Longevity Risk and Retirement Income Tax Efficiency: A Location Spending Rate Puzzle

Abstract

We document the pattern by which Canadians de-accumulate financial wealth during retirement – and find it rather puzzling. While the Modigliani lifecycle model can justify a variety of de-accumulation or draw down rates depending on risk preferences, the existence of asymmetric taxes imply that certain financial accounts should be depleted faster than others. Yet our analysis of data from the Survey of Financial Security indicates that Canadian retirees maintain approximately two-thirds of their financial wealth in tax-sheltered accounts and a third in taxable accounts throughout retirement, regardless of age. The ratio of taxable to tax-sheltered wealth increases slightly or remains relatively constant depending on household income which is not what one would expect from the lifecycle model. And although these are population averages, we use this empirical evidence as motivation to model and solve a retirement consumption problem under longevity risk aversion with differentially taxed accounts. Indeed, we can’t locate a plausible tax function that justifies a constant “account ratio” regardless of age. For example under flat rates taxable accounts should be depleted well before tax-sheltered accounts are ever touched. The account ratio should go to zero quite rapidly in the absence of government mandated withdrawals. We also demonstrate that under progressive income taxes withdrawals are made from both accounts but at different rates depending on account size, pension income and longevity risk preferences. Again, the “account ratio” should eventually decline. The fact that (Canadian) retirees don’t optimize location-spending is puzzling and likely due to behavioural considerations linked to mental accounting, etc. It remains to be seen whether retirees in other countries exhibit the same behaviour, or perhaps they are less emotional with their taxes.

Keywords: Personal Finance, Portfolio Choice, Investment Decisions, Optimization Techniques

JEL Classification: G11, D14, C61, G22, D91