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.

Monday, February 24, 2014

How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! - Part 6

Parts 1-5 of this series highlighted the challenge in determining a definitive retirement number. Nevertheless, against my better judgment, today you will receive some simplistic retirement nest egg calculations; since we all like to know what everyone else thinks their number should be. Who the heck knows, if any of these numbers will be in the ballpark or not.

Before I get to the numbers, you will read about some Canadian income tax idiosyncrasies and the impact income taxes and inflation have on your anticipated retirement withdrawal amount.

Made In Canada Idiosyncrasies


One significant issue for retired Canadians is that your annual minimum Registered Retirement Income Fund (“RRIF”) withdrawal starts at 7.38% and averages approximately 8% of your actual RRIF balance over the first ten years. If your spouse is younger, you can elect to use their age to calculate your minimum RRIF withdrawal amount, which will lower your yearly required withdrawal. In either case, where the majority of your retirement funds are in your RRIF, the required withdrawal may be substantially higher than the 3-4% you plan to withdraw annually from your retirement nest egg (However, as per my example for Mr. and Mrs. Bean below, if you can split pension income with your spouse, the income tax cost of the excess withdrawal may be mitigated).

A discussion of how to manage the drawdown of your RRSP and take into account the minimum RRIF withdrawals is too fact specific and beyond the scope of this series. I may however, post a future blog on this topic.

For higher income Canadians, their Old Age Security may be clawed back as their retirement income increases. For 2014, the clawback starts at $71,592 and your OAS is fully clawed-back at $115,715.

I am The Blunt Bean Counter –So let’s get Tax Centric


As discussed way back in Part 1 of this series, the 4% withdrawal rule ignores income tax. Thus, I will provide you with some examples of how income taxes may impact your selected retirement withdrawal rate. These examples illustrate the tax centric framework I use for one of my own retirement nest egg estimates, which I then compare with other retirement calculators, formulas, etc. proposed by other expert retirement planners.

You will note my model is just a variation on the 4% rule and still ignores investment fees. However, I am going to assume you use low cost ETF’s so that your costs are minimal or if you use an investment advisor, your returns are at least market after accounting for your management fees ( ha ha). I am also going to assume the yearly inflation adjustment under the 4% rule will cover off inflation if not overcompensate for it. Just accept these assumptions for the time being. I know Michael James is flipping with the investment fee assumption.

Sample Data – Mr. and Mrs. Bean


Let’s say Mr. and Mrs. Bean each expect to receive full Old Age Security (approx. $6,500) upon retirement and that Mr. Bean and Mrs. Bean anticipate they will receive $12,000 and $6,000 respectively a year in CPP retirement benefits. Finally, assume Mr. and Mrs. Bean will have equal RRIF’s or make the election to split pension income such that they will each receive $50,000 in RRIF payments in Scenario 1, $40,000 in Scenario 2, $30,000 in Scenario 3, $25,000 in Scenario 4 and $20,000 in Scenario 5.

Using the sample data above, here is the Bean’s income tax situation upon their retirement.

Mr. Bean
Scenario 1
Scenario 2
Scenario 3
Scenario 4
Scenario 5
Old age security
$6,500
$6,500
$6,500
$6,500
$6,500
CPP
$12,000
$12,000
$12,000
$12,000
$12,000
RRIF
$50,000
$40,000
$30,000
$25,000
$20,000
Total income
$68,500
$58,500
$48,500
$43,500
$38,500
Tax payable
$14,400
$11,100
$7,700
$5,800
$4,500
Net after-tax amount
$54,100
$47,400
$40,800
$37,700
$34,000
Mrs. Bean
Scenario 1
Scenario 2
Scenario 3
Scenario 4
Scenario 5
Old age security
$6,500
$6,500
$6,500
$6,500
$6,500
CPP
$6,000
$6,000
$6,000
$6,000
$6,000
RRIF
$50,000
$40,000
$30,000
$25,000
$20,000
Total income
$62,500
$52,500
$42,500
$37,500
$32,500
Tax payable
$12,600
$9,100
$5,600
$4,200
$3,000
Net after-tax amount
$49,900
$43,400
$36,900
$33,300
$29,500
Combined after-tax
$104,000
$90,800
$77,700
$71,000
$63,500


The Tax Effect – Ouch


In Scenario 1, Mr. and Mrs. Bean will pay almost as much in personal income tax ($27,000) as they receive in OAS and CPP ($31,000). Consequently, their true cash available for spending is essentially the gross withdrawal from their RRIF’s, likely a huge cash flow surprise for Mr. and Mrs. Bean. In Scenario 2, taxes eat up approximately 2/3 of Mr. and Mrs. Bean’s pension income. For Scenario’s 3-5, the impact of taxes though still significant, starts to decrease as a percentage of pension income and overall income under each of those scenarios.

