The One-Two Punch of Inflation and a Weak Stock Market

We are currently facing the highest inflation rates in forty years. In April, the inflation rate was 6.8% in Canada and 8.3% in the United States. It is scary to think that these rates pale in comparison to the levels hit in the 1980’s which were as high as almost 14% in Canada and 15% in the United States.

In addition to the current inflationary pressures, the stock markets performance is also the weakest since 2008. How this double whammy affects you is based on your age, working status and income bracket. Today, I will look at two scenarios: those of you still working and those of you retired or close to retirement.

Working Individual

The Effect of Inflation on Your Cost of Living 

 

The current environment of low interest rates (although they are moving higher quickly), the war on Ukraine and supply chain issues are a rare economic mix. I certainly have no clarity of where inflation is going and I am definitely not qualified to comment. I will just say personally, I am concerned we are stuck with higher than usual inflation for a while until the supply chain is restored to “normal” or the demand side drops.

While not representative of the population in general, a sizable portion of my blog’s readership are high-net-worth (“HNW”) individuals and owners of successful private corporations. If you are part of this economic group, you are undoubtedly feeling the impact of the rise in inflation. However, in general, HNW individuals are typically not as significantly impacted by inflation, as their higher monthly income provides a buffer to absorb higher monthly costs. In addition, many HNW jobs and business goods and services are in demand currently, resulting in higher wages and/or profits. While the above is not the case in all situations, for many high-net-worth people, inflation has a minor impact on their day to day lives.

If you are not a high net worth individual, the rise in inflation can be painful. The high cost of gasoline, groceries, restaurants, clothing, travel, appliances, cars etc. has raised your monthly costs 7% or so, or maybe higher depending upon how you consume or if you are required to drive long distances for work.

So how does one offset inflation costs if their wages are not covering the increase in costs? Essentially, you have to watch your day-to-day spending and consider delaying or cutting-out some discretionary spending. This is also a suitable time to update or create a monthly budget.

You may want to consider the following tips to help you offset your rising costs and expenses:

1. Review your Mortgage Term -As we are seeing, governments are increasing interest rates to offset inflationary pressures. How high and for how long these rate hikes continue are unknown. But interest rates in most cases cause the largest potential impact to family costs in the form of higher mortgage costs. If you have a mortgage advisor or financial planner, you should discuss with them whether you should lock in rates for a longer-term mortgage to provide cost stability. If you do not have a planner, educate yourself as best as possible and speak to people you trust about what tact you may want to take in respect of your mortgage.

2. Reduce and Consolidate Consumer Debt - Consumer debt can become very costly when interest rates rise. You need to consider if you can pay down any of this debt or consolidate into a lower interest rate.

3. Contain Food Costs -This is not a micro-cost savings blog, so I am not going to get into cost saving details, but as we all know, grocery and restaurant costs have increased substantially. You may need to pay more attention to your grocery planning and cut back on your restaurant visits.

4. Drive Smartly -With the explosion in gasoline prices, it may be prudent to cut down some non-essential driving and when driving with your spouse or companion, you may want to use the most gas efficient vehicle rather than the “nicer car”.

5. Cancel Unnecessary Subscriptions and Fees -You may want to review your various subscriptions and fees; as if you are like most people, one or two are not providing much value. This would include gym costs that are often new years resolutions that fade by March.

6. Review Larger Discretionary Costs -You unfortunately may have to consider cutting back or delaying on planned discretionary expenditures such as travel, home improvements, RRSP contributions etc.

Many of your other expenses can be reduced or cut. Again, I suggest you prepare a detailed budget to help identify those expenses.

The Second Punch – The Stock Market Decline

The stock market has taken a large hit in 2022 (the TSX has done better than most), however, the reality is that unless you are near retirement, you should have several more years to make-up any current year losses whether you are a high-net worth individual or not.

While your investment statements will not be pretty, the strong market returns of the last few years have created a buffer. Historically, a long-time horizon until retirement will allow you to recover any current losses and hopefully have some significant future returns.

This may be the appropriate time to review your advisor’s three, five and ten year investment returns to their established benchmarks and review their annual fees, to ensure you returns are reasonable and you are receiving value for your fees. I will not discuss potential re-allocations of your portfolio, as those should be discussed with your investment advisor. Keep in mind short-term fixes often come back to haunt you when things turn around. So, keeping to your plan with a couple tweaks, often is the best course of action, but speak with your advisor who is aware of your personal situation.

Given many people have reported significant capital gains the last few years, you may want to discuss with your advisor (or consider yourself if you are a DIY investor) realizing capital losses on speculative holdings or other stocks that have suffered losses and do not fit your current investment strategy. Any losses realized in 2022 can be carried back against capital gains in 2019, 2020 and 2021.

The Effect of Inflation and Poor Markets on Retirees or Those People Close to Retirement

I have written a couple times on how much money you need to retire. In 2014, I wrote an extensive six-part series titled How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! (the links to this series are under Retirement on the far-right hand side of the blog).

I updated this series between January and March 2021, including a discussion on the factors that can impact both the funding of your retirement nest egg and your withdrawal rate in retirement. The randomness and unpredictability of these factors can derail even the most detailed retirement plans.

Two of the most impactful factors on retirement planning are inflation and sequence of returns. As both these factors have reared their ugly heads at the same time, this one-two combo can really throw a wrench into the accumulation of your future nest egg if you are close to retirement. Furthermore, they can impact the retirement savings and withdrawal rates of those already retired.

