MoneySense Magazine, May 2009
Save your retirement
Our 10-step program will repair your portfolio and ensure your money lasts as long as you do.
This article was first published in the May 2009 issue of MoneySense.
The past few months have shattered retirement plans. Crashing stock markets, mounting layoffs and falling home prices have devastated the nest eggs that many of us were counting on to finance our golden years. Whether you’re 35 or 65, it’s natural to wonder if the old rules of retirement still apply. After what we’ve just been through, how can an investor ever trust the stock market again? And how can those on the verge of retirement or already in retirement manage to extract a living income from portfolios that are now worth a third less than they used to be a year ago?
We know how you feel — but the picture is brighter than you think. Relatively minor adjustments can help resuscitate your portfolio and squeeze more from your retirement dollars. You’re already familiar with many of the classic retirement-boosting tactics — like cutting out a latte a day to save money, or switching to low-cost mutual funds to boost your investment returns — but there are new tactics to consider as well. Annuities, for instance, are attracting growing attention as a way to boost your cash flow in retirement. Tax-Free Savings Accounts provide a new channel to bolster your retirement savings. And many investments, such as corporate bonds, look more attractive than they have in years.
We’re not saying that overhauling your retirement plans is easy. “It puts real strains on people to make that kind of decision,” says Bill VanGorder, chair of the Nova Scotia chapter of CARP, which represents older Canadians, and who himself has gone back to work to repair his reduced savings. But if you stay calm and take things one step at a time, you can still look forward to a long and prosperous retirement. To help you along the way, we’ve distilled the best of old and new wisdom into what we call the 10 rules of retirement — revised edition.
Count your invisible blessings
Stocks and real estate have taken a beating over the past year, but the true value of all your assets is greater than you think. That’s because it’s easy to overlook your invisible assets. Many people, for instance, don’t realize the value of a workplace pension. Many people also underestimate the value of their skills and how much those skills can generate after they retire from a full-time job.
We’ll talk more about both of these assets later in this article, but for now let’s focus on the biggest invisible asset of them all. We’re referring to government pension plans, including Canada Pension Plan (or its Quebec Pension Plan equivalent) and Old Age Security. You’re entitled to a CPP or QPP pension in your old age if you’ve worked in Canada as an adult. You are entitled to OAS simply by virtue of having lived in Canada for a substantial period.
These government programs deliver far more than many people expect. If you’ve worked your entire adult life in Canada and retire at 65, you can count on CPP and OAS to pay you a combined total of as much as $17,000 a year in retirement, fully indexed for inflation. Both programs appear to be financially sound for decades to come.
Government stipends cover a surprising amount of your basic living costs in retirement. Assuming that your house is paid off and your kids have moved out by the time you quit work, most of us can live comfortably in retirement on 50% to 60% of what we were used to earning while we were still working. For a typical middle-class Canadian, CPP and OAS provide a solid down payment on a comfortable retirement.
Master the art of the drawdown
Take out too much from your savings in retirement and you run the risk of running out of money before you die. Take out too little and you deny yourself for no reason. (Although your heirs may appreciate the big legacy you leave behind!) If you want to enjoy a stress-free retirement, no decision is more important than deciding how much you can safely draw from your portfolio each year.
How much is just right? Over the past few years, researchers such as William Bengen, a U.S. financial planner, have examined stock market history to determine a safe withdrawal rate. The researchers have concluded that a standard balanced portfolio of stocks and government bonds should be able to safely support a 4% drawdown rate. That’s assuming you retire at 65, live for 30 years, and adjust your withdrawals each year to keep up with inflation. So if you have a $100,000 portfolio, and inflation is running at a steady 2% a year, you can withdraw $4,000 the first year, $4,080 the next, $4,162 the next, and so on, until you finally keel over at 95.
Many people naively assume that the safe drawdown rate should be far higher than 4%. Until quite recently, it was quite common to see planners recommend a 6% or even 7% rate. But while there are ways to boost your drawdown rate to 5% or so (we’ll examine one of those ways in just a minute) a rate that creeps much higher can leave you penniless in your old age. You’re particularly vulnerable if you’re unlucky enough to retire just as the market implodes. If you then insist on aggressively drawing down your already diminished portfolio, you may run out of money before the market finally turns around. To avoid such a calamity, the 4% recommendation is designed to let you safely ride out the most severe market drops— even one as bad as the past couple of years.
Of course, it always helps to build in an even greater margin of safety. Allan Webb (whose name we’ve changed) plans to draw down only 3% a year (plus inflation adjustments) from his portfolio when he eventually retires. “It’s probably a conservative figure, but when you’re faced with the decision to give up your employment income, I think you had better be pretty conservative,” says the 60-year-old businessman in Kelowna, B.C.