Playing with Numbers to get a Tax Centric Number


At this point, let’s play with some of these numbers and see if we can come up with a crude ballpark number for the Bean’s retirement nest egg. As I stated on day 1, this framework is clearly limited, is
based on the 4% withdrawal rule and has no academic basis and should not be relied upon as the sole determinant for your own retirement planning. 

Determine Your Spending Requirements


One of the most important inputs into any retirement calculation is your anticipated spending. Mr. Bean, who is an anal accountant, has used Quicken for years to track his spending and can project which of these expenses he will still have in retirement. The amount he needs to add to his projected spending amount for travel is his “retirement wildcard”, but Mr. Bean is comfortable he can estimate this amount and not be materially wrong. Your spending requirement should really be a yearly calculation and should typically account for higher spending in the early years of your retirement and lower spending in the later years, plus account for one-time expenses like a car purchase, helping pay for a child’s wedding or assisting your child buy a house; however, for this crude calculation, I just use a set spending rate.

Reverse Engineering Mr. Bean’s Retirement Needs

 

[Note: For purposes of this example I am assuming all the Bean's funds come from a RRIF to exaggerate the income tax effect; in reality, you will probably have anywhere from 20-40% of your retirement funds in a non-registered account(s). In addition, I do not try and account for the fact the required RRIF withdrawal may be in excess of 4%].

Once Mr. Bean determines his spending requirements, I can work backwards to help him determine his retirement number under my tax-centric formula. For example, if I assume the Bean’s spending requirement is going to be $71,000 a year in retirement and they have $31,000 in pension benefits, the Bean’s will need to make up a $40,000 retirement shortfall before I factor in income taxes. By co-incidence Scenario 5 reflects that exact situation. The Bean’s will each draw $20,000 from their RRIFs and have a combined income before tax of $71,000 ($38,500 + $32,500).

Of course, Scenario 5 reflects that after tax, they will only have $63,500 to spend, which is $7,500 short of their needs. Thus I need to gross-up the $40,000 withdrawal so the Beans can achieve their required retirement objective of $71,000 a year. Luckily I have a tax program that makes this easy to determine (you can do this with your personal tax program if you do your own taxes or use an online calculator) and when I run the numbers, I determine the Bean’s will need to take $50,000 or $25,000 each from their RRIFs (instead of the $40,000 or $20,000 each I required before tax in Scenario 5) to net out to their required $71,000 a year spending requirement. Again by a strange co-incidence, this is essentially Scenario 4 above.

Mr. Bean is short a few beans.
Since the Bean’s will need approximately $50,000 before inflation for each year of retirement (in addition to their CPP and OAS), I can now utilize the 4% withdrawal rule to estimate the amount of money they will need to retire. The magic number is $1,250,000 ($50,000/.04), which if you believe the 4% rule, will allow the Bean’s to withdraw $50,000 plus inflation for approximately 30 years or $71,000 after-tax including their pension income. If the Bean’s want to provide a measure of safety and use a 3% withdrawal rate, they would require a nest egg of $1,666,666 ($50,000/.03). Mr. Bean however told me to stick with the 4%, since as an accountant; he has led a stressed life and does not anticipate making it past 85 anyways.

The above calculation results in an inflated magic number as it assumes 100% in registered funds. In reality, the number would be based on a draw-down between your registered and non-registered accounts.

