My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Monday, February 3, 2014

How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! - Part 1


Let’s be honest. No one knows how much money they really need to retire. My own attempt to quantify my “retirement number” results in a range of hundreds of thousands of dollars. Unless you fancy yourself a two-headed economist/soothsayer, you can only plan based on historical investment returns, anticipated spending requirements and assumed inflation rates. That does not even account for wild cards such as your longevity and the random sequence of returns you will get from the stock market. The best laid retirement plans of mice and men can often go awry… when bam -- you get a sudden economic shock or stock market aberration and your retirement plan becomes as worthless as the paper you wrote it on (those of a cynical nature have be known to say; all any retirement plan proves is ink sticks to paper).

I’ve been pondering this question for over a year as I have attempted to figure out the nest egg I need to fund my own retirement. My final conclusion: the financial and economic variables you need to consider to even attempt to answer this question are staggering (I detail these in Part 5 of this series) and I will never come to a definitive answer. This realization is actually liberating yet frightening. Liberating as I realize the best I can do is to create a plan that is based on a framework of historical data, actual data and my best guess estimates. Frightful in the sense that I may not know until it’s too late if I have grievously miscalculated my retirement needs. While going through this nest egg building process, I made some notes and read various papers. I soon realized I had a blog post in the making; in fact a six- part series that I will post throughout February.

For some, this series may be far to detailed. For others, these posts will provide food for thought. For the mathematicians and academics out there, the discussion will not be “academic” enough (although the problem with many academic papers is that only the author and other retirement/mathematical experts understand what the heck they are proposing). However, in all cases, despite the difficulty I see in making a definitive determination of how much money you or I need to retire, burying your head in the sand and ignoring the issue is not an option. It is imperative you try and at least get a ballpark number for planning purposes and continuously refine that number over time. I hope this series of blog posts will provide you the impetus to plan for your own retirement if you have not yet done so.

So where does one start? The 4% withdrawal rule is one of the most commonly accepted rule of thumb retirement strategies. Simply put, the rule says that if you have an equally balanced portfolio of stocks and bonds, you should be able to withdraw 4% of your retirement savings each year, adjusted for inflation, and those savings will last for 30-35 years.
If you embrace this rule of thumb, then in theory you should be able to determine how much money you need at retirement by working backwards. Unfortunately, as I will discuss, it is not quite that simple. The 4% withdrawal rule has some inherent flaws which I discuss below and therefore should only be used as part of your retirement framework to provide you an idea of what would be a sustainable nest egg.

Whether the withdrawal percentage is reduced from 4% to 2%, or you modify the formula, everyone is still searching for the holy grail of retirement planning, that being, what is your safe withdrawal rate? I.e.: How much money can you safely withdraw from your nest egg each year and not run out of money before you pass away.

Some retirement experts feel the search for a safe constant withdrawal rate is a foolhardy. In this Toronto Star article, Moshe A. Milevsky, a well-respected finance professor at the Schulich School of Business at York University says the following:

“If the rule means that you start by withdrawing 4 per cent of the value of the portfolio at retirement — and then adjust that by inflation every year regardless of how markets perform over time, then it is a horrible rule of thumb. The spending rate over time should depend on the markets, interest rates, how your portfolio is performing and your attitude to longevity risk. You cannot pick a rule at the age of 65 [and say] that is how you will behave over the next 30 years.”

Mr. Milevsky has some very interesting original thoughts on retirement that I discuss in the third part of this series. In fact, if you agree with his views, I tell you to exit the series at that point and return for Parts 5 & 6. Notwithstanding his comments (which I believe have validity), because of the simplicity of the calculation, many people and Financial Institutions still feel the 4% rule is an excellent starting point in the determination of your retirement nest egg if you understand its limitations and flaws. I agree that this rule is simple to apply and understand and thus over the next few posts, I will discuss various studies and papers that deal with the determination of a safe withdrawal rate and whether 4% is a safe withdrawal rate in this day and age. Finally, I will discuss variations of the rule put forth by retirement experts to adjust/correct for the perceived/flaws of the rule of thumb.

Limitations of the 4% Rule


Some of the criticisms of the 4% model include:

1. The model does not account for income taxes on non-registered accounts and registered accounts. Michael Nairne in this National Post article descriptively calls the deferred tax liability on registered accounts
the “Dark Side” of RRSP’s.

2. The model does not account for transaction fees or management fees related to your investments.

3. The model treats everyone exactly the same.

4. The data for the model was based on only historical U.S.stock data and does not include foreign equity data.

5. The model builds in an inflation adjustment; however, some commentators feel the cumulative inflation adjustment may force you to take larger and larger withdrawals.

A Tax Centric Variation on the 4% Withdrawal Rule


As result of the omissions above, especially the income tax component, I created a very crude tax centric variation of the 4% rule to provide an alternative comparison to some of the other retirement formulas I discuss in Part 6. (Please note I said crude and tax centric. When I posted last Monday I was going to run this series, I got various comments on the blog and to my inbox that people were excited to see what I came up with and did I use a Monte Carlo simulation etc. I do not have the qualifications, let alone the time, to run statistical simulations to come up with a unique formula that like every other formula will be flawed because of the unquantifiable variables that must be considered in determining your retirement number).

Now that I have dampened your expectations for my crude variation, I simply determined my spending requirements in retirement and subtracted from my spending requirement, my estimated sources of income outside of retirement (Old Age Security, CPP etc.) which results in a retirement withdrawal shortfall.

Here is where my calculation gets tax centric. I first calculate the income tax owing on my total estimated retirement income. This tax liability causes my retirement shortfall to increase. The next calculation is a bit circular, but I then come up with a revised withdrawal amount that after-tax covers my anticipated spending shortfall.

I then divide my required retirement after tax withdrawal above by 4% (3% for a conservative approach) which tells me how much money outside of any CPP, OAS or company pension (which I don’t have) I need to accumulate for retirement. When I post actual numbers in part 6 this will be much easier to follow and make a little more sense.

This crude estimate will give mathematicians heart palpitations. I know this tax centric variation does not address multiple issues, but bear with me until you see where I go with this in Part 6.

In no way should you rely on this framework as the sole determinant for your own retirement planning. However, as you will see in my last blog post, this number is not that far off from what I get when I have a financial planner use his software to provide me with “a number” and the number I get when I compare to some other calculations suggested by retirement experts.

I feel like a Lawyer with all these Caveats


One last final caveat before I discuss some data and analysis. Please be aware that I am not a retirement expert, financial planner, mathematician (I dropped statistics in University), or a psychic and understand this series should not be construed as specific personal retirement planning advice. The intention of this series is to:
  • summarize prior research (the information is overwhelming and the arguments made by some brilliant people, hard to disprove)
  •  assist you in determining your safe withdrawal rate percentage or provide you with an alternative method to the constant withdrawal methodology
  •  provide links to the articles I read
  •  share my thought processes in trying to determine my own retirement needs
Hopefully all this will provide you with a launching point to help you consider what may be a reasonable retirement nest egg and/or a reasonable spending amount for your retirement.

On Wednesday I discuss the history of the 4% withdrawal rate rule of thumb in greater detail.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.