Inflation Can Dramatically Impact Your Retirement

Many financial plans I have seen over the last few years have been using a 2% inflation rate. However, a 2% inflation rate is at least in the short-term 4-5% too low. If inflation holds, many retirees will need to reduce costs and may have to make larger than anticipated withdrawals from their retirement funds.

The following excerpt taken from Investopedia, quantifies an example of the damage inflation can do to an American receiving social security. “In terms of the actual amount of money that inflation can cost retirees, the numbers are startling. LIMRA Secure Retirement Institute constructed a model demonstrating the effect inflation could have on the average Social Security benefit over a period of 20 years. According to its research, a 1% inflation rate could swallow up $34,406 of retirees’ benefits. If the inflation rate were to increase to 3%, the shortfall would total more than $117,000”.

Hopefully, the spike in the inflation rate is a short-term blip and government policies cause the rate of inflation to settle down to more recent levels. If not, there is no magical panacea. Retirees will be forced to review spending and possibly cut-back on items that are not necessary or substitute cheaper alternatives.

Stock Market Declines and Sequence of Returns

As discussed above, for non-retirees, a drop in the market historically provides short-term pain only, as the investors portfolio has a long-time frame to recover and grow. However, for retirees (and possibly near-retirees) that is not the case and they are subject to what is known as Sequence-of-Returns Risk. For purposes of retirement planning, this refers to the random order in which investment returns occur and the impact of those random returns on people who are in retirement. In plain English, it relates to whether you are the unlucky person that retires into a bear(ish) market in 2022 or the lucky person who retired into the bull market five years ago. This is important because if your returns are poor early on, your retirement nest egg will not last as long as someone who had good returns early in retirement.

For full transparency, most of the discussion below comes from prior blogs I have written on the subject of sequence of returns.

The sequence of returns phenomenon is illustrated very clearly on page 7 of this report by Moshe Milevsky and by W. Van Harlow of Fidelity Research Institute. In this example, two portfolios have the same return over 21 years but in inverse order. The portfolio with the positive returns initially ends up worth $447,225 in year 13, while the portfolio with the negative returns was depleted in year 13.

If you read the article, you will note the authors also discuss the affect of inflation.

Can you solve for the sequence of returns?

Michael Kitces and Wade Pfau two of the most renowned retirement specialists both seem to agree that people can reduce the impact of sequence of returns near to, or early in retirement, by using something called a rising equity glidepath in retirement.

This strategy has you starting retirement with a lower equity component in your portfolio—30%, for example—and increasing it throughout retirement to, say 65% or 70%. The advice is counterintuitive, since consensus advice has always been to reduce equity as we age. But as Mr. Kitces and Mr. Pfau point out here and here (at the 6:12 mark), the glidepath actually reduces losses in your nest egg when you most need it (at the beginning of your retirement) and allows for recovery in later years as your equity increases.

I am not qualified to condone or dismiss the equity glidepath. I am just pointing out some alternative thinking by two retirement specialists.

Retirement planning is difficult at the best of times, it can get downright ugly when inflation and poor markets occur simultaneously. Let’s hope, these are just short-term blips, but they are a wake-up call to the random risks we always have in saving for retirement and more acutely, for those already in retirement.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

How much do you need to retire in Canada? (Part 4)

In the first three parts of this series, the focus was on the safe-withdrawal rate for retirement. Today, in the final installment of this series, I revisit factors I discussed in my 2014 retirement series that can impact both the funding of your retirement nest egg and your withdrawal rate in retirement. The randomness and unpredictability of these factors can derail even the most detailed retirement plans.

How long am I going to live?

In Canada, depending upon which study you utilize, the average male will now live to approximately 80 years old and the average female to around 84 years old. There is also around a 50% chance that one spouse will live to age 90 if both are alive at 65 years old and a 20% chance one spouse will reach 95, again depending upon which study you review. These numbers are not intended to provide absolute actuarial accuracy but to reflect your planning needs. Bottom line: There is a good chance one spouse will still be alive at 95 years old.

The fact that we don’t know how long we’ll live creates the ultimate dilemma of retirement: do you scrimp in the early years of retirement, when you are likely healthier and full of energy, to ensure you have money to support yourself if you live longer than average?

I have seen far too many people die without spending their nest egg and enjoying their retirement (and as the Michael Kitces studies noted earlier in this series reflect, most people’s nest eggs seem to last longer than expected). I am in the camp that values those early retirement years, without being reckless about saving. Based on the studies, I would consider erring slightly on the side of early-retirement spending.

Interest Rates

We have been in an unprecedentedly low-interest environment for many years, and it’s now been exacerbated by COVID. This has weakened the benefit of GICs, term deposits and similar investments to fund and keep funding retirement. Bonds have been a bit of a buffer, but if rates turn upward, bonds may not provide the backstop they have over the last few years.

There is no consensus answer for this issue. Many investment advisors are suggesting a higher allocation to equities, but this involves far more risk than many people are willing to assume. So, this is a current-day quandary that has no clear answer.

Inflation

In addition to being in a low-interest rate environment, we have also been in a period of low inflation. Post-pandemic, it is unclear if inflation will rear its ugly head again, but a strong recovery could be problematic. An economic environment of low market returns and high inflation can severely impact the funds you accumulate to fund your retirement and the real returns you achieve in retirement.

Sequence of returns risk

Sequence-of-returns risk for purposes of retirement planning refers to the random order in which investment returns occur and the impact of those random returns on people who are in retirement. In plain English, it relates to whether you are the unlucky person that retires into a bear market or the lucky person who retires into a bull market. This is important because if your returns are poor early on, your retirement nest egg will not last as long as someone who had good returns early in retirement.