When I told Mr. Bean these results, he was thoroughly depressed. However, with my warped sense of humour, I went on to tell him if he was to retire in ten years and he required $50,000 in non-indexed RRIF withdrawals (CPP and OAS are indexed for inflation) he would actually require approximately $61,000 in yearly withdrawals if inflation averaged 2%. That would push him closer to Scenario 2 above. That would mean he would require almost $80,000 in RRIF payments and using a 4% withdrawal rate he would need to have $2,000,000 at retirement, a staggering number. Personally, I think you cannot look at a 2% inflation rate and just inflate your spending expectation. I would suggest wage increases may partially offset these increases and presumably the extra 10 years of investment returns and new deposits would make it possible to get to $2M in 10 years even if they don’t have $1.25M now. In any event, it is a sobering calculation.

Comparing Apples to Oranges to Pineapples


When I started this series, I was foolish enough to think that I could utilize the Bean's income and spending parameters to provide you with comparable nest egg numbers using various retirement expert's formulas. However, as I discussed in Part 5, there are multiple variables and assumptions that affect each calculation which makes an apples to apples comparison impossible. This will be vividly demonstrated as I walk through the various comparisons below.

Yet, I thought it would still be interesting to see how various retirement experts and their formulas, equations etc. compare when given the same retirement spending level and the same pension numbers. It is enlightening, if not slightly amusing, to see how the retirement variables are applied and the significant variances in the final nest egg determination.

What a Financial Planner Says


William Bengen, the man behind the 4% rule, says that “Where the client has any degree of complexity to their retirement situation at all, I find I must have financial planning software to incorporate all these factors….The financial planning software is essential to blending all these elements and coming up with a withdrawal rate and the use of Monte Carlo, and so forth—I just find that essential”.

So I took Mr. Bengen’s advice and had a financial planner run some numbers on his software for me, based on the above $50,000 RRIF requirement and $31,000 of pension income. In the end our comparison was not apples to apples. His software forced him to make various assumptions I could not include in my crude calculation and he wanted to use a 3.5% real rate of return. He also decided he wanted to allocate the non-registered and registered accounts equally amongst other assumptions I could not make with my limited tax centric model. So what did his software reflect as the required nest egg? His number was $1,335,000.

In this Globe and Mail article from last week, the financial planner comes up with a retirement nest egg of $1,240,000 with a couple retiring at 65 and planning to spend $75,000 a year, with a life expectancy of 95 who receive two-thirds the maximum CPP/OAS payments ($25,000 a year) and who achieve an annual return of 5 per cent, in an environment of 2-per-cent inflation.

Jim Otar’s Retirement Asset Multiplier


I next turned to Jim Otar, a financial planner and mechanical engineer (what is with engineers and retirement?). Jim is the author of Unveiling the Retirement Myth. Jim considers there to be three basic risks for retirement financing:

1. Longevity risk
2. Market risk
3  Inflation risk.

He uses an asset multiplier to factor in these risks. Jim does an awesome job of using “plain English” in this article “Do we have enough to retire?”.

You may not believe this, but I had done all my calculations above before I found Jim’s article. Honestly, it is just a fluke he used $70,000 as his required retirement spending (versus my $71k) and $32,000 for his pension income (versus my $31k). When I use Jim’s multiplier of 28 x my $40,000 pre-tax shortfall, I come to required retirement assets of $1,120,000. I am not sure how, or if Jim even factors in income taxes, into his multiplier.

Moshe Milevsky’s Equation


In Chapter 1 of Mr. Milevsky’s book , “The 7 Most Important equations”, he has a chart showing how much money you need for a 30 year retirement based on a real (after inflation) spending amount. Now to be fair to Mr. Milevsky, he says his first equation does not address taxes and you should use his final all-encompassing equation in Chapter 7. However, that chapter is about sustainable spending and I can easily grab a number from his Chapter 1 chart, so I will use the numbers in this chart and take some liberties with my calculations. If I gross my required spending up to $50,000 to account for  taxes as I did in my tax centric model and use a 3% real return rate that Mr. Milevsky says in his book is reasonable in today's economic environment, his equation would reflect a retirement nest egg of  approximately $990,000.
However, I have read where Mr. Milevsky has stated that in general you need 20-30 times your anticipated spending in retirement, so I think $990,000 would be at the low end of what he would suggest, so I will take the liberty of saying he would probably be more comfortable using a number closer to $1,100,000 for comparison purposes.

