Retirement math: Why you may need more (or less) than you think
I don’t like retirement rules of thumb. I think they can be deceiving. If someone says you need $1 million to retire, they may be right. Or really wrong.
$1 million in an RRSP is very different from $1 million in non-registered investments. Withdrawals from the RRSP are taxable, whereas withdrawals from the non-registered account are effectively tax-free (with tax payable on the annual income and capital gains instead).
There’s also a big difference in how much you need if you’re retiring at 55 versus 65. Or, if you have longevity in your genes and expect to live to 100. Or, if you still have debt in retirement or expect to downsize or receive an inheritance. And what about risk tolerance? A GIC investor no doubt needs more savings than someone with an aggressive allocation towards stocks.
So, while I’m reluctant to use rules of thumb when it comes to retirement planning, there are a few general retirement math mistakes I see made frequently when it comes to retirement planning that I’d like to share.
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Overestimating income tax payable
I recently met with clients who retired last year. We prepare their tax returns and they were surprised at how little tax they paid in 2017.
Their income sources include (rounded figures):
Combined Canada Pension Plan (CPP) and Old Age Security (OAS) – $25,000
Registered Retirement Income Fund (RRIF) withdrawals – $30,000
U.K. pension – $3,000
Canadian stock dividends – $28,000
Foreign dividends and interest – $11,000
Taxable capital gains – $3,000
Total income – $100,000
Despite a healthy $100,000 of combined income – a lot for a retiree – they were surprised that their tax payable was less than $3,000 for 2017. They did deduct carrying charges of about $11,000 (management fees paid to their investment advisor) as well as $3,000 of capital losses carried forward from previous years that were claimed against their capital gains. However, $3,000 of tax paid on $86,000 of taxable income is still less than 4% tax.
When they were both working, their incomes were relatively high, and their tax rate was correspondingly high. They were used to paying tax at a high rate. Generally, in retirement, people’s incomes are lower, their income sources are more tax efficient than salary during their working years, and they aren’t paying certain taxes like Canada Pension Plan (CPP) or Employment Insurance (EI) premiums. CPP and EI premiums alone may be up to $7,000 per year for a working couple ($10,000 if they were both self-employed).
Underestimating the power of compounding
People sometimes use linear thinking when they’re trying to figure out how much money they need to have to fund their retirement. If they need $50,000 per year from their investments, they figure they need $1 million to cover 20 years of spending ($50,000 x 20 years = $1 million).
This math ignores the power of compounding. Let’s assume a 4% investment return. If you withdraw $50,000 from a $1 million nest egg and draw it down to $950,000, but the remaining $950,000 earns a 4% return, that means you’ve got $988,000 at the end of the year – not $950,000.
If we ignore inflation and assume a static $50,000 annual withdrawal, a $1 million nest egg earning 4% annually would be depleted after 38 years, not 20. Most portfolios won’t earn 4% consistently each year with no volatility, but you get the point.
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Ignoring the impact of inflation
Taking the above example a step further, it’s not enough to assume you’ll need $50,000 each year from your investments because that’s what you need today. The cost of living rises over time. Over the past 30 years, the annualized Consumer Price Index (CPI) measure of inflation in Canada has been 2.1%. That means prices have risen by more than 2% annually.
If you needed to withdraw $50,000 annually indexed to inflation of 2% from a $1 million portfolio earning 4% per year, your capital would be depleted after 25 years (not 20 or 38).
Further, something that costs $100 at age 55 would cost $200 by age 91 assuming the same 2% inflation rate.
Misunderstanding life expectancy
Canadian life expectancy is currently about 82 years of age. But it’s important to understand what this statistic means. It’s actually the average age at which Canadians die.
When planning for retirement, retirees and their advisors should instead consider their life expectancy based on their current age.
Consider a 55-year old couple. A 55-year old woman has a 50% chance of living to age 91. A 55-year old man has a 50% chance of living to age 89. And there is a 50% chance that one of the two of them will live to age 94. The couple has a 25% chance that one of them lives to age 98 and 10% to age 101.
So, barring extraordinary circumstances, today’s retirees probably need to plan to provide for themselves well into their 90s, in order for their money outlasts them.
Why you can’t rely on rules of thumb
However great it is to have quick answers for financial questions to keep things simple, it simply isn’t enough to rely on retirement rules of thumb. Everyone is different and retirement planning is an art that reflects this fact.
If nothing else, take into consideration some of the retirement math mistakes above. Try to avoid them and it will help you better plan for retirement, whether on your own, or with a professional.