The sequence of returns phenomenon is illustrated very clearly on page 7 of this report by Moshe Milevsky and by W. Van Harlow of Fidelity Research Institute. In this example, two portfolios have the same return over 21 years but in inverse order. The portfolio with the positive returns initially ends up worth $447,225 in year 13, while the portfolio with the negative returns was depleted in year 13.

If you are looking for solace about retiring at a market peak, read this blog I posted in 2019. There I discuss an article by Norman Rothery on the sustainability of the 4% rule even when you start your retirement in a poor market.

Michael Kitces, whom I referenced in my blog post a couple weeks ago, has also written extensively on the sequence of return phenomenon. As noted in the prior posts in this series, Mr. Kitces has used the worst years in history as his floor for the 4% rule, and the rule held up. Here are a few helpful links on his sequence of returns articles:

• The extraordinary upside potential of sequence of return risk
• Understanding Sequence Of Return Risk – Safe Withdrawal Rates, Bear Market Crashes, And Bad Decades
• Retirement Date Risk – The Impact Of Sequence Of Returns Risk On Those Still Accumulating For Retirement

Can you solve for the sequence of returns?

Finally, Mr. Kitces and Wade Pfau, whom I noted in Part 2 of the series, both seem to agree that people can reduce the impact of sequence of returns near to or early in retirement by using something called a rising equity glidepath in retirement.

This strategy has you starting retirement with a lower equity component in your portfolio—30%, for example—and increasing it throughout retirement to, say 65% or 70%. The advice is counterintuitive, since consensus advice has always been to reduce equity as we age. But as Mr. Kitces and Mr. Pfau point out here and here (at the 6:12 mark), the glidepath actually reduces losses in your nest egg when you most need it (at the beginning of your retirement) and allows for recovery in later years as your equity increases. You may lessen your child’s inheritance, but you may protect yours.

I am not saying yeah or nay on the glidepath alternative but rather providing you with some alternative thoughts.

Your principal residence

While most of us would love to ignore the value of our home for purposes of our retirement planning, the reality is that for most Canadians, our homes will in small or large part fund our retirements. For some, their home will just backstop any retirement shortfall; for many, their retirement funding includes at least the incremental capital benefit of downsizing their home; and for most, retirement can only be fully funded by selling their home at some point in their retirement.

Parenthetically, the same applies to business owners, who often consider selling the business to support their retirement plans. Business owners do need to add several factors when planning their retirement.

The scary thing about relying upon your home is that its reliability for retirement funding depends on a key variable: its value upon sale (and continued tax-exempt status).

What will my house be worth?

Over the last 10 years, house prices have skyrocketed in most Canadian cities. The million-dollar question is whether these increases in value will continue. Interest rates may increase. Government policy may change. And baby boomer sellers may eventually outnumber younger buyers.

What can I do?

Almost all the factors discussed in this post are impossible to plan for. However, you can adapt and compensate in two ways.

Work Longer

While the old retirement ideal was to sit back and sip cocktails in retirement, many now believe in finding part-time work during the victory lap period of life—or even full-time work doing something you enjoy that pays less. People often say it makes them feel more alive and keeps them mentally sharp, while providing the added benefit of not dipping into their capital. Remembering this may provide comfort if you need to work after you retire to account for the factors above.

Reduce your yearly withdrawal rate

Although possibly challenging, if your nest egg takes a hit due to any of the above factors, you can reduce your yearly withdrawal rate from, say, 4% to 3%, by some dollar value, or the future inflation withdrawal rate as suggested earlier in the series. It’s a tough pill to swallow, but you may need to forgo some short-term plans, perhaps travel for a year or two. As we learned this year, we can all adapt far better than we ever thought if we absolutely need to.

Life is hard enough to plan when things are status quo. It really gets challenging when random economic factors impact your life or retirement planning. The best we can do is recognize these factors exist and adapt and adjust when they arrive.

The content on this blog has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The blog cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information on this blog or for any decision based on it.

Please note the blog posts are time sensitive and subject to changes in legislation.

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The Best of The Blunt Bean Counter - How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! - Part 5

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am re-posting Part five of my 2014 six part series titled "How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does!" If you have not read this series, the links to each part of the series can be found down the right hand side of my blog, under the retirement section.

I decided to re-post this particular blog post because recently there have been numerous articles discussing whether the 4% withdrawal rate is too high (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).

One of the reasons retirement experts are concerned about using the 4% rule is that our longevity continues to increase. Longevity is just one of the many factors that can impact not only your withdrawal rate in retirement, but the funding of your nest egg.

Today's post discusses these various factors and how the unpredictable nature of most of these factors, make it virtually impossible to determine a definitive retirement number and is why I say the "Heck if I Know or Anyone Else Does" how much money you need to retire.

Your Longevity - The Ultimate Wildcard

It goes without saying, that if we knew who long we would live, retirement planning would be a lot simpler. Unfortunately, the best we can do is plan based on longevity studies and family medical history. The Vanguard paper I referenced in Part 3 of this series cites such as study by the Society of Actuaries which found:

“there is an 80% chance that at least one spouse will live to age 85, a 55% chance that one will live to age 90 and 25% chance one spouse will reach 95.”

In Canada, the average male lives to approximately age 79 and the average female lives to approximately 84. Based on the above, your retirement planning should at a minimum assume one spouse will live to at least 95 years old.

