How to calculate your retirement
Nearly one-third of retired Canadian are worried that they'll run out of money over the long term, even though they’re generally satisfied with the current quality of retirement, according to a new study from CIBC.
But 38 per cent of this group admit they don’t really have a plan to help them determine how long their savings will last and how much they can withdraw each year to support their lifestyle.
Among those who do have a plan, there’s an even split in how they came up with it. Thirty one per cent say they built one with an advisor, but an equal number admit they simply developed one on their own.
The trouble is, DIY calculations can often go astray — particularly if they’re not subject to regular scrutiny.
Try to think of everything you can forecast, in as conservative a way as possible, but only for the next five years, recommends Baumeister, a frequent contributor to early-retirement.org, a popular retirement forum.
“It seems to me that projecting the future beyond that point is hardly more than a wild guess,” he says. “As long as I can feel comfortable with where I see myself in five years, based on my detailed projection, I can relax and assume the rest of my life will also be under control.”
He’s been using this trick for 12 years now, making his five-year projection each year, and has pretty much overcome any anxiety over the more distant future. Your mileage, however, may differ.
One popular strategy assumes that retirees can simply spend up to four per cent of their savings annually, adjusted for inflation, without worrying about running out of money.
Another rule of thumb is to spend only the portfolio's interest and dividends, leaving the principal untouched. But there are drawbacks to both these strategies.
Someone looking to spend only interest and dividends may take on too much risk, loading up unduly on high-yielding stocks, says Anthony Webb, research economist with the Center for Retirement Research at Boston College.
As for the four per cent rule, it doesn't allow people to adjust their spending patterns periodically in response to actual investment returns, Webb maintains.
More worrisome is the fact that many retirees drawing fixed dollar amounts from a declining portfolio could quickly come up short.
Analysts call this “sequence of returns” risk. If you live through a poor set of returns during the years just before you retire or shortly thereafter, your plan could be thrown completely out of whack, leaving you without sufficient time to recover.
A better option, Webb suggests, may be to base annual spending on the Internal Revenue Service's required minimum distribution (RMD) rules (similar to those governing registered retirement income funds in Canada), which force investors to begin taking a minimum amount of money out of tax-deferred savings plans at age 70.5.
In a recent study, he found that such a strategy outperformed both the “spend only the income” strategy and the four per cent rule.
The researchers analyzed a hypothetical married couple of 65-year-old retirees with $250,000 in assets, excluding their home.
To compare this approach with others, the researchers developed a measure called “strategy equivalent wealth” (SEW), which represents the factor by which the value of the couple's wealth at age 65 would be multiplied so that they would be as well off as if they’d got everything just right.
The four per cent rule had an SEW of 1.49, making it the worst method of the strategies analyzed. The RMD formula had an SEW of 1.39, while depending on interest and dividends had an SEW of 1.36.
Although blending the latter two can improve results — particularly if you leave any capital gains to grow — the success of a basic RMD strategy lies in its simplicity, according to the researchers.
First, it’s easy to follow. The IRS stipulates withdrawal percentages based on life expectancy tables.
Second, an RMD strategy allows the percentage of remaining wealth consumed each year to increase with age, as your remaining life expectancy decreases.
Third, because spending is not restricted to income, you’re less likely to chase dividends and more inclined to maintain a balanced portfolio.
And fourth, actual spending responds to fluctuations in the market value of your assets, because the dollar amount of the drawdown is based on the portfolio's current market value. In other words, you effectively cut back a bit when returns are poor.
One potential criticism of this approach is that it results in relatively low consumption early in retirement. You might prefer, for instance, to have more income at a younger age, when you’re better able to enjoy it.
But looking at things this way does guard against running out of money too soon.