Meet the new investment in town
Worried about outliving your money? Then it may be time to look into annuities. While these financial products have been around for a long time, they have only recently become central players in middle-class portfolios. Used properly, annuities offer two big benefits to retirees: they provide you with peace of mind and they help to boost your safe drawdown rate.
You can think of an annuity as a do-it-yourself pension plan. You buy an annuity from an insurance company; you then receive regular payments until the day you die. Moshe Milevsky, professor of finance at York University’s Schulich School of Business, says annuities can allow you to increase your safe drawdown rate from 4% a year to at least 5% because they provide a guarantee that you won’t outlive your money. As a result you can draw on your nest egg more aggressively, including the payments you receive from your annuities plus withdrawals from the rest of your portfolio.
Milevsky suggests you add annuities gradually to your portfolio between the ages of 65 and 75. By the time you hit 75 your portfolio should be roughly one third stocks, one third bonds and one third annuities. Just one note of caution: annuities are complicated products, with fees to match, and new versions are being introduced all the time, so seek out independent advice before buying.
Think Freedom 68
The simplest, most risk-free way of replenishing your battered nest egg is to work two or three years longer than you may have planned. “It’s a lot more powerful [strategy] than many people think,” says Steven Sass, associate director of the Center for Retirement Research at Boston College.
Each added year of employment benefits you in at least three ways: it gives your beaten-down investments a chance to recover, it reduces the number of years you have to live off those investments, and it can increase the income you receive from pensions. (Among other things, your CPP payments increase 6% a year for each year you delay taking payments up to age 70.)
Few people look forward to working longer, but prolonging your working life doesn’t have to be torture, either. VanGorder, the CARP chairperson in Nova Scotia, says he went back to work almost full time to help make ends meet after the market meltdown burned a hole in his mutual fund portfolio. The 66-year-old Halifax resident regrets not being able to devote as much time to woodworking, community theatre and travel as he had planned, but he enjoys his new job as a business development manager for a human resources company. He thinks he’ll continue working at least another five years. (For more on the pros and cons of working longer, see Reward Years on page 14.)
Make the most of your pension
Many Canadians ignore their workplace pensions and that’s a big mistake. By the time you’re in your fifties, your pension may be worth more than your home. In many cases, it constitutes your biggest single asset. So there’s no time like the present to learn more about it.
The most common type of company pension is what is known as a defined contribution plan. In these arrangements, your employer contributes a predetermined amount to your pension, but you have to choose where to invest that money from among a menu of options. Losses fall squarely on your shoulders and your employer isn’t on the hook to make up any shortfalls in your retirement plans that result from falling stock prices or your own bad decisions.
If you have a defined contribution plan, make sure that you’re getting the most from it. Some plans are based on the notion that your employer will match any contributions you make up to a certain limit. Given the tax advantages of contributing to a pension plan, and the free money from your employer, it’s nearly always worth your while to contribute right up to the limit.
But remember to diversify your investments. This reduces your risk and can boost your return. If in doubt, put roughly half your money in a mix of Canadian and foreign stocks, and the other half in bonds. This is a standard allocation that is suitable for just about anyone. Some pension plans also offer you the option to invest in so-called target date funds. These funds attempt to tailor your mix of assets to the year you plan to retire. You simply pick the fund with the target date closest to your expected retirement — 2015, say — and the fund does the rest, gradually reducing the risk in your portfolio as you get older.
While defined contribution plans are becoming the norm in the private sector, a fortunate minority of Canadians still enjoy what’s known as a defined benefit pension plan. These plans guarantee you a set payout every month when you retire. The payout is based on what you are earning near the end of your career and it isn’t tied to stock markets or interest rates. In defined benefit plans that are 100% employer-funded, your employer shoulders all the risks involved in financing the plan and undertakes to make the payments no matter how the market performs. For employees, it’s the ultimate in peace-of-mind arrangements.
If you’re lucky enough to have a 100% employer-funded defined benefit plan, the only thing you have to worry about is the prospect of your employer going bust— but even then, the news isn’t all bad, says Brian FitzGerald, an actuary with Capital G Consulting Inc. and co-author of The Pension Puzzle. If your employer does go out of business, your pension might be reduced, but by no more than an amount proportional to whatever shortfall exists in the plan.”The important thing is that if your pension plan is 15% to 20% underfunded and the company goes bankrupt, you haven’t lost all your pension,” FitzGerald says. “You can lose something but you don’t lose everything.” Pension assets are held in a trust separate to the company’s own funds, so the company can’t dig into it when they’re trying to stave off bankruptcy,” he says.
Supercharge your savings
If you’re 50 and still haven’t started saving for retirement, don’t lose heart. You can still save enough for a comfortable retirement, even if you don’t have an employer pension. The key is to pay off your house as soon as possible and get your kids through school — then to save with a vengeance in your 50s and early 60s.