Inflation – Grasping for the unknown

The rate of inflation can drastically alter your retirement savings and consumption. An economic environment of low market returns and high inflation can severely impact the funds you accumulate to fund your retirement and the real returns you achieve in retirement. Conversely, interest rates tend to rise with inflation, providing a potential buffer if you lock in higher interest rates and inflation subsides (I remember Canada Savings Bonds paying 19.5% interest in 1981 when inflation was around 12.5%, however, inflation was back down to 4.5% by the end of 1983 and many people were very pleased they had CSB's or GIC's paying very high rates of interest for many years). An average inflation rate of 2% will mean that the $50,000 you expect to spend in retirement in 2014 dollars will require approximately $61,000 in spending in 2024.

One of the criticisms of the 4% rule is that the models cumulative inflation adjustment may force you to take larger and larger withdrawals without regard to your actual spending requirements. Substantive evidence for this criticism is provided below by David Blanchett, the head of retirement research at Morningstar in Chicago.

In this Wall Street Journal article by Kelly Greene, Mr. Blanchett said the following about the correlation between spending and inflation. "Pretty much every paper you read about retirement assumes that spending increases every year by [the rate of] inflation." Ms. Greene went on to say that "when he analyzed government retiree-spending data, he found otherwise: Between the ages of 65 and 90, spending decreased in inflation-adjusted terms. Most models would assume that someone spending $50,000 the first year of retirement would need $51,500 the second year (if the inflation rate were 3%). But Mr. Blanchett found that the increase is closer to 1%, which has big implications over decades, 'because these changes become cumulative over time,' he says".

Sequence of Returns – Bull vs Bear Markets upon your Retirement

The various studies that support a 4% retirement withdrawal, included periods of both bear and bull markets. If you are lucky enough to retire at the beginning of a bull market, your retirement funding will be drastically different than if you retire at the beginning of a bear market. William Bergen in his original 1994 article said:

“This is a powerful warning (particularly appropriate for recent retirees) not to increase their rate of withdrawal just because of a few good years early in retirement. Their “excess returns” early may be needed to balance off weaker returns later.”

It is interesting to note that Mr. Bergen showed that even if you started retirement in the great depression or in the recession of 1973-1974 (which also included a period of high inflation); your money would still have lasted over 30 years, because of the power of stock market recoveries.

However, Moshe Milevsky and Anna Abaimova in this report for MetLife (see page 4 of the report, page 7 of the PDF), very clearly reflect the dramatic difference in retirement outcomes you will have when you have negative market returns early in your retirement vs later in your retirement.

In this blog, Wade Pfau states that:

“In fact, the wealth remaining 10 years after retirement combined with the cumulative inflation during those 10 years can explain 80 percent of the variation in a retiree's maximum sustainable withdrawal rate after 30 years.”

Thus, prudent planning would be to start your retirement following a bear market :).

Registered vs. Non-Registered Accounts

The allocation of your retirement funds between registered (RRSPs, LIRAs, Pensions, etc.) and non-registered accounts (bank, investment, TFSA, etc.) will have a significant impact upon your cash flow in retirement. If you consider all the money in those accounts as capital, the capital in the registered accounts is fully taxable, meaning that if you are a high income tax rate taxpayer, you may be paying as much as 46% or higher upon the withdrawal of those funds. For non-registered accounts, the withdrawal of capital is tax free. This issue raises the much debated question of TFSA vs. RRSP as you accumulate your retirement nest egg and for those who own corporations, the issue of salary vs. dividend (see my three part series "Salary or Dividend? A Taxing Dilemma for Small Corporate Business Owners" from last year on this issue and my 2014 Update). The drawdown of your RRSP/RRIF and/or funds from your holding company in a tax effective manner requires a detailed analysis of your specific situation and cannot be addressed here in a generic manner; however, suffice to say, it is an important cash flow issue. 

Home Sweet Home

Some planners suggest you try and exclude your home from your retirement savings and have it serve as a back-up for any retirement shortfall. However, for many people, part of their retirement will include at least the incremental benefit of downsizing their home. For others, their retirement will only be funded by selling their home and moving into an apartment or reverse mortgaging their home.

Spending in Retirement - Sharpen your Pencil

If you are diligent about this process, you should be able to at least determine a ballpark number for your anticipated spending upon retirement. The spending wildcard for many people is travel. Good health will allow for years of travel, while poor health will not only restrict how much you can travel, but could lead to significant medical costs. In a perfect retirement model you would factor in greater spending as you begin retirement and smaller spending as you grow older. In addition you need to consider occasional and lump sum expenditures.

The aforementioned David Blanchett suggests many peoples spending in retirement maybe overstated by as much as 20% in traditional retirement models. Mr. Blanchett details these views in a very interesting paper on “Estimating the True Cost of Retirement”.

You may also wish to consider your spending in context of the three stages of retirement Michael Stein CFP came up with in his book “The Prosperous Retirement, Guide to the New Reality". In his book Michael suggests there are 3 stages of retirement:

Go-Go Stage- Retirees maintain the same lifestyle and their spending remains fairly constant with their spending pre-retirement, essentially because they still consider themselves “young” and travel extensively.

Slow-Go Stage - Stein says that between the ages of 70-84, your budget will decline 20-30% as your body is not quite able to keep up with your mind and your intended activities or you just become weary of airports and trains.

 No-Go Stage - As you reach 85+, health issues tend to cause you to restrict travel and you are tied to a certain place, be it your home or a retirement home.

Pensions - The Older you are, the more you Appreciate them

If there is one thing this series has revealed to me, is that I truly underestimated the worth of a defined benefit pension plan. I had never really considered the possibility of purchasing an annuity in retirement, however, the more calculations I undertook, the more I realized that without a company pension plan, it may be prudent to consider purchasing at least a small annuity in my retirement. Moshe Milevsky and Alexandra MacQueeen suggest that annuities should be used to “pensionize” part of your retirement funds and that it may be worth the piece of mind to forgo potential growth of your nest egg to provide some comfort that you will not outlive your retirement funds.

