numerous and expensive (golf, cottage, boating, etc...).

Sadly, the survey found that 8% of pre-retirees had no retirement funds whatsoever and almost 30% would fall short of their pursuit. Of those with retirement funds, over a quarter didn't know how much income to expect.

For many, the true shortfall in their pension will not become apparent until they are ready to retire.

And then it will be too late.

What is your list of ingredients to be content in retirement? Drawing up your own list will make it easier to build your post-retirement budget. Planning retirement is not only about figuring out how to keep the lights on and put food on the table, it's also about figuring out the price tag of retirement happiness!

By: RetireWare / Equisoft On 5:39 PM

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The Long-Term Care Risk

Too far to consider

It may be far away in the future and something we'd prefer not to think about, but increasing life expectancy comes with an unfortunate side effect: not only will we live longer, but we also will live longer in poor health.

The long-term care (LTC) risk is the risk of requiring an increased need for assisted care because of declining health in old age. It is hard to predict for individuals and even harder to predict far into the future. According to American Association of Retired Persons, the odds of needing nursing home care or assistance with daily living activities 65%.

In light of this, there is a good chance that most of us will need long-term care services, and an even greater chance that one spouse in a couple will need it. Accordingly, a financial plan should cover future long-term care needs. Knowing what options are available will help you decide on the most suitable approach to manage this risk for your circumstances.

Provincial health insurance in Canada pays for hospital stays and doctor care, but there is limited availability of custodial care for a long-term disability or illness. With the ageing of our population and increasing health care costs, we can expect that more services will be privatized. This means the burden to pay for these costs are mostly for the individual.

The table below will give you a sense of monthly costs of care by province.

Province	Private Room	One bedroom suite
Alberta	$953 - 4,285	$2,658 - 4,440
B.C.	$995 - 3,500	$1,595 - 5,400
Manitoba	$1,359 - 2,475	$1,690 - 3,300
New Brunswick	$800 - 2,533	$1,943 - 3,500
Newfoundland	$1,500 - 1,800	$1,065 - 4,200
Nova Scotia	$1,705 - 3,100	$1,900 - 3,490
Ontario	$1,236 - 6,000	$1,849 - 8,000
P.E.I.	$1,825 - 2,880	$1,950 - 3,750
Quebec	$850 - 6,700	$750 - 2,500
Saskatchewan	$1,380 - 3,700	$1,200 - 4,300

[Source: LifestageCare™ -- lifestagecare.ca]

On average, a 65-year-old today will need some type of long-term care services for three years, according to the National Clearinghouse for Long Term Care Information in the United States. Women need care an average of 3.7 years, and men require long-term care an average of 2.2 years.

If you spend your own funds to pay for long-term care, your assets will go down quickly. This is why transferring the risk to an insurer may make sense.

Long-term care insurance

Long-term care insurance provides financial protection if you become unable to care for yourself because of an illness, disability or cognitive impairment such as dementia. It covers stays in a nursing home or the services of a caregiver in your home.

The longer you wait, the harder it is to get coverage. This is because when you apply in later life, you risk being in poor health and that means higher premiums or making you uninsurable.

According to the American Association for Long-Term Care, Alzheimer’s is the most frequent cause of claims over age 65, and they are the longest and most expensive claims.

The cost of LTC insurance depends not only on health history but also on the choice of insurer. Premiums can rise over time, but increases are never based on new personal medical issues. LTC insurance has limits on the total amount of claims. Many plans also have deductibles, meaning you will have to pay out a certain amount for care before coverage kicks in. And if your medical needs exceed those amounts, you will have to pay the balance.

When reviewing your application, the insurance company will take into account several factors to determine eligibility and the premium amount, especially health status and age at the time of application.

Shopping around is difficult because the many features that come with different policies. Other than age and health, three factors have the biggest impact on determining the premium are the type and amount of coverage, specifically the daily benefit, length of coverage, and inflation protection.

