The Great Pension Experiment – 2019 Update

I parted ways with my previous employer in 2015, which was a significant financial hit because it had a “gold plated” defined benefit (DB) pension. If I had stayed with that employer until I retired, I was on track to receive a pension of $70,000 per year, significantly higher than the average employment income for a male in Canada (see appendix). However, when I did leave, the value of my DB pension only equated to $7,200 per year, about 90% less than what I should have received. Needless to say, this was a huge point of stress for me as it significantly impacted my retirement plans. Notwithstanding the drop, with such a long time horizon, I asked myself: “Is it worth it to take the $600/month salary in 25+ years, or can I do better?” From that question was borne The Great Pension Experiment.

To recap from previous posts, I felt confident that I could earn a better pension than $600 a month, if I started managing my DB pension myself. To “manage” the DB pension meant that I would have to take a lump-sum payout, and invest the money into securities I felt would give me a better rate of return. My strategy was to leverage a variation of the very popular couch potato portfolio to grow my assets, and when I reached the age at which I could withdraw the funds, convert those into an annuity.

For the annuity, I assumed that I would receive a 4% cashflow on the annuity. Reviewing the latest (as of August 2020) annuity rates from Life Annuities, the lowest available annuity provides $391.19 in monthly income per $100,000 invested, which equates to $4,694 per annum or a yield of 4.7%. With that in mind, a 4% payout ratio still seems like a reasonable metric. (If anything: targeting a 4% payout and receiving a higher payout puts us even further ahead). The original DB pension was paying $600 per month, or $7,200 per year. At a 4% payout, that means we need a lump sum of $180,000 to invest into an annuity to break even with the DB pension.

Company Age 60 Age 65 Age 70 Age 75 Age 80
BMO Insurance $440.35 $509.68 $605.15 $693.64 $886.69
Canada Life $418.10 $474.66 $557.80 $676.60 $859.51
Empire Life $407.36 $466.50 $546.67 $653.42 n/a
Great-West Life $418.10 $474.66 $557.80 $676.60 $859.51
RBC Insurance $408.09 $460.90 $539.87 $661.86 $860.85
Sun Life $391.19 $471.91 $565.45 $681.44 $862.72

The original payout of the DB pension was a little under $65,000, which means I need to triple my money over a 25-year timeframe. With that in mind, key measures of success are:

  1. Portfolio income. How much is it currently generating, and what is the probability that we will generate at least $600/month in the future?
  2. Portfolio performance. What is the net value of the portfolio relative to the present value of the pension I would have received, and how is the portfolio performing relative to the professionals?

With those metrics in mind, how are we faring for 2019?

Portfolio Income

The first metric for portfolio income is to review the actual income that the portfolio received. For the 12 months ending October 31, 2019, the portfolio generated $1860 in income, which equates to $155/month – that is 75% less than what my DB pension would provide. However, that $600 won’t be paid for another 21 years, so I have some time to catch up. To that end, when I review the yearly income numbers for my portfolio, the results look promising:

Year Ending Income Growth CAGR Income Growth
2016
2017 11.2% 11.2%
2018 4.8% 8.0%
2019 11.6% 6.4%

With 21 years left, $155/month income at the current CAGR will generate $608 in income. However, that number is based off of the assumption that CAGR will remain at or above 6.4% going forward.

The second metric is to check how much income I could receive from an annuity today if I were to cash out the entire portfolio. The portfolio did well in the year ending October 31, 2019, and if I were to cash it out into a 4% annuity it would generate $3,392 in annual income, or $283 in monthly income. Again, this is a far cry from the $600 I would receive from the DB pension, but it is as of this moment, and I expect the portfolio to grow in value over time; more on that in the performance section.

Those first two measures are summed up succinctly in this graph:

The red line represents the value of the DB pension (i.e. the $600/month) in today’s dollars. That $600 per month in the future is worth a lot less today, so for an accurate measure we should compare the discounted value to what the portfolio is currently generating. With that in mind, the point of success will be when one of the black lines crosses the red line: that means that the income the portfolio is generating (real income in the case of the solid line, or annuity income in the case of the dotted line), is exceeding that of the DB pension.

The third, and what I consider biggest, test to ascertain income in the future is in the use of a Monte Carlo simulation. With this method I run a number of simulations (250,000 simulations to be precise), and see how the value of the portfolio changes over time based on the randomness of expected returns. The reason I do this is that using a historical average is not necessarily the best way to estimate the future value of a portfolio: an average is just that, an average of high and low values. As an example, if the historical average return of a portfolio is 5%, that means that some years it could have lost 2%, but some years it could have gained 12% – the 5% is just that mid-point between the low and high return values. For that reason, we should take into account some variability in portfolio returns. While not the only way to consider this variability, the Monte Carlo simulation is straight forward to implement: we see how the portfolio performs over a given time period (in this case, from 2020 to 2040), make note of the results, do this a quarter of a million times, and then determine what the most likely outcome is based on those 250,000 simulations.

For this year, I used an annual average return of 8.15% and an annual standard deviation of 8.36%. The standard deviation is important because it gives me the effective range around which the annual average is focused. These values were calculated by taking the average returns of the benchmark portfolio from 2005 to 2019.

The results of the simulation are captured in this histogram:

The histogram illustrates the most likely monthly income based on converting the value of the portfolio to a 4% annuity. Reviewing this, the peak (i.e. most likely) scenario is monthly income between $1006 and $1256, based on cashing out the portfolio and purchasing an annuity with a 4% return (which implies a portfolio value between $301,000 and $377,000). If we poke at this a little further, this implies that the probability of generating at least $600 in income is 90%.

Portfolio Performance

The other metric is how well the portfolio is performing, especially against professional fund managers such as my previous employer.

Period Ending TTM Return Since Inception Return OPTrust Returns OPTrust since inception
2016-10-31 5.79% 5.79% 6.00% 6.00%
2017-10-31 12.05% 18.53% 9.50% 16.07%
2018-10-31 (0.91%) 17.45% 1.00% 17.23%
2019-10-31 11.54% 31.00% 11.20% 30.36%

Since I started this experiment, my total return has been 31.00%, vs. my former employer’s 30.36% return – so based on numbers alone I am exceeding what my investments would have made with my former employer.

Summary

Due to time commitments I was unable to do an update in 2018, so the results here are relative to my 2017 update. That said, overall, the experiment to date has been a resounding success:

  • Based on simulations of average returns, the portfolio has an 89% chance of exceeding the income I would have received from my employer
  • The total return of the portfolio is slightly better than what I would have received if I left my money with them
  • To date, the actual and projected income are inline with what I would expect, given the time horizon remaining

This emphasizes the fact that you don’t have to take what is given to you. If you have the patience and the stomach to weather the markets, you have a higher probability of coming out ahead than if you settle for what is given to you.

I am worried about the 2020 update; with COVID-19 the markets have just now started recovering from the massive drops at the beginning of the year, and the dividend income landscape is constantly shifting as companies revisit their dividend policies. However, that will be a discussion for later this year.

Onwards and upwards!

Appendix

Average Income for Males as of 2018

Source: Statistics Canada.

Data inputs:

  • Age group: 16 and over
  • Income source: Employment Income
  • Sex: Males


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