If you have a pension plan that covers off most of your retirement spending needs, you are afforded the freedom to take greater equity risk in retirement; since you can withstand stock market swings, knowing your day to day costs are covered off by your pension. Those without a pension face the dilemma of whether to annuitize some portion of their retirement funds or not.

Healthcare coverage - Will we be Fully Covered in 25 Years

As Canadians, we assume we will always have full medical coverage. But who knows if the government will have the money in twenty-five years to support a top-heavy population. In addition, if your health deteriorates and you require private care, all your retirement funds could be eaten up by those costs.

Interest Rates – Will they ever Rise?

People have been expecting interest rates to rise for several years. Many of those same people now think the US government will be forced to keep rates low for the foreseeable future. Selfishly, higher interest rates would be welcomed by many people in or near retirement. A spike in interest rates would likely cause some disgruntled stock market investors to re-allocate their equity investments to fixed income instruments.

Inheritances - No One Plans for an Inheritance do They?

Baby boomers will inherit a massive amount of money in the next twenty or so years. However, the size of individual inheritances will fluctuate widely based on the longevity of their parents. I wrote a blog a while back on whether you should plan for an anticipated inheritance. I suggested that if you are certain you will inherit money, you should at least consider factoring a discounted amount of your potential inheritance into your retirement planning.

Lifestyle in Retirement

For Canadians who live in large cities, have expensive homes and lifestyles, an easy solution to an underfunded retirement is to downsize/sell your home and move to a less expensive city. Whether you are willing to do that is another question.

Evolving into retirement - Keeping the Income Stream Alive

Stan Tepner, CPA, CA, MBA, CFP, TEP, First Vice-President & investment advisor with CIBC Wood Gundy and an advisor to some of my clients, told me "he often finds many people consider retirement an absolute event. One day you are working and the next you’re golfing". He adds "that more and more people 'evolve' into retirement. They may shift into part-time employment or self-employment. This shift may be required for financial reasons or because you wish to keep your mind sharp. Either way, the extra income will assist in funding your retirement needs, especially if you have a savings shortfall because of poor market returns or you have just miscalculated your actual retirement needs".

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! - Part 5

In Parts 1-4 of this series, I reviewed various studies and commentaries to help you determine an appropriate safe withdrawal rate for your retirement nest egg. I also provided alternatives and/or variations to the safe withdrawal guidelines. Today, I examine the factors that can impact both the funding of your nest egg and your withdrawal rate in retirement. The unpredictable nature of most of these factors make it virtually impossible to determine a definitive retirement number and is why I say the "Heck if I Know or Anyone Else Does" how much money you need to retire.

Your Longevity - The Ultimate Wildcard

It goes without saying, that if we knew who long we would live, retirement planning would be a lot simpler. Unfortunately, the best we can do is plan based on longevity studies and family medical history. The Vanguard paper I referenced in Part 3 of this series cites such as study by the Society of Actuaries which found:

“there is an 80% chance that at least one spouse will live to age 85, a 55% chance that one will live to age 90 and 25% chance one spouse will reach 95.”

In Canada, the average male lives to approximately age 79 and the average female lives to approximately 84. Based on the above, your retirement planning should at a minimum assume one spouse will live to at least 95 years old.

Inflation – Grasping for the unknown

The rate of inflation can drastically alter your retirement savings and consumption. An economic environment of low market returns and high inflation can severely impact the funds you accumulate to fund your retirement and the real returns you achieve in retirement. Conversely, interest rates tend to rise with inflation, providing a potential buffer if you lock in higher interest rates and inflation subsides (I remember Canada Savings Bonds paying 19.5% interest in 1981 when inflation was around 12.5%, however, inflation was back down to 4.5% by the end of 1983 and many people were very pleased they had CSB's or GIC's paying very high rates of interest for many years). An average inflation rate of 2% will mean that the $50,000 you expect to spend in retirement in 2014 dollars will require approximately $61,000 in spending in 2024.

One of the criticisms of the 4% rule is that the models cumulative inflation adjustment may force you to take larger and larger withdrawals without regard to your actual spending requirements. Substantive evidence for this criticism is provided below by David Blanchett, the head of retirement research at Morningstar in Chicago.

In this Wall Street Journal article by Kelly Greene, Mr. Blanchett said the following about the correlation between spending and inflation. "Pretty much every paper you read about retirement assumes that spending increases every year by [the rate of] inflation." Ms. Greene went on to say that "when he analyzed government retiree-spending data, he found otherwise: Between the ages of 65 and 90, spending decreased in inflation-adjusted terms. Most models would assume that someone spending $50,000 the first year of retirement would need $51,500 the second year (if the inflation rate were 3%). But Mr. Blanchett found that the increase is closer to 1%, which has big implications over decades, 'because these changes become cumulative over time,' he says".

Sequence of Returns – Bull vs Bear Markets upon your Retirement

The various studies that support a 4% retirement withdrawal, included periods of both bear and bull markets. If you are lucky enough to retire at the beginning of a bull market, your retirement funding will be drastically different than if you retire at the beginning of a bear market. William Bergen in his original 1994 article said:

“This is a powerful warning (particularly appropriate for recent retirees) not to increase their rate of withdrawal just because of a few good years early in retirement. Their “excess returns” early may be needed to balance off weaker returns later.”

It is interesting to note that Mr. Bergen showed that even if you started retirement in the great depression or in the recession of 1973-1974 (which also included a period of high inflation); your money would still have lasted over 30 years, because of the power of stock market recoveries.

