In part three of this series, we investigated the life expectancy of Canadians and how that information can be used to shed light on their retirement planning. In part four, we will examine what kind of returns a person can expect on their investments, and conclude with an example based on the process we discussed.
In a field full of difficult forecasting – inflation, mortality, expenses – investment returns might be the most challenging item to predict. In the short-term, investment performance is extremely difficult to predict with any sort of accuracy. However, in the long-term we can look at historical investment returns to establish a fair estimate for what might be expected in the future.
Looking back over the last 40 years in Canada yields the results presented in the chart below.
Based on these long-term averages, Canadian equities could be reasonably expected to produce returns somewhere in the mid to high single digits before inflation, taxes and investment expenses, while bonds might have returns a few percentage points lower. After accounting for inflation (around 3% historically and shown as change in CPI above), management fees (varies widely depending on the investment product), and taxes (investor-dependent), a portfolio with a balanced mix of stocks and bonds could be expected to produce actual spendable income of about 3% to 4% per year.
We expect that over time, stocks will continue to outperform bonds and receive beneficial tax treatment on capital gains and dividends. However, the stock market is usually considerably more volatile than the bond market and being forced to sell stocks in a down market can have real long-term consequences on a portfolio. One of our primary responsibilities as portfolio managers is to monitor the construction and composition of our client portfolios over time to ensure that the asset allocation is appropriate for each client’s changing lifestyle as they age and their circumstances change.
Now that we have answered the four big questions in retirement planning, we can take a swing at determining what amount of savings a couple might need to retire and meet their spending goals.
Let’s imagine a couple, newly retired and both age 65. Prior to their retirement, they earned $200,000 combined, or about $150,000 after taxes. There is approximately a 60% chance that one or both will live to age 90, and so it would be prudent to assume they will need funds to age 100, another 35 years. The couple is making sure that they minimize taxes whenever possible.
We determined that their required spending in retirement will likely be around two-thirds of their pre-retirement spending. Since they were spending $150,000 per year, in the early stages of retirement they will need after-tax income of about $100,000 per year. Assuming a 4% net real rate of return on their investments, a portfolio of $2.5M should produce enough annual income to meet their needs without any capital erosion, though the portfolio’s value will fluctuate.
The portfolio could also see some growth, particularly as the couple’s spending declines over time. It should be able to produce the required income effectively in perpetuity, and the couple will be able to leave an estate with the same purchasing power as $2.5M today. If the couple is not concerned with leaving an estate, then a portfolio of about $1,850,000 is likely sufficient to allow withdrawals of $100,000 each year for thirty-five years, before being exhausted around age 100. So, this couple should be aiming to have an investment portfolio between $1,850,000 and $2,500,000 at retirement.
For many young people starting their careers, the notion of saving $2 million seems impossible. The keys, of course, are an early start, consistent savings, and reasonable investment returns over an extended period. We can help with a savings plan to accomplish that goal; but that’s a discussion for another day.
I hope this helped illustrate the depth of analysis we can provide for these important topics. Let us know how we can help you in planning for the future.