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Wednesday, March 29, 2017

The Missing Piece in Retirement Planning

Posted by Robert on January 10, 2011

This is a guest post by Robert, who lives in Calgary and works as a financial adviser. He is married, has three kids and plans to retire at age 35.  Robert and his wife then plan to return to school and become teachers, eventually living and working overseas.

I occasionally have people ask me, usually in the context of financial planning, “So, how much do I need to retire?” I’m tempted to give the easy answer: $1 million, but that wouldn’t be honest. Instead, I always start my answer with: “It depends.” That probably feels like a cop out, but it’s entirely true.

How much do you spend in a typical year? This varies greatly from person to person. If we assume that a couple owns a home and has no mortgage, they can probably live on anything more than $1500 per month. And most people could realistically spend as much money as they have available. This question is almost always ignored in discussions about pension reform. Much hand-wringing attends headlines such as: “Canadians not saving enough for retirement,” or “2 out of 3 boomers worried about retirement.” How do we know how much Canadians will spend in retirement? My answer is that we don’t, since we haven’t asked them.

What will you do with yourself in retirement? Do you want to spend as much in retirement as you do now? Will you spend less on clothes, lunches and gasoline/transit by not going to work? Will you spend more on hobbies, social clubs and travel? In retirement, some people will spend significantly less. A rule of thumb sometimes used in financial planning is that 70% of pre-retirement income is adequate. That may be true, but some people may prefer to save more and spend significantly more.

How do you invest your savings? Whereas most people I’ve spoken with have little idea of how much they spend in a given month and many have never thought seriously about what their ideal retirement lifestyle will cost, most of them can tell you how they invest their savings. Some buy only GICs, and can expect less growth than those who invest in a mix of bonds and stocks (or mutual funds) and a different level of income (and part-time work) than those who invest in real estate. Investment choices dictate the level of return that can be expected and the amount, dependability and taxation of income available in retirement.

How long will you live? This is the hardest question of all, with no answer. If a retiree knew he would only live 12 months after retirement, and I’ve heard a number of stories where this was the case, he would blow it all. On the other hand, if a retiree expected to live past age 100, she would have more savings and be more conservative with her spending plans. Since we can’t know, we can only plan to never run out of money, then design a will to handle our excess assets, just in case.

Let’s look at a quick example. A couple wants to retire with $3000 per month of income (not including . We’re planning that this income will last as long as they live, so they require a sustainable withdrawal. They will have roughly equal income, or $18,000 per year each. This will attract almost no taxation. Suppose they invest in only dividend paying stocks, with a current yield of 4%. They plan to live on the income, without realizing capital gains except as a backup plan. $36,000 (total annual income) is 4% of $900,000, so that’s how much this couple will need to retire.

In the end, it doesn’t matter whether a person wants to retire at 65 or 55 or 45, if you want your income to last indefinitely. First, decide how much the ideal retirement lifestyle will cost. Next, determine how retirement funds will be invested, and plan a withdrawal rate accordingly. Then it should be a simple matter to find out how much capital is require to produce the desired amount of income. How much do you need to retire? If you don’t know, it’s probably $1 million.

Comments

11 Responses to “The Missing Piece in Retirement Planning”
  1. dlm says:

    Or if you had $700,000 in GICs hoping for 5% = $35,000. And how much can you deduct from the investment amount necessary for CPP, OAS, and other pension income?

  2. Traciatim says:

    In your example is that 18K per person per year without CPP/OAS?

    The average CPP payment monthly is 504.50 (say 500) and the average OAS is 490.47 (say 500) plus the allowance if their other income is so low of 390.15 (say 390). So they already have 1390 and will only need 110 per month per person of supplemental income, or 2640 per year. Just to be safe lets say they need 3K, or at a 4% withdraw rate they need $75000.

    It doesn’t seem so hard to retire comfortably as long as you own your own home and it’s paid off when you plan to retire. This is especially true if you don’t want to leave an estate to your family when you die, you could simply save nothing, reverse mortgage your house when you retire and invest the proceeds to create the income you need on top of your regular government payments.

    If it is really that incredibly easy to retire fairly comfortably how come so many people have problems with it?

  3. Robert says:

    dlm, The tricky thing about GICs and bonds is “reinvestment
    risk” (as you’ve implied), or not knowing what the interest rate
    will be when your GICs mature and it’s time to roll them over.
    Currently, I believe GICs are paying under 5% and I think that’s
    been the case for the last 3.5 years. The best way to find out your
    CPP entitlement is to inquire from the government. You can find the
    maximum and average benefits here:
    http://www.sdc.gc.ca/en/isp/pub/factsheets/rates.shtml (Retirement
    Pension at 65) For OAS, most Canadians will receive the maximum,
    found here: http://www.sdc.gc.ca/en/isp/oas/oasrates.shtml Also, if
    your income is from an RRSP (or similar) or interest in a non-RRSP,
    don’t forget to deduct taxes. Remember, too, that OAS won’t start
    before age 65 and CPP estimates are given for age 65. Here’s an
    example using your numbers (assuming age 65): Net spending money
    required: $2500/month. Suppose $900/mo CPP + $500/mo OAS. Net
    income required: (2500-1400=) $1100/mo or $13,200 per year + $5,000
    per year for taxes for $18,200 per year required (instead of
    $35,000 in your example). At 5% interest, this reduces the required
    capital to $364,000.