There are two types of plans: one that provides reimbursements for eligible expenses such as homemaking or private nursing services, up to a pre-determined maximum. The other type provides a pre-determined monthly benefit amount. Most plans include a waiting period: once eligible for benefits, payments only start after a specified period of time such as 90 days.

To find which companies offer long-term care insurance, look at the insurance finder of the OmbudService Website for Life and Health Insurance: http://www.olhi.ca/insurance-finder/

Here are a few other features to consider:

• Pooling coverage between spouses may result in lower premiums,
• Having a waiver of premiums once you are collecting benefits, and
• Adding an inflation protection rider.

The last item, inflation protection, may be the most crucial aspect of the policy. With typical claims occurring typically at an advanced age, say in the eighties, a policy purchased at age 60 would lose much of its value without inflation protection. This is made more acute with  health care inflation having been higher than general inflation in the last several years. There is a good chance this trend will continue.

Benefits are typically paid when you can no longer perform a essential activities of daily living without substantial assistance, such as bathing,  dressing, mobility, maintaining continence or eating.

Long-term-care insurance can make the difference between living out your life the way you want and becoming a burden to your family or depending on the state. But it is becoming significantly more expensive and harder to get LTC insurance. Average premiums on new policies have risen significantly and some insurers are no longer selling these policies. This is because of low interest rates, increased life expectancies and increasing size of claims.

If the cost of insurance is too high, consider reducing coverage to an affordable level and rely on other savings to supplement it.

Self-insuring for long-term care

For many people, long-term care insurance is simply out of reach. If you have assets to protect, you should carefully review your financial situation to determine that you can self-insure. Self-insuring might work if there are plenty of assets. If you're not in this situation, you'll need to determine how much income will be available during retirement -- income from registered and non-registered accounts, and public and private pensions -- and evaluate how much income is required to maintain your lifestyle. desire. Doing a budget works best, as it accounts for all expenses with precision, including medical costs.

This thorough review will help determining whether you have enough left over for long-term care.

Life insurance

If you already have or can get whole life insurance, it may serve as a source of funds down the road. This type of policy allows loans against the cash surrender value and this can help to cover long-term care expenses. The appeal of this approach is that your heirs get a payout if you don't use the cash surrender value for long-term care expenses.

Lifestyle changes

It’s not too late to reduce our risk of major health problems by lifestyle changes involving diet, exercise, smoking, etc.

Here are a couple of interesting videos that provide strategies to improve our chances of living a healthy lifestyle.

Dr. Esselstyn, famous for his central appearance in the widely successful documentary 'Forks over Knives' and who helped inspire President Bill Clinton to go on a plant-based diet, speaks in this video on the topic of 'Prevent and Reverse Heart Disease'.



In "More Than an Apple a Day: Combating Common Diseases", Dr. Michael Greger has scoured the world’s scholarly literature on clinical nutrition and developed this live presentation on the latest in cutting-edge research on how a healthy diet can affect some of our most common medical conditions. Dr. Greger is a very entertaining speaker with a great sense of humour and the timing of a stand-up comic!
 

By: RetireWare / Equisoft On 7:25 PM

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Monthly pension

Question:

I'm trying to enter a pension into one of my files; however, I'm not clear on how to do so.

If someone has a $2,000/month pension, what do I put into lifetime pension payable at age 65?

Answer:

If it is a pension that will not grow from future years of service, enter it as a 'Pension from a former Employer'.

In your case, you would enter Bridge as 0 (assuming no temporary bridging pension from the plan) and Lifetime pension at 65 as $24,000.

If there are future accruals, enter as a 'Pension from a Current Employer', you would enter $24,000 if this is the amount payable at age 65 based on service to date, and the program will calculate future pension accruals based on expected future service (at the age of termination from the plan or retirement).
In both cases, it will apply an early retirement pension reduction by selecting the appropriate early retirement rules in the program.

By: RetireWare / Equisoft On 11:10 AM

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TFSA savings after retirement date

Question:

The software appears not to allow for savings to be allocated to TFSA after retirement date.

Is there a way to grow my TFSA account after retirement?