Making this plan work depends on your ability to rechannel into savings the money that you previously spent on mortgage payments and your kids. Since this was never money that supported your lifestyle anyway— it used to go to the bank and your kids — you shouldn’t miss it. So long as you enjoy at least 10 years of supercharged savings before retiring, you can accomplish a tremendous amount.
Consider a 55-year-old couple that together earns $100,000 a year. If their house is paid off and their kids have left home, the couple should be able to save up to 40% of their income, or $40,000 a year, before retiring at 65. By that time they should have at least $400,000 (in todayâ€™s dollars) in their retirement portfolio. If they count on that to provide $16,000 a year and each receives $17,000 a year from CPP and OAS, they will enjoy a respectable retirement income of $50,000 a year — and that’s starting from zero, with not a penny saved at 55.
Actual amounts will vary with each person, but the important point to remember is that you have to make the most of your personal “sweet spot” when major expenses are paid off, but you’re still earning a high income — to sock away as much as you can. “We’re in our peak years of savings and really trying to take advantage of it,” says Peter Richardson, 57, of Mississauga, Ont. He and his wife Susan, 62, (whose names we’ve changed) live mainly on Peter’s $85,000-a-year income. Yet they’re saving about $25,000 a year and expect to bump that up to about $35,000 a year when the younger of their two daughters finishes university in two years.
Peter and Susan have paid off their home. They also have a mutual fund portfolio that was hard hit by the market crash and has shrunk to about $250,000. But Peter sees a silver lining in the timing of the crash. “Being in my peak savings years I do have the opportunity of putting fresh money into the market at lower stock prices, when it’s at the beginning of the growth cycle,” he says. So long as he can remain employed for the next seven or eight years, he’s confident his portfolio will swell in value.
Confused about where to invest these days? You’re not the only one. GICs, government bonds and money market funds provide only paltry returns. But after the recent market massacre, it’s difficult for most people to even contemplate plunging back into stocks.
Maybe you don’t have to. If you still have a mortgage, your best investment is probably right under your feet. Bumping up your mortgage payments and paying off your house more quickly provides an after-tax return that few stocks or bonds can match.
If your house is paid off and you want to build your portfolio, it pays to take a long view— the longer, the better. Nobody can predict what the next couple of years will hold. But over periods of a decade or more, a balanced portfolio composed of roughly half stocks and half bonds has always done well. Such a mix typically produces higher returns than an all-bond portfolio, but less volatility than an all-stock portfolio. So if you find yourself with a portfolio that is nearly all bonds or GICs, now may be a good time to start slowly edging back into stocks. That’s what Allan Webb is doing. At 60, the B.C. businessman has about 30% of his nest egg invested in stocks and plans to slowly raise that to 50%. “Prices are reasonable and I feel there will be reasonable gains,” he says.
If you still have qualms about stocks, consider investing in a mutual fund or exchange-traded fund (ETF) that invests in corporate bonds. You can find many bonds issued by high-quality companies that are yielding more than 6%. “In our view this is probably a generational opportunity for high quality corporate bonds and provincials and federal agency bonds,” says Scott Lamont, head of fixed income at Phillips, Hager & North Investment Management Ltd., and manager of the firm’s bond fund, a top-rated performer on the MoneySense Best Mutual Funds Honor Roll. “The reality is you don’t have to go very far down the credit quality spectrum to get attractive yields.”
As an example, Lamont points out that, early this year, five-year bonds issued by the big Canadian banks were yielding more than 6% — more than four percentage points above Government of Canada bonds of equivalent term. That’s an unusually high premium for investing in some of Canada’s biggest companies. If you’re interested in raising your exposure to corporate bonds, visit www.moneysense.ca and look up our 2009 Honor Roll of top-rated bond funds. For a low cost way to invest, check out exchange-traded funds that invest in this area such as the iShares CDN Corporate Bond Index Fund (TSX: XCB).
Learn a new acronym
Saving for retirement is seldom easy, but Canadians just got another good reason to try. This year the federal government introduced Tax-Free Savings Accounts (TFSAs), which allow your money to grow tax free, just as it would within an RRSP. Otherwise, though, a TFSA is the mirror image of an RRSP. With an RRSP, you earn a tax rebate for your contributions, but have to pay tax when you take money out. With a TFSA, you get no tax rebate when you contribute money, but you pay no tax when you take money out. Anyone 18 or older can contribute up to $5,000 to a TFSA in 2009.
