Q: I’m pretty lucky to have a defined benefit pension from my employer. I will receive $60,000 annually from it in five years. Unfortunately, it will not be indexed. How can I calculate the amount of saving that I need before retirement to cover the inflation for 40 years? I want to keep the same power of buying.
A: Isa, having a Defined Benefit (DB) pension is indeed lucky and with CPP and OAS that could be another possible $20,000 on top of that. You may not need to make up for 40 years of indexing to have a successful retirement. In actuary and retirement expert Federick Vettese’s book Retirement Income for Life, he suggests that during retirement, people’s spending will match inflation to about age 70 and then decrease by one per cent per year through their 70s and two per cent per year through their 80s.
So how much do you have to save over the next five years to make up for 40 years of inflation? It’s going to be a big number, Isa. How much do you think you’ll need to save? Here’s how to find out.
First, how much money does your pension company have to set aside so you can have an income of $60,000 per year for 40 years, assuming no investment return? The answer is $2,400,000. That was simple. Forty years x $60,000.
Let’s complicate it a little and assume your pension company earns five per cent on their investments. Now they only have to have $1,052,931 saved by your retirement date.
Now let’s index your pension at two per cent per year and you’ll see your pension company needs $1,552,177 by your retirement. The two per cent inflation added an extra $500,000! If you don’t have any other money saved, and you want to save $500,000 over five years, you should target saving $100,000 a year. If you get some good returns you can relax your savings rate a little in the final years.
Play with the calculator a little bit and check to see what happens when you change the rate of inflation. A one per cent change is huge over 40 years.
I don’t really expect you to save $100,000 per year. Your CPP and OAS are indexed and at some point in your retirement, your spending will decrease. If you’re concerned about your income, have someone do a projection for you. Sometimes we get too focused on one thing and we don’t see the big picture. Often when I show people the big picture and how everything is going to come together it allows them to think about other, more reasonable solutions to income gaps, if in fact there are any gaps.
Remember you want to enjoy your pre-retirement years also. Keep having fun, Isa!
Allan Norman, M.Sc., CFP, CIM, is a financial planner with Atlantis Financial Inc.
This commentary is provided as a general source of information and is intended for Canadian residents only. Allan offers financial planning and insurance services through Atlantis Financial Inc.
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