Answer:

There are two places to enter TFSA amounts:

• In 'Registered Investments' for retirement purposes
• In Pre-retirement Budget, on the 'Budget Information' tab, to enter TFSA balances for a purpose other than retirement.

By: RetireWare / Equisoft On 11:09 AM

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The Interest Rate Risk

Risk of risk-free investing

The interest rate risk is the risk of low earnings or reduced market value of a portfolio due to low future interest rates.

Lower interest rates affect retirement income in many ways:

• Lower income on guaranteed income certificates and bonds.
• At maturity, capital reinvested earns a lower rate.
• Need to save more to have sufficient funds to provide adequate retirement income.
• Annuities provide lower income when long-term interest rates are low at the time of purchase.

Strictly speaking, the interest rate risk applies to risk-free investments, such as Treasury bills, which are issued and guaranteed by Governments. This blog post expands this definition and discusses the risk of earning low returns on all types of fixed income investing, including bonds.

Stuck with low interest rates?

Low interest rates have been part of the economic landscape for many years, in part because of declining inflation over the last 20 years, and have been kept low to overcome the housing debacle in the United States. Having the economy churning with artificially low interest rates negatively impacts pensions, annuities and retirement savings.

The Bank of Canada cannot increase interest rates independently from the US without consequences. Higher rates in Canada will lead to inflow of investment, which in turns will strengthen the currency and adversely impact central Canada manufacturing and exports. The only option for Canada may be to move rates in tandem with the US.

Are higher interest rates desirable? It may seem to make retirement more affordable and secure, however, higher rates usually means higher inflation, which makes purchases of goods and services more expensive. It also increases the burden for those who carry mortgage and other debts.

Bonds and interest rates

If interest rates rise in the future, it will cause the value of bonds to fall. Interest rates and bond prices move in opposite directions. When interest rates fall, the value of bonds rise. Interest rates have been falling for a long time, which is why bond performance has been strong. When rates start to rise, bonds performance will inevitably suffer.

Long-term Government bonds have no credit risk, but they have a significant interest rate risk. A rise of 1% may cause long-term bonds to lose as much as10% of their value.

Interest rate risk can be quantified by looking at the "duration" of bond. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. It is expressed in terms of years. The sensitivity depends on the bond's time to maturity and its coupon rate.

By ensuring the duration of your entire portfolio is kept at a reasonable level, you are reducing your exposure to the interest rate risk.

Interest over time

It is "interesting" to look at money market returns over the last 50 years in Canada in light of inflation.

Interest rates often move up or down at about the same rate as inflation.

The 1980s and 1990s saw a prolonged streak of high real rates of returns (the difference between the nominal rate of return and the rate of inflation). But it has been succeeded in the last decade by zero or negative real rates of returns, and we may expect that the "new normal" will be an epoch of returns that barely exceed the rate of inflation, i.e., zero real returns for the foreseeable future.

[Source: DEX 91 Day T-Bill Index and Consumer Price Index, Canada All items]

Strategies

Are there strategies to help investors earn more on their cash and fixed income investments? With bond yields are at their lowest point in modern history, they don't earn sufficient returns to fund retirement needs.

Corporate bonds provide higher returns, but are more volatile and have a risk of default. Nevertheless, high quality issues and diversification make corporate bonds a viable option.

In order to generate adequate returns, equities must continue to be part of the mix during retirement. Minimizing volatility is achieved by investing in a diversified portfolio with emphasis on large capitalization and value.

As the economy improves, inflation will begin to increase. To keep inflation in check, central banks will increase interest rates to slow growth. When rates do rise, the value of bonds will fall.

Lowering risk in retirement

Bonds serve not only as a source of income but also as a way to lower the volatility of the portion of the portfolio that has equities. Many recommend reducing exposure to equities at retirement.

This is because time horizon shortens and the ability to make up losses is reduced. Risk appetite is lower, after all, if retirement is to be worry-free. As well, one or more years of poor returns may lead to a serious depletion of the portfolio when taking withdrawals (the sequence of returns risk).

