We talk of retirement when you put away your cares and worries, kick back and enjoy the wealth you’ve worked so hard to accumulate over the years.
Retirement for many is an exercise in calculating odds and balancing one probability against another. Should we go on vacation? Or should we stay at home because we need the money years from now to pay for a nursing home? Should we invest aggressively to increase our chances of growing our nest egg? Or play it safe and take as few chances as possible?
The problem is that we are living longer with new technologies and drugs thus increasing our life span. Back in the 1920s, a newborn Canadian could expect to live for less than 65 years. Today, a baby born in Canada can expect to live to 84, that is a 19-year difference and means more money is needed. Our parents and grandparents didn’t spend a lot of time thinking about retirement! Why? They had a pension plan that would take care of them. Well we all know where those pension plans are going, in many cases they no longer exist or have been taken away as cost saving measure for the employers. Meaning you now have to budget and plan for those years after retirement.
A lot can go wrong over time, we don’t have a crystal ball to predict the future. Even if you set things up perfectly for a nice retirement, fate has an odd sense of humor. After years of planning, you may die young—or live long, long past your best before date.
Most people do believe they will live to life expectancy. What you need to know is the average life expectancy is just the median in a huge range of possibilities that the actuary calculates on your behalf.
Life expectancy figures are usually expressed in terms of what a newborn child can expect. It assumes there will be a steady number of deaths at every age along the way—a few people will die in childhood, a few others in adolescence, and so on. Those early deaths drag down the overall figure. So if you’ve dodged disease and accidents and made it to 65, your life expectancy is considerably greater than the average for a newborn would suggest. Someone who is 65 today has a better than even chance of living to 84 and past.
The problem, from a financial perspective, is that there are no guarantees. A 65-year-old man who retires today faces an 10% chance of dying before he turns 70. He also faces the same 10% chance of living past 95. So how do we plan for that discrepancy?
So what if our 65-year-old man may expect to die relatively young. He may burn through his cash and treat himself to lots of expensive indulgences— only to find that, Oops, he has to live the last quarter century of his life trying to make ends meet on a meager budget.
On the other hand, he could play it safe and save his money to ensure he will have enough to last until he meets his maker in years and years to come. But finds himself in a hospital bed at 68 or 69, with a life threatening diagnosis, and cursing because he did not enjoy life more when he had the chance. We all know someone who was waiting to retire to go out and explore and they never made the trip.
So how must you approach retirement?
A smart approach is to think of your retirement plans as consisting of two separate figures: one for things you must have, the other for things it would be nice to have.
The first and most important part of retirement planning is taking care of things you must have. You want to ensure you have enough to live on without feeling deprived of anything vital.
You can estimate this figure by adding up how much you spend in all areas, then deducting the expenses that will disappear in retirement— no more mortgage payments, no more child care or tuition payments, no more retirement savings. You should also deduct any luxuries that you could live without in retirement, such as eating out frequently or having a second car.
The amount that’s left represents what it would cost you to maintain the essentials of your current lifestyle in retirement—and that figure is probably a lot lower than you think. Most middle-class couples are delighted to discover that they arrive at a must-have figure that amounts to just $40,000 to $50,000/ couple a year in after-tax income.
What will you do in retirement?
We all have dreams and you need to budget for them. Maybe you want to golf every day, or winter down south. How much will it cost to retire with these dreams? Figure that out as the second part of your budget for retirement planning.
Remember when assessing your dream list, age takes its toll. Right now you may dream of travelling all the time. Once you’re past your early 70s, however, the lust to travel maybe diminished. Similarly, you may find that golfing every day is no longer a pleasure once you’ve hit 75. So might I suggest when budgeting for luxuries, it may make sense to set a larger budget for your early retirement years, and a smaller one for the later years.
Will the Government contribute?
Yes Canada Pension Plan (CPP) will be around for a while to come. Old Age Security (OAS) will also be around, although OAS benefits have been delayed until age 67 for those born after 1962. If you’ve worked in Canada all your life, you and your partner are each eligible to receive approximately $18,000 a year from those two sources, this will depend on what you earned during your working years, and how early you start collecting your pension. You can start collecting reduced CPP as early as age 60. That money will keep pouring in as long as you live, with no particular planning required on your part.
