People are looking forward to the return of normalcy. The stock market will make a little sense, bonds will return a reasonable rate, real estate will be predictable, jobs will be available for those with skills and work-ethic, government will restrain itself and there will be joy and prosperity in the land.
Might not happen. Then what?
You need to understand how the problem is structured. Think about it this way. Your cost of living from the time you retire until you have died is a liability that you will need to pay off during the time you are earning income. With annual savings.
But how much is it?
Suppose I know that my cost of living now is a number and I replace children and debt payments with golf club fees and travel. Say it comes out to $5,000 per month – $60,000 per year. If retirement is going to be 30 years long and it is 30 years to the start date, I can figure it out once I know three things.
Over the past 50 or so years, the average inflation rate is about 2.5%. It could be that in the future but we don’t know. It certainly won’t be a smooth 2.5% and that could matter. High inflation at year 31 and following and low inflation before could be a very bad pattern.
If 2.5% works then $5,000 now will cost $10,500 the first month of retirement. Over the 30 years of retirement I will spend a little over $5.5 million. To do that I will need about $2.95 million at the moment of retirement if I can earn 5% on my investments, after taxes. Something around 8% before fees and taxes. I hope I can do that and once the stock market comes back I can probably do better than that.
All very nice and theoretical. What does it mean?
It means you will need to save $31,500 annually plus inflation each year.
If I can use a tax sheltered retirement plan with a tax cost on income of 20% after retirement, then I will need about $2.85 million and that will cost only $25,500 pretax plus inflation or about $15,000 out of pocket.
Suppose 8% does not happen, and pension specialist Zvi Bodie thinks it might not, then if I can’t get 8% but only 6% before fees and taxes, about 3.5% clear, then my tax sheltered deposit needs to be $54,000 and aside from the fact that I cannot legally put that much in, I cannot afford it in any case.
The point is accepting 8% as a yield that will work is not clever. Do not fall in love with assumptions. They are not real. No one knows what the future will be other than it will be different. Be prepared in the conventional ways.
If it turns out that 8% happens, then you will be okay. Retire a bit early. Take an extra trip or help children. Whatever pleases you.
Hoping for 8%, no matter how dedicated you are at hoping will not necessarily work. Better to be a little safe by assuming less. Time will tell.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
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