New type of retirement plans cut risk of outliving your money — but there's a catch

Perhaps the biggest fear of people saving for retirement is outliving their money. But paradoxically, that fear can create a second problem: saving too much.

Studies have found some people are so worried about running out of money that their balances grow even after retirement.

Thus the challenging retirement conundrum: Save too little and risk the poorhouse; save too much and you could die before you have the chance to enjoy the golden years you spent an entire career saving toward.

People struggling with this decision can use some or all of their retirement savings to buy an annuity from an insurance company that will pay them an annual income for life. But guaranteed income annuities have not been a popular choice.

People don't want to give up control of their money. Many worry about dying early and not getting their money's worth, and compared with the amount of income generated in the old days of high interest rates, annuities are expensive.

Now there is another, more cost-effective way to generate income for life — one that will allow you to maintain control of most of your money and won't see the bulk of your savings go to an insurance company if you do die unexpectedly early. 

It's called an Advanced Life Deferred Annuity, or ALDA.

"I think it's just as good as it gets. The peace of mind that it would give to people and all the other things, it's a really neat solution," said Bonnie-Jeanne MacDonald, director of financial security research at Ryerson University's National Institute on Ageing.

MacDonald is part of a coalition of retirement experts that had been lobbying Ottawa for legislative change around different types of annuities. That coalition got what it wanted, and more with two changes quietly announced in the recent federal budget involving ALDAs and something called Variable Payment Life Annuities, or VPLAs.

Assuming all goes well, the changes would likely take effect in 2020.

Both ALDAs and VPLAs could provide crucial guarantees in a society where defined benefit pensions are disappearing and Canadians are increasingly dependent on individual savings vehicles, such as RRSPs and TFSAs, and defined contribution pensions, all of which are subject to the whims of the financial markets.

"If those people aren't managing that savings really well and they do run out of money, it's not just bad for them in that their living standards will drop. There's also going to be a bigger stress on government subsidies like OAS and the guaranteed income supplement and also the provincial subsidies," said MacDonald.

"The traditional defined benefit plans are dying in the private sector and being replaced by defined contribution plans, group RRSPs, and individual RRSPs," said Keith Ambachtsheer, director emeritus of the Rotman International Centre for Pension Management and a member of the coalition pushing for the changes.

Much cheaper option

"These do not have 'income for life' back ends, leaving people with the risk of outliving their retirement savings. The ALDA/VPLA options provide these 'income for life' options in a cost-effective manner," he said. 

The difference in cost is startling.

Let's take a 65-year-old woman who has $500,000 in retirement savings. According to Sun Life Financial's annuity calculator, if she used those savings to buy an annuity, she could immediately begin collecting an annual pre-tax income-for-life of about $28,000.

An ALDA generating the same income would cost about one-tenth as much, or just $50,000.

The catch is that with an ALDA, the income payments don't kick in until or unless the woman reaches the age of 85.

An ALDA is by order of magnitude cheaper, because the initial lump sum cost has 20 years between the purchase and the beginning of the payout to grow with interest and or investment returns. Only about half of Canadians will live past 85, and those who do benefit from the funds of those who don't. Some refer to this as a mortality credit.

Free to spend your money

An ALDA will allow a relatively young retiree to essentially insure they will have money for life for a fraction of the cost of a traditional annuity, leaving them free to spend the majority of their retirement savings as they would like during a period in their life when they likely will be more active and able to enjoy those funds.

"And by age 85 people are usually much more sedentary, they're not going to be travelling, their costs are going to be more regular and so it's a great fall-back to give them that peace of mind," said MacDonald.

The second change in annuity rules involves pooled retirement plans and defined contribution pension plans. With most of these plans when people get to retirement the money comes out of the plan and the retiree has to deal with it themselves.

Under the new scheme, people in these plans can buy a VPLA directly from the plan. Like a traditional annuity, VPLAs provide income for life, but that income is variable because the size of the payments is still dependent on the markets.

Risk is pooled

However because of the pooled nature of the VPLA's investments and because of that mortality credit where the funds of those who die are pooled with those who live longer, VPLAs tend to be much more stable than individual investments.

VPLAs have been allowed in Canada in the past, but the government changed the rules in 1988. The University of British Columbia has had a VPLA option since 1967, and it is still offered now because it predates the rule change. UBC's is believed to be the only VPLA option of this type in the country.

"It just makes sense," said Debbie Wilson, director of pensions at UBC.

"Otherwise once [plan members] are in retirement, what do they do with this pot of money? They're kind of left on their own."

Income from UBC's VPLA is also higher than it would be with a corresponding amount in a traditional annuity, Wilson says, because UBC's plan isn't tied to interest rates like annuities offered by insurance companies. Rather, it's invested in the university's own balanced mutual funds.

And even though that income may fluctuate, it will always be there.

"We are guaranteeing a lifetime pension. So if they live to be 100, we're paying them until 100," she said.

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