 

Michael James


I asked Michael to use his calculator that I discussed in Part 3, to determine the Bean’s required nest egg. He assumed an allocation of 15% in bonds, 15% fully safe and 70% in stocks. He also assumed a 4% real return for stocks and a 2% real return for the bonds. He also assumed a very efficient ETF portfolio with fees of only 0.2%:

Michael determined if the Bean’s want to live indefinitely, they will need a nest egg of approximately $1,680,000. If they plan to live to the age of 95, they will need approximately $1,070,000. If they plan to live to 90 they will need around $960,000 or so.

If Michael used a 2% Management Expense Ratio (“MER) instead of his ultra low cost MER of 0.2%, his figures jump to $3,250,000 if you plan to live indefinitely, $1,270,000 for age 95 and $1,090,000 for age 90.

Summary of $71,000 Spending Requirement


If the Bean’s require $71,000 to spend in retirement after-tax (including $31,000 in pension income), the various calculations would suggest that they should be shooting for a nest egg at the low end of $1,100,000 to $1,350,000 at the high end.

As noted above, I have taken liberties with some of the calculations and the variables would change for your specific assumptions and facts. Like I say in my title, who the heck really knows what you need to retire; all these numbers may be consistently wrong, but the above at least provides a starting point of some sort, even if simplistic.

What if the Bean’s have a $104,000 after-tax Spending Requirement?


Since my chart for the Bean's includes a scenario (#1) where they have a requirement for a $104,000 in after-tax spending ($131,000 in pre-tax income), let's see what the various formulas would reflect as their nest egg requirement for that level of spending.

Blunt Bean Counter – $2,500,000 ($100,000 RRIF/.04%=$2,500,000 for a 100% registered account).

Jim Otar –$2,044,000 (as the $104,000 is an after-tax spending amount and Jim uses a pre-tax spending shortfall, I have estimated that spending shortfall to be approximately $73,000)

Financial Planner –$2,250,000 using the same variables as noted in the prior example.

Moshe Milevsky –$1,978,000 at 3% real return, $2,100,000 at 2.5% return (as per his chart in Chapter 1 for a $100,000 after-tax shortfall).

Michael James – if you want to live indefinitely you will need approximately $3,370,000, if you live to age 95 the magic number drops to around $2,150,000 and at 90, it's $1,920,000 and finally, at 85 it's approximately $1,650,000.

If Michael used a 2% MER instead of his ultra low cost MER of 0.2%, his figures jump to $6,510,0000 if you plan to live indefinitely, $2,530,000 for age 95 and $2,190,000 for age 90.)

Summary of $104,000 Spending Requirement


If the Bean’s require $104,000 to spend in retirement after-tax (including $31,000 in pension income), the various calculations would suggest that they should be shooting for a nest egg at the low end off $2,000,000 to $2,500,000 at the high end.

Canadians Know Best


A recent BMO Harris Private Banking survey said that Canadians with investable assets of $1million or more say they need on average $2.3 million to live out their ideal retirement lifestyle. Based on the above, it looks like they are in the ballpark.

Final Caveat


Throughout this series, I’ve shared with you my research and analysis and provided you with as much information as possible so that you can try and determine (or at least consider) the assets you need to accumulate for your own retirement nest egg. There is not one definitive number. Keep in mind, one size does not fit all. My retirement funding includes the sale of my partnership interest; yours may include the sale of a business or a severance payment for taking early retirement. The point being, we all have unique situations.

Conclusion – This Series is Finally Over!!


After going through the analysis I provided to you, I've determined that I am much further away from my retirement goal than I had anticipated and I will still be working for several more years. I now wish I had a company pension. The largest surprise of this exercise to me is that I may give consideration to purchasing an annuity with some portion of my retirement funds, to ensure I have a constant minimum cash flow. Depressing as this exercise was, it brought some clarity to my retirement planning. I also realized that I have no idea whose Monte Carlo simulator will hit the jackpot and that historical data can be interpreted in so many ways it leaves your head spinning.

I do know a multitude of factors beyond my control may impact my expected withdrawal rate (see Part 5 for the laundry list) and thus as a result, I will have to:

1. Be flexible in my spending requirements and may need to be open to working part-time in retirement

2. Review, revise and refine my retirement plan on a consistent basis to account for financial and life events and any changes in my behaviour

In conclusion, I hope my quest or journey for freedom 55,65,75, helps guide your retirement planning. 

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.