So we may think eliminating equities altogether may be the best approach, but it may actually make your portfolio more volatile. More volatility means more risk, investment risk to be precise.

Keeping exposure to equities will help boost investment returns, while reducing volatility. Stocks are more volatile, but they have low correlation to bonds. The combined asset classes can produce higher returns while reducing volatility, because stocks do not move in tandem with bonds. The overall effect reduces the volatility of the portfolio.

Taxation

Interest is taxed as income. It may be sensible to hold interest-bearing investments first in a tax-free savings account (TFSA) to avoid any taxation of investment income, then in a registered retirement savings plan (RRSP) to defer income tax to a time when you are in a lower tax bracket.

Non-registered accounts are more appropriate for equities, as capital gains enjoy favoured tax rates and capital losses can be used to offset capital gains.

Fees and funds

If you hold part or all of your interest-bearing investments in a money market fund, pay special attention to fees. With current low or negative real returns on such investments, fees can wipe out return or make you lose capital in real terms.

Chasing higher returns

A ladder is a series of bonds that mature in succession, providing both yield and a steady stream of principal repayments as the bonds mature. It offers some protection against rising interest rates, because lower-yielding bonds can be reinvested into higher-yielding ones as they mature.

Bond ladders require significant investments to achieve proper diversification, but there are exchange-traded funds that simulate a bond ladder and can be purchased in any quantity.

Keeping up with inflation while taking little risk can be also be achieved by holding real return bonds. Real return bonds are Government issues that pay interest based on a formula linked to the current rate of inflation. There are real return ETFs and also funds, although the latter category may come with higher fees that can erode signficantly your returns.

High-yield corporate bonds could provide decent returns even if rates rise moderately, because rising interest rates would occur if economic conditions are stronger, lowering the chances of default for such bonds.

Annuities

Income annuities provide retirees with a guaranteed fixed income, despite changes in the interest rate environment. Prevailing interest rates will determine the amount of annuity payout that can be purchased from a given lump sum. Low interest rates have caused annuity premiums to increase. You can gauge the value of your annuity purchase by dividing the premium by the annual income. If it costs $200,000 to provide $10,000 per year for example, it will take 20 years to get back you premium. The higher this number, the better. A higher number shows the value you get from pooling mortality risks and investment income on your funds beyond your life expectancy.

It's difficult to predict the future direction of interest rates. This is why it may be a good idea to buy annuities in stages to take advantage of better premium rates if rates do increase. Nevertheless, making annuities as part of your retirement income mix will provide a basic layer of lifetime income together with the Canada Pension Plan and Old Age Security that you can count on regardless of economic conditions.

Planning for low interest rates

Currently, interest rates on both short and long-term instruments are low. In this environment, expect lower investment returns if a significant portion of your assets are in cash and fixed income.

This means more savings are required to fund your retirement, or you must plan for less if you can't add to your nest egg.

By: RetireWare / Equisoft On 3:08 PM

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Investment Income Calculation

Question:

It seems the program may be treating withdrawals from a TFSA as "income" for purposes of the OAS "clawback" test.

Answer:

No, TFSA investment income is never included in taxable income.

The OAS clawback is based on all income plus realized investment income. Investment income for the year shows on the cash flow table. The portion that is interest, dividends is taxed. But there is also realized income based on the selected 'Percentage of gains realized annually' in 'Economic Outlook' on the 'Forecast' page.

For example, assume all your non-registered assets are in fixed income that has a cost base of $250,000, a market value of $300,000 and you earn 4% per year.

Your market value is $312,000 at the end of the year, with interest of $12,000. If you sell and reinvest 20% of your portfolio each year, you will sell $60,000 of bonds and have a realized gain of $10,000. This amount is added to income to figure out the tax payable and assigned to the non-registered account.

This in turn affects the clawback on Old Age Security.

By default, this portfolio "churning" is 20%. You can control this (and set it to 0%) in the 'Advanced' section on the 'Economic Outlook' tab on the 'Forecast page'.

By: RetireWare / Equisoft On 9:50 PM

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