TFSAs are a boon for couples like the Richardsons of Mississauga, who are in their peak savings years and can benefit from both RRSPs and TFSAs. Peter contributes the maximum of about $13,000 to his RRSP, and also this year contributed $5,000 each to TFSAs for both himself and Susan. “I need to protect everything I possibly can from taxes, so I can save as much as possible and have the growth tax free,” he says.
Ideally you have enough money to follow the Richardsons’ path and contribute to both an RRSP and TFSA. But if you have limited funds, you will have to figure out which plan will offer you the greatest benefit. The answer depends on how far away your retirement is, and what tax rate you’re paying at the moment.
If you’re not going to retire for at least a decade, and you are in a fairly high tax bracket, itâ’s hard to argue with the tax rebate that goes with contributing to an RRSP. You will have to pay tax when you eventually take the money out of your RRSP in retirement, but you will probably be in a lower tax bracket at that point, so the rebate you get now looms larger than the tax you will pay in the future.
On the other hand, if you’re in a low tax-bracket, your first choice should be your TFSA, since you’re not paying much in tax anyway and don’t benefit as much from the RRSP tax rebate. A TFSA should also be your first choice if you think you might have to tap into your savings over the next few years— if you withdraw money from your TFSA, you pay no tax, while RRSP withdrawals are fully taxable.
People over the age of 60 should pay particular attention to the TFSA versus RRSP question. RRSP withdrawals count as income, so, if you’re a low-income senior, taking money out of your RRSP after age 65 can reduce the Guaranteed Income Supplement you would otherwise collect. If you’re a high-income senior, RRSP withdrawals after age 65 can push your income past the threshold ($66,335 for 2009) where government starts to clawback your OAS.
Money withdrawn from a TFSA isn’t counted as income, so it doesn’t pose the same problems. And as a senior, you can keep your TFSA intact — and even contribute to it further — long after you have to start drawing down your RRSP funds at 71.
It’s easy to be discouraged by the dismal economic climate, but odds are that you have more room to maneuver than you think. Your first step should be to look at how you live and ask yourself if you can spend less. Substantial savings can come from small economies— fewer restaurant meals, more modest vacations — but the easiest way to make a big difference is to cut out a major expenditure. Maybe you and your spouse can get along with one car instead of two. Perhaps you can free up cash by selling your home and moving somewhere cheaper.
That’s what Linda Anderson, 63, and her husband did three years ago, when they sold their Vancouver-area townhouse and bought a home in the Kootenay region of B.C. The $30,000 they netted from the sale and purchase of the homes was a big boost to their savings, which now stand at about $240,000. Thanks to the generally lower cost of living in their new location, as well as the savings generated by getting rid of one of their two cars, Anderson (whose name we’ve changed) was able to retire immediately. (Her 60-year-old husband continues to work as a warehouse supervisor.) They’ve made new friends in the Kootenay area and are quite happy with their new home town. “I’m quite an adventurer so it doesn’t bother me to move away,” says Anderson of the relocation.
If you’re a real adventurer, there’s an even more extreme way to magnify the buying power of your pension: move to a low-cost country. Mexico, Panama and Malaysia are just some of the destinations where the low cost of accommodation and food allows you to live well on a modest stipend. (To see a sampling of what’s available, read “Endless summer” from our January 2008 issue.)
Moving abroad isn’t for everyone, but simply knowing the option is there may open your eyes to other possibilities for changing your life right here in Canada. You could launch a small business in retirement, draw on your home equity through a reverse mortgage, or open up a new source of income by renting out part of your home. None of these decisions should be undertaken lightly, but, taken together, they demonstrate a simple truth: you always have more options than you think.
Remember: It’s all relative
You might feel glum at the thought of the money you lost in the stock market. Remember, though, that most people— including most of the experts — lost just as much. So while your net worth may have shrunk, you are probably just as well off, relatively speaking, as before. If you measure your success by how well you’re doing compared to others, nothing has really changed.
So long as you have enough money to cover your basic needs, most retirees find that having more money has little effect on happiness. That’s not just folk wisdom, that’s research. “For most retirees, money is important, but the extra impact on happiness isn’t nearly as important as a whole host of other things,” says Keith Bender, associate professor of economics at the University of Wisconsin at Milwaukee. Bender has found that for a retiree of average income, a $10,000 increase in pension income per year increases the probability of being very satisfied with retirement by only one percentage point. What matters more? Good health and good friends.
Anderson and her husband have come to a similar conclusion about what’s important. “When this big crisis hit, my husband started to worry about our financial situation because it started to look like it was going to be a total meltdown. But I said, ‘We can pay off our home. We have the [CPP and OAS government] pensions. We may not be able to live in the lifestyle we want. But we have a roof over our heads, food on the table, and our bills paid’” No matter what happens, the Andersons are confident their retirement will be OK. And, in all probability, so will yours.
MoneySense Magazine, May 2009