Overview
This educational material is not intended to push you into becoming a do-it-yourselfer. Almost everyone can benefit from going to a reputable fee-only financial planner to help them develop a plan and set an initial asset allocation consistent with objectives, risk tolerance and constraints. The information that will be discussed should help you become a better do-it-yourselfer or more informed customer of the advisor and help you decide what portions of the planning, execution and ongoing monitoring you are prepared to do yourself.
Planning
Planning phase typically means that you are still working and are typically more than three years from your planned retirement date. You are still in the accumulation phase of your lifecycle. This means that your focus is on:
-goals: planned retirement age, desired retirement income,
-means: savings rate, investments strategy and portfolio used for implementation
-constraints and assumptions: inflation, asset class return rates/volatility/correlations
-asset accumulation, monitoring and course adjustments toward goals
How much do I need to retire?
To keep things simple we’ll start with some simplistic rules of thumb. Clearly everyone is unique in accumulated assets, ability to save, risk tolerance, desired retirement income, willingness/ability to take part-time employment, desired retirement age, expected longevity, etc. Of course, nobody can predict what actually will happen with returns and their volatility, the inflation rate, unexpected events resulting in significant increase/decrease in asset base.
Let’s take the following rules of thumb and assumptions:
-diversified portfolio with 4% average real return (7% nominal and 3% inflation)
-annual withdrawal rate of 4%, to minimize chances of outliving assets during a 30 year retirement
-desired spend-rate at start of retirement same as just before retirement
-effective tax rate in retirement 25%
-indexed pension (real) income of $15K (CPP, OAS or SS)
So if your current, pre-retirement, after-tax and after-savings take-home pay is $48.75K, then you may want the same $48.75K real after-tax spend rate in retirement. To get $48.75K after tax in retirement, you’ll need $48.75/(1-0.25)=$65K before the 25% tax; since in retirement you are getting a $15K indexed (real) pension income, then you need an additional ($65K-$15K)= $50K real before tax in retirement. If we obey the 4% withdrawal rule of thumb then the capital required at start of retirement is 50,000/0.04=1,250,000 or $1.25M current dollars. (If retirement takes place in 25 years from now and inflation is assumed at 3%, the $1.25M current dollars become $2.6M in nominal dollars; 1.25M*(1.03)**25= 2.6M)
The impact of taxes is much more complicated then the calculation shown above, but for illustrative purposes this will suffice here. As you can see, the funds required for retirement are quite substantial. The next question is “How do you accumulate the funds required for retirement?”
How do I accumulate the funds required for retirement?
A number of variables are required to be considered to answer this question:
-what current assets are already allocated toward retirement? (to be assumed zero for now)
-what other major expenditures must be considered, e.g. kids’ education (assumed zero for now)
-how much, in $’s or percent of income, can you save per year toward requirement?
-how many years are left to accumulate funds until retirement?
-what is the expected return on the funds saved for retirement?
Again, for simplicity, assume that your income is growing at the rate of inflation, and we can then do the calculation in current/real dollars. Then the accumulated funds after 20, 25, 30 and 35 years assuming real $10K, $15K and $20K of annual saving are as follows. (You can do this calculation with a financial calculator or on Microsoft Excel Future Value function FV)
Assuming 4% real return you’d have to save about $15K/year for 35 years or $20K/yr for 30 years to reach the approximate $1.25M real assets required.
| Return=4.00% |
| $Saved/yr |
Years to retirement |
|
|
20 |
25 |
30 |
35 |
| $10,000 |
$297,781 |
$416,459 |
$560,849 |
$736,522 |
| $15,000 |
$446,671 |
$624,689 |
$841,274 |
$1,104,783 |
| $20,000 |
$595,562 |
$832,918 |
$1,121,699 |
$1,473,044 |
For 3.5% real return you’d have to save $20k/tear for 35 years to reach the approximate $1.25M real assets required.
| Return=3.50% |
| $Saved/yr |
Years to retirement |
|
|
20 |
25 |
30 |
35 |
| $10,000 |
$282,797 |
$389,499 |
$516,227 |
$666,740 |
| $15,000 |
$424,195 |
$584,248 |
$774,340 |
$1,000,110 |
| $20,000 |
$565,594 |
$778,997 |
$1,032,454 |
$1,333,480 |
And for 4.5% real return you’d have to save $20K for 30 years or $15K/year for 35 years to reach the approximate $1.25M real assets required.
|
Return= |
4.50% |
|
|
| $Saved/yr |
Years to retirement |
|
|
20 |
25 |
30 |
35 |
| $10,000 |
$313,714 |
$445,652 |
$610,071 |
$814,966 |
| $15,000 |
$470,571 |
$668,478 |
$915,106 |
$1,222,449 |
| $20,000 |
$627,428 |
$891,304 |
$1,220,141 |
$1,629,932 |
When to start saving? How much do you need to save?Just about every retirement website has a section on the power of compounding or time and the damage caused by procrastination on your retirement plans. There are many approaches the writers try to get their readers to comprehend the power of starting immediately and penalty of delay. For example at the Wells Fargo website John and Mary each contribute $100/month. John starts at age 25 and stops contributions after 10 years at age 35, for a total of $12,000. Mary starts to contribute at age 35 and continues to do so for 30 years until age 65, for a total of $36,000. At age 65 John will have approximately $200,000, whereas Mary will only have $149,000 (assuming 8% hypothetical nominal return for both). I like to think about retirement savings in terms of percentages of gross income. I always felt that this was a relatively simple way to implement an employee’s savings program. Set the percentage and then the dollars saved are adjusted automatically as salary is increased due to inflation and contribution. EBRI (Employee Benefit Research Institute) has a ballpark calculator. To get a feeling for the required saving percentage as a function of age at which saving program was started. I made some conservative assumptions (3% inflation, 100% of final year salary replaced in retirement, 7% nominal return on investments, and no other sources of income in retirements). While these are somewhat onerous assumptions, I did assume that individual will retire at age 65, which is beyond current actual retirement age. I included an extra parameter, the annual wage increase.
Saving rates
Clearly, there are many unknowns that are difficult to predict investment return rates, wage increase rates, inflation rates. There could also be an adjustment for CPP or SS, and for potentially less than 100% final salary replacement rate (due no longer saving for retirement). However, the above numbers assume retirement at age 65, not at 55 or 60. So 15% of gross salary at age 25, increasing at 1% of gross with each year of later start would be a reasonable rule of thumb to start with and reviewing it every couple of years to see of assumptions still make sense.
The numbers speak for themselves. The earlier you start the earlier you’ll be able to retire without dramatically reducing your lifestyle. A 25 year old should really be saving more than 15% of gross because (s)he will need funds for a down payment for a house and one would prefer not to raid the tax-sheltered retirement savings (e.g. RRSP or 401K). If retirement savings are removed for some other immediate spending, that would reset the start saving rate age and the corresponding percentage that must be saved.
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