I have not looked yet, but I would be willing to believe that of all the books and videos on personal finance, the majority deal with one question.
“How much money do you need to retire?”
The sad reality though is most of them never address that question. They address how you go about having the money available. That creates a risk of finding a solution to no known problem. So lets look at the question.
You need enough to spend plus a margin for error. The error could be yield fluctuations, inflation, tax changes, or differences in personal circumstances. Enough, and margin for error should be dealt with as separate questions.
How much is enough?
First, how do you spend your after tax, after debt payments, after savings now. Some living costs will go away at retirement and some new ones will appear. Children costs will disappear and travel may become more prominent. Recreation will change, but may not go up appreciably. If you have teenagers now, the food bill will go down. No more designer jeans and costly running shoes.
Everyone is different. Many people just assume what they save on children, they will find a way to spend later. Simple enough.
Next, find the components of lifestyle. There are four:
- Basic needs. Food, shelter, recreation, transportation, simple vacations.
- Conveniences. Second car, gifts, hobbies, entertainment and meals out of the home.
- Luxuries. High end vehicles, more exotic travel, secondary residences. Watch for currency issues around travel outside Canada
- Disposable. Cottages, homes in a warmer climate and ski chalets are not forever. When they are sold, new capital appears and the operating costs disappear.
The third aspect is how long do you need it?
For a couple both aged 65, there is about a 50-50 chance that at least one of them will live more than 25 years. So the amount of money is 25 years plus of spending as defined above.
The fourth aspect is inflation.
We break down spending in categories because not all behave the same way under inflation. Normally we assume basics change by the CPI assumption. That tends to be conservative for most people. The other three behave differently and in many cases, the ability to spend declines faster than the prices rise. The cost of skiing is not a serious issue for 90-year-olds. Similarly clothing, driving, and recreation change downwards. History shows that total spending in dollars at 70 is not much different than it is at 90. The relative size of the components changes though.
The fifth aspect is spontaneous income.
You need not replace income that will be replaced by other plans. In Canada, Old Age Security and Canada Pension Plan benefits are about $18,000 per year and indexed to inflation. For a couple, even one where one spouse did not pay into CPP at maximum, the total can exceed $30,000.
Calculating the sum needed.
If expected expenditures are $70,000, then only the other $40,000 must be saved. Some of that might come from an employer pension plan. If $25,000 does, there is a need to provide for $15,000 plus inflation.
Inflation applies during the run up to retirement. For the time after, a much lower rate because of diminishing ability and desire to spend. We usually use CPI before retirement and zero or maybe half CPI on non-basic after.
Then the taxation of income that applies. In Canada the taxes are fairly benign for a couple who wish to spend less than about $80,000 annually. $40,000 each would be in the range of $72,000 after taxes.
Margin for error is often something like two or three years spending. It depends a little on health history and family history.
The rest is just arithmetic. In this case, in the $350,000 to $400,000 range plus $200,000 more for emergencies. For a couple who are 40, investing at 3.5% over inflation and tax deferred, the saving need is about $550 per month rising with inflation. Something around $350 after the tax saving on the RRSP deposit. Doable.
Forget about formulas like 70% of pre-retirement income or some other multiple. A bespoke plan has two advantages. You will not oversave except by choice, and you will understand why you are doing it.
And you can see how to change as you go. Important, no plan is forever.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772