However, Moshe Milevsky and Anna Abaimova in this report for MetLife (see page 4 of the report, page 7 of the PDF), very clearly reflect the dramatic difference in retirement outcomes you will have when you have negative market returns early in your retirement vs later in your retirement.

In this blog, Wade Pfau states that:

“In fact, the wealth remaining 10 years after retirement combined with the cumulative inflation during those 10 years can explain 80 percent of the variation in a retiree's maximum sustainable withdrawal rate after 30 years.”

Thus, prudent planning would be to start your retirement following a bear market :).

Registered vs. Non-Registered Accounts

The allocation of your retirement funds between registered (RRSPs, LIRAs, Pensions, etc.) and non-registered accounts (bank, investment, TFSA, etc.) will have a significant impact upon your cash flow in retirement. If you consider all the money in those accounts as capital, the capital in the registered accounts is fully taxable, meaning that if you are a high income tax rate taxpayer, you may be paying as much as 46% or higher upon the withdrawal of those funds. For non-registered accounts, the withdrawal of capital is tax free. This issue raises the much debated question of TFSA vs. RRSP as you accumulate your retirement nest egg and for those who own corporations, the issue of salary vs. dividend (see my three part series "Salary or Dividend? A Taxing Dilemma for Small Corporate Business Owners" from last year on this issue and my 2014 Update). The drawdown of your RRSP/RRIF and/or funds from your holding company in a tax effective manner requires a detailed analysis of your specific situation and cannot be addressed here in a generic manner; however, suffice to say, it is an important cash flow issue. 

Home Sweet Home

Some planners such as David Aston suggest you try and exclude your home from your retirement savings and have it serve as a back-up for any retirement shortfall. However, for many people, part of their retirement will include at least the incremental benefit of downsizing their home. For others, their retirement will only be funded by selling their home and moving into an apartment or reverse mortgaging their home.

Spending in Retirement - Sharpen your Pencil

If you are diligent about this process, you should be able to at least determine a ballpark number for your anticipated spending upon retirement. The spending wildcard for many people is travel. Good health will allow for years of travel, while poor health will not only restrict how much you can travel, but could lead to significant medical costs. In a perfect retirement model you would factor in greater spending as you begin retirement and smaller spending as you grow older. In addition you need to consider occasional and lump sum expenditures.

The aforementioned David Blanchett suggests many peoples spending in retirement maybe overstated by as much as 20% in traditional retirement models. Mr. Blanchett details these views in a very interesting paper on “Estimating the True Cost of Retirement”.

You may also wish to consider your spending in context of the three stages of retirement Michael Stein CFP came up with in his book “The Prosperous Retirement, Guide to the New Reality". In his book Michael suggests there are 3 stages of retirement:

Go-Go Stage- Retirees maintain the same lifestyle and their spending remains fairly constant with their spending pre-retirement, essentially because they still consider themselves “young” and travel extensively.

Slow-Go Stage - Stein says that between the ages of 70-84, your budget will decline 20-30% as your body is not quite able to keep up with your mind and your intended activities or you just become weary of airports and trains.

 No-Go Stage - As you reach 85+, health issues tend to cause you to restrict travel and you are tied to a certain place, be it your home or a retirement home.

Pensions - The Older you are, the more you Appreciate them

If there is one thing this series has revealed to me, is that I truly underestimated the worth of a defined benefit pension plan. I had never really considered the possibility of purchasing an annuity in retirement, however, the more calculations I undertook, the more I realized that without a company pension plan, it may be prudent to consider purchasing at least a small annuity in my retirement. Moshe Milevsky suggest that annuities should be used to “pensionize” part of your retirement funds and that it may be worth the piece of mind to forgo potential growth of your nest egg to provide some comfort that you will not outlive your retirement funds.

If you have a pension plan that covers off most of your retirement spending needs, you are afforded the freedom to take greater equity risk in retirement; since you can withstand stock market swings, knowing your day to day costs are covered off by your pension. Those without a pension face the dilemma of whether to annuitize some portion of their retirement funds or not.

Healthcare coverage - Will we be Fully Covered in 25 Years

As Canadians, we assume we will always have full medical coverage. But who knows if the government will have the money in twenty-five years to support a top-heavy population. In addition, if your health deteriorates and you require private care, all your retirement funds could be eaten up by those costs.

Interest Rates – Will they ever Rise?

People have been expecting interest rates to rise for several years. Many of those same people now think the US government will be forced to keep rates low for the foreseeable future. Selfishly, higher interest rates would be welcomed by many people in or near retirement. A spike in interest rates would likely cause some disgruntled stock market investors to re-allocate their equity investments to fixed income instruments.

Inheritances - No One Plans for an Inheritance do They?

Baby boomers will inherit a massive amount of money in the next twenty or so years. However, the size of individual inheritances will fluctuate widely based on the longevity of their parents. I wrote a blog a while back on whether you should plan for an anticipated inheritance. I suggested that if you are certain you will inherit money, you should at least consider factoring a discounted amount of your potential inheritance into your retirement planning.

Lifestyle in Retirement

For Canadians who live in large cities, have expensive homes and lifestyles, an easy solution to an underfunded retirement is to downsize/sell your home and move to a less expensive city. Whether you are willing to do that is another question.

Evolving into retirement - Keeping the Income Stream Alive

Stan Tepner, CPA, CA, MBA, CFP, TEP, First Vice-President & investment advisor with CIBC Wood Gundy and an advisor to some of my clients, told me "he often finds many people consider retirement an absolute event. One day you are working and the next you’re golfing". He adds "that more and more people 'evolve' into retirement. They may shift into part-time employment or self-employment. This shift may be required for financial reasons or because you wish to keep your mind sharp. Either way, the extra income will assist in funding your retirement needs, especially if you have a savings shortfall because of poor market returns or you have just miscalculated your actual retirement needs".