You should compare what government will provide you with and what you figure your minimum retirement needs will be. If you and your spouse estimate you can maintain the needs parts of your current life, of $50,000 a year, the good news is that retirement becomes a very affordable proposition. You and your partner may have to add only $32,000 a year in after-tax income from corporate pensions or savings to ensure the key components of your retirement plan.
Pensions and RRSPs
You may be fortunate enough, if you’re a public servant or work in the right industry, to be the recipient of a defined benefit pension. If so, you can simply contact your employer’s human resources department to find out the size of the monthly retirement cheque you can expect.
If that amount is enough to bridge the gap between government stipends and your retirement needs, then congratulations—your retirement planning is largely done. You may still want to contribute to an RRSP to finance luxuries, to provide you with a buffer against inflation, and to guard against the possibility that your employer will go bust and renege on its pension promises, but, in all probability, those contributions will simply increase your security, not determine your retirement lifestyle.
Maybe you don’t have a pension plan. Or perhaps your employer’s pension plan is a defined contribution plan that only promises how much your employer will contribute each year you work, but leaves the actual investing up to you. Or maybe your employer’s defined benefit payouts aren’t enough to bridge the gap between government pensions and what you need. In any of those cases, you’re going to have to deal with uncertainty.
What is your risk tolerance?
No portfolio, though, can guarantee a given return. What makes planning during retirement so difficult is that you’re drawing down your portfolio at the same time as the markets are moving up and down. The first few years of your retirement are particularly crucial. If you have the bad luck to retire at just the moment that the markets head into a bear market plunge—as they did in late 2008— your withdrawals combined with market losses could put a hole in your portfolio from which it will never recover. On the other hand, if you retire at the same moment the markets decide to go on a tear, the surging market returns may more than cover your early withdrawals. You may actually end up increasing your net worth in retirement. Unfortunately, this is something you can’t control.
If you want to make your money last for 30 years, count on withdrawing no more than 5% of its initial value each year, adjusted for inflation. You should begin your retirement by withdrawing $5,000 a year for each $100,000 you start with. If inflation were running at 2% a year, you would withdraw $5,100 the next year, $5,202 the following year, and so on.
The 5% figure comes as a shock to many people, who assume that they can count on their portfolio for 10% or more in the way of annual payouts. At such an aggressive withdrawal plan you would need to assume more risk in your portfolio to make up for any shortfall that may happen during the retirement years. This may not be advisable, as you would have to time the market well to support a continued 10% rate of return.
You will require balance.
Here’s where individual preferences become important. While a 5% withdrawal rate gives a well-balanced portfolio an excellent chance of surviving 30 years. Chances are that things will turn out better than the worst case scenario. If they do, you will be leaving behind a small inheritance. Your heirs will no doubt like this arrangement, and if you want to leave them something, that’s fine—but it’s probably not the optimal deal for you. In fact, if you apply the 5% withdrawal figure to your entire portfolio, you’re probably living on a lower income than you could during your retirement years.
An alternative idea is to treat the needs and wants of your portfolio in different ways. When it comes to your needs portion, play it safe and count on a 5% withdrawal rate. If you calculate, for instance, that you’re going to need $30,000 a year on top of CPP and OAS to provide you with the necessities, you should accumulate at least $600,000 in RRSP savings, or the equivalent in corporate pension plans. That $600,000 should be able to fund an inflation-adjusted withdrawal rate of $30,000 for as long as you live.
If you don’t want to worry about the volatility of the market, you can use some of your needs savings to purchase an annuity that will provide you with a guaranteed payout for the rest of your life. Be sure to compare annuities from different companies to get the best possible deal. Look at all the different options available—some annuities pay your heirs a lump sum if you die early; some are inflation-protected; some cover both you and your spouse.
Once you’ve built a fortress around the needs component of your portfolio, you can treat the wants portion with more freedom. You can and should plan to run through a chunk of your wants budget in the early years of retirement, when you’re going to be most active. By the time you turn 75, your appetite for luxuries is likely to diminish, and by the time you hit 85, many of your discretionary expenses will have dropped away completely. If your wants money is running low at that point, so be it—you will have extracted maximum value from your wants money when you were still healthy enough to enjoy it, while protecting your future by ensuring that your needs are well covered.
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Note: The numbers used in this illustration are for the purpose of easy calculations. We do not suggest that these numbers are hard facts but just guidelines to show you how you should think about your retirement and accumulation. The value of your portfolio is directly related to how much you want to save and what your needs and wants will be in the future.