6 Steps to a wealthy retirement

An excerpt from the newly updated MoneySense Guide to Retiring Wealthy on sale now wherever MoneySense sold or buy it online here.

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by Special to MoneySense
June 4th, 2012

Online only.

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Retirement is supposed to be the time of life when you put away your cares and worries, kick back and enjoy the wealth you’ve worked so hard to accumulate over the years.

Well, maybe.

In fact, retirement for many of us is going to be an exercise in calculating odds and balancing one probability against another. Should we treat ourselves to that grand tour of Europe? Or deny ourselves because we may 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?

These are anxiety-inducing questions and, ironically, you can blame that anxiety on the long, healthy lives we’re now living. 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 80. So while our grandparents and great-grandparents didn’t spend a lot of time thinking about retirement—and with good reason!— we now have to budget and plan for 20 years or more of not working.

A lot can go wrong over a couple of decades. And even if you set things up perfectly for a nice 20-year retirement, fate has an odd sense of humor. After years of planning, you may die young—or live long, long past what you thought would be your expiry date.

One of the most common mistakes that people make in retirement planning is basing everything on the notion that they will live to what they believe is the average life expectancy. You should remember that the average life expectancy is just the midpoint in a huge range of possibilities.

Bear in mind, too, that the life expectancy figure is 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 85.

The problem, from a financial perspective, is that there are no guarantees. Moshe Milevsky, associate professor of finance at the Schulich School of Business at York University in Toronto, points out that a 65-year-old man who retires today faces an 8% chance of dying before he turns 70. He also faces the same 8% chance of living past 95.

Think about the practical implications of those figures. 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, gosh, he’s a Methuselah who has to live the last quarter century of his life trying to make ends meet on a meagre budget.

On the other hand, he could play it safe and pinch pennies to ensure he will have enough to last until he’s a centenarian. But, if so, he faces a real possibility of finding himself in a hospital bed at 68 or 69, listening to a doctor deliver a grim diagnosis, and cursing himself for not enjoying life more when he had the chance.

The odds of disappointment are identical no matter which option our hypothetical 65-year-old chooses, so how does he—or you—make a choice? The following six-step plan can help you make the most of the retirement odds.

1. Calculate your must-haves

You often hear retirement planning boiled down a single figure—“you need $1 million to retire well.” A smarter 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 your target figure by toting 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. Finally, you can subtract the hard costs associated with the working life, such as the cost of commuting to the office, buying business attire, and so on.

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 $30,000 to $40,000 a year in after-tax income.

2. Calculate your nice-to-haves

We all have dreams and you should budget for those, too. Maybe you want to take that African safari, golf every day, or winter down south. You should size up what it would take to pay for whatever bliss you desire and regard that figure as the second part of your retirement planning.

Just one tip: when assessing your nice-to-have list, remember that age takes its toll. Right now you may dream of travelling the globe. Once you’re past your early 70s, however, you’re likely to discover that your wanderlust is diminished. Similarly, you may find that golfing every day is no longer a pleasure once you’ve hit 75. So by all means budget for luxuries, but it may make sense to set a larger budget for your early retirement years, and a smaller one for the later years.

3. Count on government

Despite what the fearmongers would have you believe, the Canada Pension Plan (CPP) is in fine shape. Old Age Security (OAS) looks to be on solid ground as well, now that Ottawa has introduced changes that will delay the benefit 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 more than $18,000 a year from those two sources, depending on what you earned during your working years, and how early you start collecting your pension cheques. (You can start collecting reduced CPP as early as age 60.) The average Canadian pulls in about $12,500 a year from those two pensions. 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 with what you figure your minimum retirement needs will be. If you and your spouse estimate you can maintain the must-have parts of your current life on, say, $50,000 a year, the good news is that retirement becomes a very affordable proposition. You and your partner may have to add only $14,000 a year in after-tax income from corporate pensions or savings to ensure the key components of your retirement plan.

4. Factor in pensions and RRSPs

This brings us to the thorny issue of pensions. 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.

Most of us, though, aren’t in that position. 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.

5. Get a handle on risk

This is where playing the odds becomes vital. Some retirees insist on playing it safe and keeping all their money in bonds and GICs. Others go for the gusto by focusing on high-yield real estate investment trusts or high-risk stocks in the hope that these bets will provide them with the income they want.

Both approaches are flawed. Stashing everything in bonds and GICs raises the risk that inflation will whittle away the real value of your savings. On the other hand, betting on high-risk investments raises the odds that you’ll make a big mistake and wipe out a chunk of your savings.

