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Question from Kristina through our GenYmoney Facebook group: My husband and I are 34 and 33. We spend roughly 28 per cent of net income on mortgage, utilities, house insurance and property tax. We have an emergency fund, don’t have any other debts, and don’t own a car. But we also have a kid and spend $1,480 a month on daycare. We might have another child. Last year because of daycare payments, we broke exactly even and saved nothing apart from a $2,000 lump sum payment towards our mortgage and $2,000 for RESP. We don’t have any investments, though looking into that is on our list.

What percentage of our earnings should we be putting towards retirement savings at this point in our lives?

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Ben Felix helps Canadians invest their money, and writes about it at csinvesting.ca.

Benjamin Felix is an associate portfolio manager with PWL Capital in Ottawa.

Answer: Your current spending on shelter is in line with the average. Based on 2016 data, the average Canadian household spends about 30 per cent of their net income on shelter.

Determining how much you need to save to retire comfortably is a bit harder to pin down, and involves making assumptions. Some of the most important assumptions are inflation, rate of return, tax rates, retirement age, retirement living expenses, Canada Pension Plan (CPP) entitlement, life expectancy, and your savings rate. With a set of reasonable assumptions, we can build a model that will give you an idea of how much you need to save to fund your lifestyle in retirement.

The Bank of Canada targets a 2 per cent rate of inflation. It’s anybody’s guess what inflation will actually be in the future, but 2 per cent is a reasonable long-term assumption.

Estimating future rates of return for stock and bond markets is not an exact science, but it is possible to take a sensible approach to estimating future returns. A more conservative portfolio (with a higher allocation to bonds) will have a lower expected return than a more aggressive portfolio (with a higher allocation to stocks).

Here is a set of expected annual returns that you could use for financial planning purposes. The chart also shows each portfolio’s standard deviation, which is a measure of risk. A higher number indicates a more volatile - or risky - portfolio.

Asset Mix (% Stocks/Bonds)Expected Return (%)Standard Deviation (%)
0/1003.023.965
10/903.383.99
20/803.604.21
30/703.944.77
40/604.225.40
50/504.526.18
60/404.847.09
70/305.148.01
80/205.438.93
90/105.749.91
100/06.0410.90

Source: PWL Capital

Future tax rates are as hard to predict as returns, but it might be reasonable to use the current tax brackets, adjusted for inflation for the duration of the projection. It is worth noting that unexpected changes in tax rates could throw a wrench in any retirement plan.

To plan, you need to pick an ideal retirement age which will help to dictate your required savings rate. The same is true for desired retirement living expenses. There are rules of thumb out there, like needing 70 per cent of your pre-retirement lifestyle expense when you are retired, but every situation is different. Your retirement age and retirement expenses are two of the most important variables in determining how much you need to save for retirement.

Figuring out your Canada Pension Plan entitlement is typically not well understood, but it is one of your most important sources of retirement income. To get the maximum benefit you need to contribute to CPP for 39 years between the ages of 18 and 65, and you need to contribute the maximum amount each year. The maximum contribution is achieved in a given year if you earned at least the yearly maximum pensionable earnings (YMPE). To give you an idea, here is the YMPE for the last 10 years.

YearYMPE
2018$55,900
2017$55,300
2016$54,900
2015$53,600
2014$52,500
2013$51,100
2012$50,100
2011$48,300
2010$47,200
2009$46,300

If you made less than that, you did not contribute the maximum to CPP, and would not expect the maximum benefit. On average, Canadians receive 57 per cent of the maximum CPP benefit. The amount of CPP that you receive is also affected by when you take it. Taking it before 65 results in a decreased benefit, while taking it later than 65 results in an increased benefit.

For life expectancy, we can use the Canadian Institute of Actuaries Canadian Pensioners’ Mortality Report. I like to use the age that you have a 25 per cent probability of reaching. That would be 94 for your husband, and 97 for you, based on your current respective ages.

Now that we have a baseline understanding of the assumptions involved, we can model the situation to see how much saving is required. We will assume a fairly aggressive 80-per-cent stock / 20-per-cent bond portfolio up until retirement, and a more conservative 50-per-cent stock / 50-per-cent bond portfolio after retirement. The expected investment returns will be reduced by a 1-per-cent fee for investment products (you would pay 1.07 per cent for index funds from Tangerine, for example). We will assume retirement at 65 with a $4,000 monthly living expense (that’s $4,000 net after tax), and CPP taken at age 65. We will assume that 57 per cent of the maximum CPP benefit is received by each spouse.

Based on those assumptions, the required monthly savings into your RRSPs would be $750 per month of after-tax income each, so a monthly total of $1,500 going into savings, to secure a 90-per-cent probability of meeting your required retirement living expense until death. $1,500 per month ends up being about 29 per cent of the average Canadian household’s net income. Keep in mind that you would be deferring some income tax by making those RRSP contributions, which could soften the blow on your cash flow. I have assumed that you each have an equal income – if there is a big disparity then you might focus on contributing to the RRSP of the higher earner.

If that amount seems crazy, don’t worry. Most people are not saving this aggressively at your current life stage. As you have pointed out, your cash flow will improve over time as things like daycare drop off. That is not an excuse to ignore saving; anything that you can do now will help.

There are some things that you can do to reduce the amount that you need to save. You could choose to be more aggressive with your investments (increasing the expected return), you could lower your investment fees (allowing you to keep more of the returns), you could retire later than 65 (adding a year of saving, removing a year of retirement expenses, and increasing CPP), or you could lower your target retirement living expenses.

Saving for retirement is a daunting task that many people fail to comprehend. If you are feeling discouraged, don’t. Remember that any amount that you can start saving for retirement now is worthwhile, even if just to get into the habit of saving.

Are you a millennial with a question for our adviser? Send it to us.

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