HOW MUCH IS ENOUGH?
The discussion we have most often with our clients involves how much they need to save in order to guarantee a comfortable life style in retirement. Entire books have been (and will continue to be) written on the subject, and an substantial number of financial planners make a pretty good living trying to answer this question in the most long winded and complicated manner possible. In fact, it is not so hard to come up with a pretty reasonable answer, and it does not require a PhD in math. Here are the key variables.
HOW MUCH WILL I SPEND WHEN I RETIRE?
Lots of work has been done on this question. For most retirees it turns out that somewhere between 70% and 80% of their pre-retirement spending is the best estimate. While retirees travel more, particularly in the early post-work years, they often cut back in other areas. For example, they may go from two cars to one car, spend less on clothes (no dressing up for work!) and have fewer expenses related to children. Obviously the very old or the infirm may have higher expenses involving health care and special assistance, but in general this is a pretty reasonable rule of thumb.
HOW LONG WILL I LIVE?
Nobody knows how long any individual will live of course, but we have a very good idea of how long, on average, persons of a given age will live. No one wants to outlive their savings, so it is certainly prudent to assume, all other things being equal, that one of you and your spouse will live as long as the average person. Non-smokers, the physically active and those with higher income tend to live longer than average. Here are the odds that the average person will live to be 90, having achieved a certain age:
ODDS THAT YOU WILL BE ALIVE AT AGE 90
In other words, if you and your spouse are both 70, there is about an even chance that one of you will be alive at age 90, and prudence demands that any financial plan must extend at least that long.
HOW MUCH WILL MY SAVINGS EARN?
This is the area of greatest uncertainty. The past decade has been very disappointing for savers, and no one can tell if this will change in the future. However, if we look at longer time spans, for example the entire 65 years of the post World War II period, we see that a reasonable expectation for returns is in the area of 4% to 6% per year after management fees and taxes. Taking inflation into account, the real return, after inflation, taxes and fees over time can be estimated at about 3% per year. Some years will be much more, and some years much less, depending on the nature of the assets held in the portfolio. Over time stocks outperform bonds, and receive more favourable tax treatment on both capital gains and dividends, but produce more volatile returns. Changing asset allocation according to age and other circumstances is a key duty of the portfolio manager.
PUTTING IT ALL TOGETHER
Imagine that you are a couple, both 65 and newly retired. Your combined pre-retirement earnings were about $150,000 per year after tax. How big should your portfolio be? Our calculation would be as follows:
- In retirement you will need 80% of pre-retirement income, so 80% of $150,000 = $120,000
- If we assume that savings produce a real return of 3% per year, without touching principal, a portfolio of $4 million will produce $120,000 per year, inflation adjusted, forever, and leave an estate with the same purchasing power as $4 million today.
- If leaving an estate is not a concern, then a portfolio of $2,500,000 will produce a cash flow of $120,000 per year, adjusted for inflation, for thirty-five years, and will be exhausted at age 100, should one of the couple live that long.
- Accordingly, the total savings target for this couple should be somewhere between $2.5 and $4.0 million.
GETTING FROM HERE TO THERE
Once a target is established, the hard work of getting from the portfolio value today to the target value begins. In general, the target will be reached through a combination of portfolio appreciation over time, and savings on an annual basis. The sooner one starts, the more compounding works to increase the ultimate value. The more consistently one saves, the higher the odds of getting to the goal. Pension fund managers assume a savings rate of 18% of pre-tax income is required in order to meet the goal of achieving retirement income at 80% of pre-retirement earnings. That is why the RRSP limit in Canada is set at 18% of employment earnings, subject to the annual cap. For a couple with pre-tax income of $250,000 per year, that suggests savings of $45,000 per year, which is just about the present maximum contribution allowed into their RRSP accounts.
A CAVEAT: EVERY SITUATION IS UNIQUE
While the information above is useful and broadly accurate, applying it to any individual or family requires caution. Every case is different. Some of us are supporting older parents or non-working children. Some of us are dealing with illness or infirmity. Some of us will be inheritors of substantial wealth. More importantly, we all have our own aspirations and goals as to what we may wish to do in our retirement years. Each of these factors can have a substantial impact on the final answer to the question of how much is enough. We stand ready to help you get the answer that is correct for you.