Almost every assumption we use in retirement financial planning is suspect and possibly flat-out wrong.
Investment return estimates are too high, and projections about how long we’ll live are too low. And then there are the societal shifts we’re just starting to understand and haven’t yet accounted for in retirement planning – seniors with mortgages and other debts, and adult children moving back home.
“A lot of the rules of thumb were built in the Leave It To Beaver era, where nobody had mortgages when they reached retirement and all the [grownup] kids lived by themselves,” said Moshe Milevsky, author of the new book The Seven Most Important Equations for Your Retirement. “But that’s not the case today.”
Prof. Milevsky, based at York University’s Schulich School of Business, has written a book that’s as good a way as any to challenge your assumptions about retirement and see how well prepared you are to live off your savings. It’s as much a very readable tribute to his mathematics heroes as a retirement planning guide, but it does focus the mind on key questions like how long your money will last.
Yes, there’s an equation for that. A mathematician named Leonardo Fibonacci developed it back in the 13th century, and to use it you need to know three things:
-The amount you’ve saved, which is the total amount in your registered retirement savings plan, tax-free savings account and non-registered savings. Don’t include estimates of the value of your Old Age Security and Canadian Pension Plan benefits here, or a company pension.
-The annual amount you’ll pull from your savings to supplement your pension income.
-The real rate of return on your investments, or gains after inflation.
This exercise is worthwhile only if you use realistic assumptions about things like investing returns. Prof. Milevsky says he’s comfortable using a real return of 1.5 to 3 per cent, which will be shockingly low to some people.
The foundation of this estimate is the expectation that inflation will average in the 2 to 3 per cent range. If he were working through the calculation for himself, Prof. Milevsky said he’d use 3 per cent.
Investment returns before inflation – they’re called nominal returns – are being squeezed today by interest rates close to historical lows and up-and-down stock markets. Still, Prof. Milevsky thinks it’s possible for investments with a reasonable level of risk to generate the nominal returns needed for real gains of 1.5 to 3 per cent.
Many investors are avoiding even modest risk by keeping money in savings accounts and guaranteed investment certificates with returns below the inflation rate. These people rightly assume they’re impervious to stock market declines, but they ignore a problem of equal seriousness. On an after-inflation basis, their returns are negative. And, Prof. Milevsky adds, they’re even more negative after taxes.
Negative real returns aren’t great for your retirement, by the way. “Fibonacci’s equation won’t even work if you put a negative number in – it blows up,” Prof. Milevksy said. “That tells you something about how sustainable your retirement is.”
Another retirement assumption that needs to be re-examined is the amount of money you’ll need to draw from your savings each year. Maximum CPP and OAS payments amount to roughly $18,000 this year – the question you need to answer is how much extra you need.
Financial planners typically address spending needs in retirement by setting out a percentage of a client’s working income. Seventy per cent has been used as a default number, but Prof. Milevsky said it doesn’t reflect the financial pressures of carrying debt in retirement or having your kids come back home to live.
Nor does it reflect the growing chance you’ll live to a surprisingly old age. Recent census results show people aged 100 and more are the second-fastest growing age group. The longer you live, the more you need to save.
Prof. Milevsky said you have four options if your money won’t last as long as you hope: Work longer, save more, scale back your lifestyle in retirement or get more aggressive in your investing. The last choice, he’s not crazy about.
“Use a conservative rate of return and, if the answer is ‘No, I can’t afford retirement at a conservative rate,’ don’t gamble your way out of that conundrum,” he warns. “Don’t delude yourself into thinking retirement is cheaper because you’re taking on risk.”
Prof. Milevsky will answer reader questions on retirement planning strategies in a live online discussion on Wednesday, June 6 at noon (ET).