moneyFYI
Financial Freedom Is Merely Organized Common Sense
How Much Money Do You Need To Retire?
That is a question that many people ask themselves. Some ask others to help. It can be decided with a spreadsheet or if you are good at it, with a calculator. You’ll need to know a few things before you start to do the calculation.
The variables
How much do you wish to spend in total each month. Strangely not so easy as you think. It breaks down into layers. Some are attached tightly to inflation, others not. The essentials are usually closely attached. Things you would like to spend, is close but not as tightly tied. You can substitute or discontinue. Things like travel that are optional, luxuries. These can inflate faster than CPI because of currency effects. Most air fares start in US dollars. Canadian dollars may not remain connected at today’s rates. Lastly there are expenses that relate to assets you may not hold forever. Ski chalets, cottages, and a large family home being the common ones. Sometimes there are things like exotic vehicles or art. These costs will increase with inflation, but will suddenly stop at some time in the future. When?
How much spontaneous income do you have:
In Canada
Old Age security $625 each
Canada Pension $750 each. you can share the benefit
Employer Pensions $1,000 each. You split the income for tax purposes. Assume they are tied to inflation. If they are not there’s another step.
So, of your spending need of $6,000, $4,750 just happens.
The simple need
Your need from personal resources. $1,250 per month more,
Plus any taxes payable to get the money in your hand to spend.
For a first step, work without taxes, there are choices about managing those and to some extent are individually specific. Deal with those later.
When does the need begin? Let’s say you are 55 now and expect to retire at 65. Early will dislocate the OAS and CPP numbers. Later, these will be larger.
So 10 years in the future.
How much pre-retirement inflation do you expect? The $6,000 number will be bigger then. Let’s use 2% as inflation over the 10 years. At 2% the cost of living will be 22% higher so $7,300. Using an average rate is normally a problem but in this case, unless higher inflation in the early years, affects savings, it should come out close.
We assumed other income was inflation protected so just the 1250 need must be increased so you need to provide $1,550 at 65.
How long do you need it? . There are simplifying assumptions.
- There is about a 50% probability of a healthy couple aged 65, one at least will live to 90, so 95 should be safe enough. 30 years. You might want to assess family history.
- If you want to live a long time you should plan past your hoped for life span. Who would want to get their wish for a long life and run out of money. The worst that happens is there is more for the estate.
- How much would you adjust. Most plans work on the idea that inflation doesn’t matter forever. At some point spending will tend to shrink at least as fast as inflation increases. The clothing budget at 85 is likely different than at 65. The second car, or even both may be gone. Travel may be less exotic. Talk to a 90-year-old for perspective. The study here will assume inflation continues for 30 years. A more sophisticated model s need for that adjustment.
- What happens after first death. We’ll assume no management issues.
For easy thinking you must supply $1,550 per month for 30 years with inflation at say 2%
What else could happen.
One is certain. One or the other of the couple will die first. Can the survivor manage the assets that remain? Will total cost of living change. CPP will drop by 40%, possibly the employer pensions will to. Assume every one lives 30 years. again the more complicated model could address the variations.
One is not so certain. One or both might need care or uncovered medical costs. The simplifying assumption is if they do, they are less likely to live a long life. In some cases, the home may be sold.
What investment income can be earned? I have found it is not so difficult to assume you can invest for some amount over inflation. It may not work out exactly each year, but it tends to happen over time without the need for exotic investments. Be cautious if you assume high inflation. Tax will distort the ratio. Lets suppose you can get 1.5% over inflation for the duration. So 3.5%
The preliminary look
How much capital at 65 would you need to supply $1,550 per month, $18,600 per year, for 30 years, with inflation at 2%, investment yield at 3.5%, and for the sake of illustration, income tax at 20% on the income.
The answer: $486,000.
How much do you have now? Assume $150,000. which at 3.5% yield after taxes while working will accumulate to $212,000
So new capital needed is $274,000 and that implies annual savings of $22,000 the first year and increasing by inflation until retirement.
What to do
First and foremost, nothing in this sort of analysis provides a guaranteed result. Models are for insight not for answers.
The idea is to be directionally accurate. If you get that from a model you are pretty well done. Refinement does not amend the future. It will be different than you can reasonably expect. you can overcome that problem in a spreadsheet by retesting with other assumptions. You should do that. If you could grow the capital with no taxes pre-retirement, you would save $21,000. Other yield assumptions would matter too.
Eventually you get a space from worst outcomes to best and put your savings to work somewhere in the middle.
The takeaway
Many things in financial planning are merely organized common sense. The organization involves isolating the implicit variables and seeing what they mean in combination.
This type of model is very limited and does not allow you test variations that are time dependent.
Building a time based model is significantly more challenging and does not create certainty either. It does allow you to test more variables though
No matter how carefully prepared your model, it is not something you can count on. It is, at best, the balance of probability.
Pay attention and adapt as circumstances change
Most of financial success comes from lifestyle choices. Planning is the outcome and is quite abstract compared to life. Be a little wiser.
The arithmetic is not especially difficult but you won’t have much success with a pencil. If there is some demand, I will create a template for the simple assumption model that permits the testing of ideas. Email or text me, and I will put something together.
I help people have more retirement income and larger, more liquid estates.
Call in Canada 705-927-4770, or email don@moneyfyi.com
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