Next Monday in the final instalment of this series, I will finally provide some numbers on how much you may need to retire.

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.

How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! - Part 3

Last week in Parts One and Two of this series, you read about the commonly accepted 4% withdrawal rule. This rule of thumb suggests 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 should last 30-35 years. Today, I consider an alternative point of view, and then review modern studies and reports on how the 4% withdrawal rule is viewed in the context of market returns over the last decade.

Set Retirement Withdrawal Rates Should Never be Used!

If you agree with Moshe Milevsky’s opinion (see his quote in Part 1) that any rule that starts with a set withdrawal rate, whether 4% or 3%, is a horrible rule, then you should just read to the end of this section and click the exit button (however, please come back for Parts 5 and 6). From what I can gather, Mr. Milevsky and many other retirement experts do not like the 4% rule because it uses a constant spending amount and does not adjust to your evolving level of wealth. By shunning a set withdrawal rate, retirees may avoid spending shortfalls where their investments underperform and will not accumulate surpluses when they outperform the market. My interpretation is that Mr. Milevsky feels you should spread your economic resources over your entire life and that your spending rate and retirement withdrawal number should not be fixed to an arbitrary level, but that your spending rate should depend upon your personal preferences and your views on longevity risks.

Mr. Milevsky may be critical of a set withdrawal rate, but he does not just point out the flaws and walk away. In his book The 7 Most Important Equations for your Retirement he provides a unique set of mathematical equations to determine your retirement needs.

These equations allow you to determine amongst other retirement issues, how long your nest egg will last, what is your suitable spending amount, and in his final chapter he helps you determine if your current plan is sustainable.

I found this book innovative and as entertaining as a math book could be (Moshe uses seven historically famous people to introduce his equations). However, to be honest, I had challenges with the math, especially the final equation in Chapter 7. You may want the math wiz in the family to assist you with your calculations. I would suggest at minimum, you use Moshe’s equations to back-test whatever retirement nest egg and spending rates you arrive at.

Michael James

Before I move onto the modern safe withdrawal rate studies, I have to give a shout out to Michael James, a fellow Canadian personal finance blogger who created his own strategy, which includes holding five years of savings in a savings investment account. His "Magic Number" calculator is here. The background to his calculator is discussed in his blog post titled "A Retirement Income Strategy" and in this second post on the topic.

Modern Studies and Reports

The Bengen and Trinity studies, from which the 4% withdrawal rule originated, utilized stock market data from 1926 to 1976 and 1926 to 1995 respectively. Many commentators feel this historical data is no longer applicable in today’s world.

To help you determine if 4% is a safe withdrawal rate for you (with the limitations I noted in my first post), I’ve summarized below several current studies and reports on this topic. Some of the studies/reports continue to condone the 4% withdrawal rate or are at least accepting of using a 4% withdrawal rate as a starting point. Others feel it is excessive and if you withdraw 4%, you will be eating cat food at some point in your retirement.

If you are like me, you will probably be overwhelmed by these reports, their arguments and their data. Although you will never achieve certainty, your withdrawal percentage is the vital wildcard in trying to estimate your retirement nest egg and, you must draw a line in the sand using a percentage within your comfort zone, assuming you believe in a constant withdrawal rate strategy or a variation of the strategy.

The Studies that suggest a 4% withdrawal is still a Good Starting Point.

 

What Charles Schwab has to Say

In this report by Rob Williams, Director of Income Planning for Schwab Center for Financial Research says that Schwab suggests “the 4% rule as a starting point for planning purposes. Then, it's important to stay flexible as you spend in retirement”.

However, the report goes on to say that “Based on Schwab's current expectations for market returns over the next 30 years, we calculate a 3% spending rate to begin retirement may be more appropriate—if you want to follow a rigid rule for spending, and have a high degree of confidence that your money will last.”

What Vanguard has to Say

In this excellent report, one of several Vanguard has written over the years, the report states:

“For the majority of years from 1926 through 2011, the yield or income returns on a 50% stock/ 50% bond portfolio exceeded 4%. Over the last several decades, however, the yield for such a balanced portfolio has

been steadily decreasing. At its peak, in 1982, the portfolio’s average yield was 10.6%; by year-end 2011, the yield had dropped to 2.8%.” Yet, Vanguard says that a 4% withdrawal rate is still a reasonable starting point.

The report goes on to say:

“Specifically, Vanguard’s market and economic outlook indicates that the average annualized returns on a balanced 50% equity/50% bond portfolio for the decade ending 2021 are expected to center in the 3.0%–4.5% real-return range (Davis and Aliaga-Díaz, 2012). Although this level is moderately below the actual average real return of 5.0% for the same portfolio since 1926, it potentially offers support for the continued feasibility of a 4% inflation-adjusted withdrawal program as a starting point for balanced investors.”

Vanguard also has an excellent report on alternative spending strategies for those who are concerned that the constant 4% plus inflation adjusted amount in the rule of thumb may result in excessive withdrawals in poor performing markets. I discuss that report tomorrow.

