Saving for Retirement

When you’re in the accumulation phase of your career you should strive to have an ever-increasing cash flow. Each year, regardless of the markets or the interest rates, you should be trying to increase your cash flow from investments. The best formula for judging when you can retire is: when your investment cash flow surpasses your life style requirement. At that point your need to earn money is replaced by your investment income. If your cash flow from investments is greater than your lifestyle requirement then the day-to-day value of your investments is of less importance. It really is that simple.

Traditional retirement planning wisdom however, is based on the question, “how much money do you need to retire on?” Financial soothsayers, for example, will tell you that at age 65 you’ll need $2,000,000 in investments. Let’s take a closer look at that figure. If your investments are generating six per cent, that would give you $120,000 of pre-tax income, but if the rate of return is reduced to four per cent the income drops by 33.33 per cent to $80,000. If the rate goes up to eight per cent the income increases by 33.33 per cent. So far that seems fine and dandy, but what happens if you’re counting on having $2,000,000 at age 65 and the value drops by 33.33 per cent the year before you retire? Now you only have $1,334,000 and even at eight per cent that’s only going to give you $106,665 per year of pretax income. At four per cent your income would be reduced to $53,332.

Do you see why so many people who were going to retire, or were retired, have been in such a panic over the last few years? These people were counting on their investments being worth a certain amount. They gambled, and in many cases they lost. Here’s a question well worth considering: do you want to gamble with your retirement?

Most people are able to sustain their standard of living as long as they’re able to work. However once they stop, the idea of going back to work may not appeal, or more importantly the opportunity of going back to work, may be limited or improbable.

My philosophy of investing for retirement is this: instead of betting on the value of your assets being worth a certain amount at a certain age, focus on the amount of income your assets are producing.

When you look at the way we’ve been taught to deal with retirement savings we are pretty much either forced into savings schemes such as the Canada Pension Plan (CPP) and employer-sponsored defined benefit pensions,33 or voluntary savings like RRSPs.

For those who belong to defined benefit pension plans, the actual value of the pension assets is of little interest. What is important is the actual monthly pension amount they are going to receive. Those who have no access to employer pension plans are left with the Canada Pension Plan and a decision as to whether or not to contribute to RRSPs.

Everyone who contributes to CPP will get some amount of monthly pension, if they live to retirement (I’ll explain why later), so the actual asset value of the CPP fund is of no concern to the average person. For those who do look at the CPP fund and its assets, the real concern is the sustainability of the fund and its ability to pay out that income.

In contrast, when we turn the focus on RRSPs, or personal retirement savings, we’ve been taught to fixate on the actual dollar amount of the investments and not the income the assets generate, nor the sustainability of those assets.

If you believe the investment community’s rule of thumb that at age 40 you should have 60 per cent of your money invested in equities and 40 per cent invested in bonds, then at age 65 you’ll have 35 per cent in equities and 65 per cent in bonds. Following this methodology, at age 100 you would have 100 per cent of your investments in vehicles such as bonds. Okay, so what income can you expect from this mix? The answer depends on the nature of the actual investments. If you have all your money in mutual funds the answer may be little or none. If you have your money invested in dividend paying equities and real estate, it could be significantly higher.

Following the same age-to-percentage methodology would require you to methodically extricate yourself from equities and increase your percentage of bonds. I see three major problems with this practice. One, interest rates on bonds right now are historically low so your income would have decreased over the last number of years. Two, everybody knows that interest rates are going to rise; this will decrease the value of the underlying bonds and three, there is a risk of default as we’ve seen played out in Europe. My suggestion is to avoid this situation by focusing on the income from your investments and controlling the timing of the sale of your investments.

If circumstances are perfect in retirement, you’ll never have to sell an investment and therefore the value of those investments won’t be a factor. If the circumstances aren’t perfect you can control the selling of any specific asset, and thereby control the rate of return.

Let me explain how we mange retirement assets at TPC Financial Group Ltd. (this example excludes defined benefit pension plans and CPP).

Say you’re 45 years old and you want to retire at age 60 with an after-tax retirement income of $80,000 per year in 2011 dollars. Assuming a two per cent rate of inflation, your retirement income requirement at age 60 would have to start at $109,822. As you move through time your income will have to increase to keep pace with inflation, so if you live to age 90 your income would have to look like this.

AgeIncome Assuming 2 per cent InflationIncome Assuming 3 per cent Inflation
Age 60$ 109,822$ 128,376
Age 65$ 121,253$ 148,823
Age 70$ 133,873$ 172,527
Age 75$ 147,807$ 200,006
Age 80$ 163,191$ 231,862
Age 85$ 180,176$ 268,791
Age 90$ 198,928$ 311,603

So the question is, how much money (investments) do you need at age 60 to be able to generate an after-tax retirement income that would be the equivalent of $80,000 today, indexed to inflation? My contention is that the actual number is impossible to calculate because there are too many variables.

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