Note: This article is part of Morningstar's September 2015 The road to retirement special report.
You have taken the first step in establishing a financial plan and determined a saving rate that has a reasonable chance of providing you a secure retirement. But can you rely on this one number to help you reach your retirement goal in 20 or 30 years? Is it realistic to use a static, one-size-fits-all approach to solve a complex problem such as retirement planning?
The ultimate goal of retirement planning is to turn your savings into a steady income stream that can last through your retirement. But figuring out how much you need to save until retirement and how much you'll be able to withdraw each year without completely depleting you nest egg is tricky to say the least. That amount depends on a number of variables including income level, investment returns, expense and cash flow requirements, the number of years until retirement, withdrawal rate and life expectancy.
All these may change over time: you may win a lottery, decide to take some time off work to go back to school or care for children or elderly parents, or you may be unemployed for a time. Life is full of unexpected surprises, and these uncertainties will directly affect your ability to maintain a target savings rate. A robust financial plan should consider a range of potential outcomes and have room for adjustments when circumstances change.
In order to determine your savings rate today, you have to figure out how much you will need in the future. Two commonly used estimates in determining your retirement income needs are retirement replacement rate and optimal withdrawal rate. Retirement replacement rate is the amount of income needed in retirement to maintain a certain pre-retirement living standard. A study conducted by Statistics Canada estimates that for the median Canadian family, 80% of average pre-retirement income must be replaced by alternative sources of income such as public and private pensions, investments and earnings as an individual makes the transition from the workforce to retirement.
Some argue that retirees could live comfortably with a replacement rate that is substantially lower than 80% since income taxes are lower and many of the expenses (such as mortgage payments and RRSP contributions) we have during our working lives no longer exists upon retirement. In general, households on the lower end of the income spectrum would need a higher replacement rate than higher-income households, because they will likely save less of their pre-retirement income, and the reduction in post-retirement income tax is smaller than those experienced by high-income households.
The reality is there is no one universal replacement rate that is appropriate for everyone; it can vary greatly from one person to another as it depends on each individual's preferred retirement lifestyle, current savings and expected income needs.
The optimal withdrawal rate is the amount of money one can take out from savings every year during retirement without outliving his or her assets. This is the biggest risk for retirees so it is critical to figure out the correct optimal withdrawal rate since small errors in the withdrawal rate compound over time and can have significant financial ramifications.
The challenge with this estimate is that most people either have unrealistic assumptions on how much they could withdraw during retirement or they have no idea how much they could safely withdraw. Most retirement planning models assume a constant withdrawal rate (or a constant dollar amount) for a fixed period such as 25 or 30 years. An annual withdrawal rate of 4% is often used as a general rule of thumb for how much a person could withdraw each year without completely depleting his or her retirement savings.
But retirement planning is subject to a great deal of uncertainties, and relying on a constant withdrawal rate is rather naïve as it ignores the dynamic nature of market and portfolio returns and changes in life expectancy. Morningstar's research in this area, as outlined in a paper titled Optimal Withdrawal Strategy for Retirement Income Portfolios, shows that regimes that dynamically adjust for market and life expectancy uncertainties are preferred over the more traditional fixed withdrawal approaches. By continuously adjusting the withdrawal rate to ongoing changes in portfolio returns and mortality probability, they offer a more realistic path that people are more likely to follow.
Investment portfolios are subject to unpredictable market fluctuations that can have a significant impact. Although average annual returns of 8% for stocks and 4% for bonds are frequently used in investment modelling, using these long-term historical averages to plan for retirement is dangerous. Past average return is typically a poor predictor of expected future performance. Financial markets, especially stocks, are volatile. Your investments will not earn 8% every year -- they may earn 10% one year then lose 15% the next. Especially in recent years, returns generated from both stocks or bonds are nowhere close to their historical averages.
Therefore, a more sensible approach is to use forward-looking returns and volatility assumptions that incorporate current economic conditions and expectations into the modelling process. As such, retirement projections should show a range of possible returns scenarios reflecting both potential upside and downside risk. It is simply not sufficient to use one single return number. Using different returns to model different scenarios allows you and your financial advisor to assess the impact that factors like market volatility, changes on saving and withdrawal rates will have on your investments, thus allowing you to adjust and fine tune your financial plan.
There is no one universal number when it comes to planning for retirement, life doesn't always work out exactly as planned, and there are many variables that are beyond your control. It is unrealistic to expect your investment returns, income level and expenses to remain constant over a period of more than twenty years. Adopting a dynamic approach, anticipating changes and incorporating flexibility in your financial plan will help you stay on track and improve your position for the future. It is also imperative that you revisit your financial plan and inputs such as savings rate, expected portfolio returns and withdrawal rates on a regular basis to ensure you are on track given your unique personal circumstances.