The best solution for nearly everyone is a welldiversified portfolio that has 30% to 50% of its assets in various fixed-income investments, such as bonds and GICs, and the remainder in a wide variety of stocks from Canada and other countries. One good approach is to build a Couch Potato portfolio using low-cost index funds or exchange-traded funds.

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 bobbing 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 stock 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 4% of its initial value each year, adjusted for inflation. You should begin your retirement by withdrawing $4,000 a year for each $100,000 you start with. If inflation is running at 2% a year, you would withdraw $4,080 the next year, $4,162 the following year, and so on.

The 4% 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. We explain more about this important rule of thumb in the guide.

6. Balance the present and the future

Here’s where individual preferences become important. While a 4% withdrawal rate gives a wellbalanced portfolio an excellent chance of surviving 30 years, it’s very much a pessimist’s strategy. Chances are that things will turn out better than the worst case. If they do, you stand a good chance of leaving behind a tidy fortune. Your heirs will no doubt like this arrangement, and if you want to leave them a big bequest, that’s fine—but it’s probably not the optimal deal for you. In fact, if you apply the 4% 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 must-have and nice-to-have portions of your portfolio in different ways. When it comes to your must-have portion, play it safe and count on a 4% withdrawal rate. If you calculate, for instance, that you’re going to need $16,000 a year on top of CPP and OAS to provide you with the necessities, you should accumulate at least $400,000 in RRSP savings, or the equivalent in corporate pension plans. That $400,000 should be able to fund an inflation-adjusted withdrawal rate of $16,000 for as long as you live.

If you don’t want to worry about the ups and downs of a portfolio, you can use some of your must-have 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. Seek the advice of a good fee-only financial planner before buying. Put particular emphasis on making sure that the insurance company that offers the annuity is financially sound. (Look for at least an AA rating from a rating firm such as A.M. Best. To learn more about these ratings, go to www.ambest.com.) You may even want to split the annuity portion of your must-have money between two or more companies to ensure no single disaster can swallow up your savings.

Once you’ve built a fortress around the must-have component of your portfolio, you can treat the niceto- have portion with more freedom. You can and should plan to run through a chunk of your niceto- have 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 nice-to-have money is running low at that point, so be it—you will have extracted maximum value from your nice-to-have money when you were still healthy enough to enjoy it, while protecting your future by ensuring that your must-have needs are well covered. That’s the retirement we all want and, as you’ll discover as you read this guide, it’s well within your reach. – BARBARA HAWKINS

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5 comments on “6 Steps to a wealthy retirement

  1. I agreed with this excellent article until the ending comment "it's all within your reach". Unfortunately,life holds too many (usually negative) surprises for this to be true. Health is a big factor and mostly out of our control, the overall economies of the world and their impact on the stock market and real estate market is completely out of our control, death of a spouse, divorce, loss of employment, etc. Etc. etc…… We can do our best, however, there are no guarantees. It is essential to prioritize your life NOW because you never know what will happen tomorrow. That is not an excuse for not planning and saving for retirement, however, it is the only reason you need to figure out what makes you happy and do your best to make that happen. Oh, and if you are under 30 make sure you get a government job now because the rest of us are going to have to rely on memories and cpp to retire. We won't be able to afford to make new memories. I say that as someone who has faithfully saved her entire life, and now realizes it will never be enough to retire on. I plan to save only enough to live on (frugally) until I am 80. Period. After that, I guess I will be the government's responsibility.

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  2. Excellent article, a must read for my kids and yours. And as an additional note on government impact on your financial well being, basically do not put too much trust on government to protect you in your retirement years. Government does many thoughtless and damaging things, like when Mr. Flaherty our Minister of Finance, abolished the income trusts just before the market crash of 2008. That action alone cut our nest egg by 68%, demolishing our dreams of comfortable retirement living. My advice is to diversify your retirement investments between multiple vehicles including real estate. And avoid most mutual funds. They will eat up your savings faster than inflation with management expenses.

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  3. how We can withdrow our RRSP money to avoid the tax

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  4. Saw Sellery on Cityline (re-run). I really appreciated this article and will buy the guide. Can you please confirm that the scenario of 30-40k in section 1 is per couple, not individual?

    Also section 5 talks about "each $100,000 that you start with". How does a home value fit into this equation assuming that even if we "downsize" from our 3 story standalone, it would not necessarily be to a less expensive property?

    Looking forward to hearing from you.

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    • Hi, to answer your question about section 1: yes, that's $30-$40K for the couple as a whole. The second question is a little more involved. Consider writing to ask@moneysense.ca. Your question might be chosen and answered in an upcoming issue of MoneySense magazine.

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