  4. Robert says:

    Traciatim, Rereading the example in my post, I see that I omitted the words “(not including”… CPP + OAS. Thank you for pointing that out. Personally, I believe if my house were paid off, I could spend well under $3000/mo + CPP each + OAS each = $5000/mo. But, as I pointed out, we can’t assume what someone’s lifestyle should be.

    If a couple were to save nothing for retirement, but each earning the CPP benefit you mention ($500/mo) and they had their house paid for, at age 65 they should receive:
    $500 CPP x 2 + $500 OAS x 2 = $2,000/mo = $24,000 / year. The GIS allowance ends after a couples income reaches $21,000 (http://www.servicecanada.gc.ca/eng/isp/oas/tabrates/tabmain.shtml), so it wouldn’t pay anything. Still, there would be no taxes owing and a reverse mortgage as a backup plan. For someone with little desire to travel or eat out, this could be easily adequate.

    I agree that it shouldn’t be so hard to retire, and that’s why I question the government’s hand-wringing about Canadians not saving enough. I guess what is hard is: living within your means, paying off your debt, and living on a fixed income from age 65 for as many as 30 years.

  5. Traciatim says:

    I thought OAS wouldn’t be included in the GIS calculations only pension or other income (so CPP). If they are both receiving average CPP They would have 12K of income, making their OAS 711 per person or 1422 combined. That makes their annual income (500 + 500 + 711 + 711) * 12 = $29064 . . . still essentially tax free. With no house payment that seems like it would be fairly comfortable living, much better than I’m doing currently (since I have a mortgage, kids at home, need a business wardrobe, pay CPP/EI . . . etc). Plus the income will be inflation adjusted unlike the withdrawal rate of personal savings making it quite a bit more valuable.

    The more I look over the numbers and what’s available (since my father retired this year I’ve been doing lots of reading for him) I find that I’m more than comfortable eventually owning my own home and having my company matched 6% going in an RRSP. If just those two items work out over the next 35 years I seem to think my family should be able to retire quite well.

  6. Robert says:

    Traciatim, Thanks for pointing out that OAS isn’t included in the GIS calculation. It’s a good day when I learn something new. You make a very good point, but one that I hope not too many people will take to heart: Canadians are very well cared-for by their government in old age. I think we should still plan to sustain ourselves when we plan to stop working, and just rely on the government benefits as a backup plan. Who knows what will change in then next 30 years?

  7. George says:

    If you had to go into a nursing home, or otherwise couldn’t live in the reverse mortgaged home, then doesn’t the home revert to the holder of the mortgage?

  8. Robert says:

    George, You’ve pointed out a problem with relying on a reverse mortgage. What would happen in your example, I believe, is that the house would be sold (like normal), with the equity available to the owner AFTER the balance and interest of the reverse mortgage are paid.

    Most of the people I work with have their investments and (possibly) pension including government benefits as Plan A. Equity in the house is Plan B. That way, if you go into a care home, the sale of the house should be able to fund the care, even if assets are inadequate.

  9. Like Traciatum above, I’m also starting to think of the benefits of the “Die Broke” philosophy – mostly because I’d really far prefer to help my kids out when they’re 30 and not when they’re 60 or 70 and don’t need my help – and I’m dead.
    I’m not banking on NO social security, since that’s not realistic but I believe it will be reduced somehow whether that’s bumping up the age requirements, reducing the benefits…
    But as time goes by too, I’m finding it hard to believe I’d ever not want to work at all – at least not for extended periods of time. And given the longevity and health in most of my family, I could be like my dad and still working in my late 80’s. :-O

  10. carbonwatcher says:

    While I find it easy to think about 2 retired people living on $30,000 (with house owned), I find it much harder to think about one person living on $15,000. There is a great chance that one of two people will die younger than the other, leaving the other to live alone. For women (who tend to live longer), especially those who have male partners that are older than them, … this could mean many years of hardship and needs to be a scenario considered.

  11. Robert says:

    carbonwatcher, You make an excellent point. OAS ends, but there is a CPP survivors benefit (http://www.servicecanada.gc.ca/eng/isp/cpp/survivor.shtml) and GIS may pay something from age 61 – age 64. This is a good reason to plan to care for yourself, with government benefits as either a piece of an entire plan or as a backup plan.

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