What David Aston has to Say

David Aston, a certified management accountant and contributing editor to MoneySense magazine, wrote an article for the September/October 2012 issued titled “Make your nest egg last”. In that article he says that if you want to stick with the 4% rule, there are four strategies to limit the risk. They are as follows:

1. Cut withdrawals if you suffer losses. “Bengen encourages retirees to keep an eye on their ‘current withdrawal rate,’ which is the annual drawdown as a percentage of a portfolio’s value today (as opposed to its initial value at the time of retirement). As a guideline he suggests cutting back if you exceed the following current withdrawal rates: 5.6% at age 65; 5.9% at age 70; 6.25% at age 75; and 7.5% at age 80.”

2. Use your home equity for backup

David feels you should exclude the value of your home from your initial retirement nest egg. You can always tap the equity as back-up in case your investment returns are not what you expect. I suggest this could be at least partially problematic for many retirees who plan to downsize to fund their retirement.

 3. Add annuities to the mix. David states that many experts suggest that age 70 is the sweet spot for purchasing an annuity. He notes that most annuities will pay nothing to your estate; they expire upon your death or the last spouse to die if you own a joint annuity. Many of the articles I read suggest that you consider annuities as a component part of your retirement. Moshe Milevsky in his book Pensionize Your Nest Egg is very keen on using annuities and other products to ensure you do not outlive your money, where you do not have a substantial pension in retirement.

4. Invest conservatively—This is self-explanatory.

On Wednesday, I will review comments made and studies undertaken by retirement experts that feel the 4% withdrawal rate is excessive.

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.

How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! - Part 2

On Monday I introduced the 4% rule, the most commonly accepted rule of thumb retirement strategy. Today I discuss the guideline and its development in greater detail. As noted in part 1, Moshe Milevsky and other retirement experts feel the rule is misleading and a terrible rule. I hope by the time you finish reading this series you will have your own opinion on the 4% rule; whether that opinion is similar to Mr. Milevsky’s or whether you feel the rule has practical application for you, as a starting point for your

retirement calculations.

Conventional Wisdom – The 4% Withdrawal Rate

The 4% rule is a planning guideline for a sustainable rate of spending over a 30 year retirement. Years ago a brilliant financial planner by the name of William P. Bengen (an MIT graduate in Aeronautical Engineering) got tired of being asked how much money his clients needed to retire, so he initiated a study that basically concluded that if you retire with a diversified portfolio split 50/50 between bonds and stocks, you will be able to safely withdraw 4% of the initial balance, plus an inflation adjusted amount for the next 33 years and quite possibly as long as 50 years.

For example, if you have $800,000 when you retire, under the 4% withdrawal rate you can take out $32,000 the first year. If inflation is 2%, your second year withdrawal amount will be $32,640 ($32,000 + 2% x $32,000). If inflation is 1.5% in your third year, your withdrawal will be $33,130 ($32,640 x1.015%) and so on. It is important to note, this is not a percentage of portfolio withdrawal method where you take the ending balance at the end of each year and draw 4%; but is a consistent withdrawal amount based on your original nest egg adjusted for inflation each year, which some experts find distasteful.

If you wish to read Mr. Bengen’s initial paper, here is a link to his October, 1994 paper in the Journal of Financial Planning. It should be noted that in a subsequent study, Mr. Bengen added U.S. small-company stocks to the mix, which increased the portfolio's volatility and potential return. To adjust for this, he revised the withdrawal rule to 4.5%. However, I will continue to use the more conservative 4% withdrawal amount for discussion purposes.

So what does Bengen say today, with our historically low interest rates? In this MarketWatch article by Glenn Ruffenach, the author says “Bengen has never claimed that his findings are right for every retiree. Indeed, he thinks some of the latest research about market valuations is terrific."

                                                                                

Ruffenach goes on to say “He told me recently that he  started with a specific set of assumptions: a retirement lasting 30 years, with savings in a tax-deferred account and nothing left for heirs. Change just one of those parameters, he says, and your "safe" withdrawal rate may differ. Still, Bengen notes, 4% remains a prudent jumping-off point for calculating withdrawal rates from nest eggs. Just keep your plan open to some adjustments.”

In this 2012 paper written by Mr. Bengen, he discusses some contingency planning, which includes potentially reducing spending and increasing income.

Mr. Bengen did not provide a detailed summary of the market returns he used in his calculations, although he provided some returns for certain extrapolated years (10.3% for stocks, 5.2% for bonds and 3% inflation ). However, in this article by Joanna Pratt, she suggests that the 4% spending assumptions are based on a 9.2% stock return, 6.85% bond return and an inflation rate of 3%.

The Trinity Study – Support for the 4% Withdrawal Rate

A subsequent study, known as the Trinity Study by Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz supports Bergen’s assertions. Some critics say this study supports Bengen because they use the same flawed data. Their 1998 paper can be found here. 

The Cooley, Hubbard and Walz study produced a number of conclusions, including:

• Early retirees who anticipate long payout periods should plan on lower withdrawal rates.
• Bonds in the portfolio increase the success rate for low to mid-level withdrawal rates, but most retirees would benefit from allocating at least 50% to common stocks.
• For stock-denominated portfolios, withdrawal rates of 3 to 4 percent represent exceedingly conservative behaviour and will likely leave large estates.

The authors comment that if history is any guide for the future, then withdrawal rates of 3-4% are extremely unlikely to exhaust any portfolio of bonds and stock (in almost any combination).

But what happens to your retirement planning if stock market history does not repeat itself? Poor stock market returns for the last few years (until last year), countries defaulting or close to defaulting, historically low interest rates and tough economic times have caused some pundits to say we are in different times and the 4% rule is outdated, as it only captures periods of great prosperity. In part three of this series, which I will post next Monday, I discuss Moshe Milevsky’s unique retirement calculations and then the various modern studies and reports on what is the proper withdrawal rate upon retirement.

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.

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.