Editor's note: This is part two of a two-part series on retirement finances.
In part one of this series, I explained how to develop a retirement budget and determine the retirement income you can expect from guaranteed sources such as government pensions. However, for many people this guaranteed income will be insufficient. Drawing on savings to bridge the income shortfall is the customary solution to this quandary, and the focus of today's article.
How much do you need to save to fund your retirement-income gap? The answer depends on your assumptions about such factors as future spending, inflation and interest rates before and after retirement, your risk tolerance and the rates of return on your savings. Testing various assumptions and calculators to see how long your money should last will help you set a realistic retirement-savings target.
A common approach to retirement-income planning is to decide on the amount of income to withdraw from savings in the first year of retirement and increase that amount annually by an inflation factor. A simple tool based on this approach is the How Long Will the Money Last calculator.
An example will illustrate what this tool can do. Mary plans to retire at age 65 and expects to receive a guaranteed income of $30,000 comprised of a full Canada Pension Plan and Old Age Security and a $9,000 workplace pension. She needs to draw $20,000 annually from her savings to meet her retirement-income objective of $50,000.
Mary makes these assumptions:
- Her savings must last to age 95 (30 years);
- An inflation rate of 2% (the current Bank of Canada inflation target) or 3%;
- A rate of return on her savings of 4% (The Financial Planning Standards Council 2016 guideline for net return on a balanced portfolio); or 5%;
- She can save $400,000 by the time she retires.
The calculator indicates that if Mary's "starting investment balance" at retirement is $400,000, her money could last as little as 23 years (3% inflation rate, 4% return rate) or as long as 30 years with lower inflation (2%) and higher returns (5%).
Mary tests higher savings targets and decides to increase her savings goal to $550,000 which, according to the calculator, should last 32 years even under the higher-inflation, lower-return scenario.
The more detailed Standard Retirement Calculator allows users to vary numerous inputs. It generates an annual savings plan to reach a target retirement income, and a post-retirement spending plan. Given Mary's assumptions, this calculator suggests that she needs about $525,000 of savings at retirement to avoid running out of money after retirement.
Income-plus-inflation calculators such as the foregoing ones usually assume the same rate of return on retirement savings while working and the same, or another rate, for the spending period. In reality, investment returns fluctuate from year to year with the performance of the underlying holdings. A poor sequence of returns could mean running out of money sooner than the calculator suggests.
Withdrawing a fixed percentage of the balance in your retirement savings account each year will avoid premature portfolio depletion. However, your annual income will fluctuate with the return rate on your savings, and could be critically inadequate in years when your investments perform poorly. This approach is best suited to retirees with a guaranteed income that will cover fixed expenses such as food and housing.
A retirement income model designed to avoid running out of money calls for withdrawal of a fixed percentage of savings in the first-year of retirement, and inflation-adjusted withdrawals in subsequent years.
As originally conceived by William Bengen, a retired financial planner in California, a first-year withdrawal of 4% should be safe. Widely debated, this number is based on Bengen's historical analysis of the performance of a 50% stock/50% U.S. Treasuries portfolio from 1926 to 1976, and longevity of 30 years. Bengen did not consider the effect of taxes. If Mary followed Bengen's model, her retirement savings objective would be $500,000.
Clearly, different retirement-income models yield different target savings amounts. There will always be an element of uncertainty, regardless of the savings amount you choose. Astute savers will opt for conservative assumptions when deciding how much to save.
If your number-crunching suggests that you are not saving enough to meet your retirement-income goal, you need to revise your retirement plan. You could choose to work longer to save more before retiring, work part-time after retirement or lower your retirement-income expectations.
How should you invest your savings leading up to and after retirement? Here are several basic guidelines:
Own a conservative, income-producing investment portfolio.
In retirement, you want investments with a high probability of generating the income you need, and a low probability of running out of money. As your retirement approaches, you should revise your portfolio to meet these twin objectives. For most investors, this is likely to require selling some equities and increasing your allocation to fixed income.
Keep your investment plan and withdrawal strategy simple and low maintenance.
This will reduce the chance of making poor decisions that could endanger your retirement finances. Professionally managed exchange-traded funds and mutual funds are prudent choices. Particularly suitable for retirees are funds that make regular monthly distributions. Some retirement savings can be used to purchase an annuity, which will provide a guaranteed income stream. Annuities are a good pension substitute for those without workplace pensions.
Assign your retirement savings to buckets based on when you will need the money.
Money needed to pay for shorter-term (fewer than five years) living expenses is held in cash. Longer-term savings are invested in a higher-risk bucket of equities and fixed income which is accessed periodically to replenish the cash bucket.
Be tax-efficient when investing and withdrawing your retirement funds.
The goal of tax planning is to maximize investment growth before paying taxes. This is a complex subject that covers such nuances as the timing of RRSP and RRIF withdrawals, when to begin taking your Canada Pension Plan/Quebec Pension Plan and Old Age Security, and managing your retirement income to avoid the OAS clawback. The advice of a suitably qualified financial professional is frequently worthwhile.
Planning your retirement finances well in advance of your last day at work is the key to easing into retirement with minimal stress about money.
