Think of retirement as a 30-year game of poker.
You begin with a certain amount of money at, say, 65. Your mission is to figure out how to make that cash last for the rest of your life.
What makes this task difficult is that you don't know what returns you can expect in any given year, or what sequence those returns will arrive in. Just as in poker, the returns you get early on can change the game entirely.
If you're lucky, you retire just before the stock market goes on a tear. Your portfolio shoots skyward and provides you with a financial cushion for years to come.
If you're unlucky, you quit work just as a bear market devastates your bottom line.
Consider a 65-year-old investor who has a $100,000 portfolio and withdraws $5,000 a year during a four-year stretch in which the market suffers a 20 per cent decline. She winds up with only about 60 per cent of her starting wealth – and she hasn't even turned 70 yet.
Even if the market goes on to stage a strong recovery, the hole dug by those initial losses and withdrawals is so deep that she is unlikely to ever regain her initial level of wealth.
Retirees have no control over the market but, like a good poker player, they can tailor their strategy to minimize the risks that can be avoided.
They should start by thinking through how much cash they will take out of their portfolio every year.
Financial planners have long operated by the 4-per-cent rule – the idea that a retiree with a balanced portfolio of stocks and bonds can safely withdraw an inflation-adjusted 4 per cent a year of his or her initial portfolio.
But the retirement poker game has become more difficult in recent years as bond yields have sunk to abysmal levels, dragging down portfolio returns. An academic paper last year by Michael Finke, Wade Pfau and David Blanchett concluded the 4-per-cent rule is not safe in a low-yield world and could result in many retirees running out of cash.
Fred Vettese, chief actuary at consultants Morneau Shepell, and one of Canada's leading retirement experts, suggests that a 3.5 per cent or even 3 per cent rule may be more appropriate to today's markets. To arrive at the right number for you, consider these questions:
Are you a risk taker? Start by considering both your age and your ability to tolerate risk.
Mr. Vettese points out that most retirees spend less after they turn 75. Many people stop driving at that age, indulge less in expensive hobbies and travel less. All things being equal, it's realistic to plan to spend more – and withdraw more aggressively – in the early years of your retirement than later on.
Another factor is your stomach for volatility. In the 1990s, cautious investors could generate close to a 4-per-cent after-inflation yield simply by buying super-safe Government of Canada real-return bonds.
Nowadays, with bond yields at historic lows, a retiree needs to hold both stocks and bonds to generate reasonable returns – but pushing up your exposure to stocks means accepting a greater chance of loss. "You have to figure out what type of portfolio, and what level of risk, you're comfortable with," Mr. Vettese says.
What are your goals? People differ in their desire to leave a legacy. Some are quite comfortable with the thought of spending every penny they have; others would like to bequeath a large amount to their kids or their favourite causes. The greater your desire to leave a bequest, the lower your withdrawals should be.
What is your margin of safety? Retirees with a generous company pension or a large portfolio can take more risks – and choose a more aggressive withdrawal rate – knowing that a run of bad results won't seriously hurt their lifestyle.
What are your alternatives? One way to reduce uncertainty is to use the portion of your portfolio that would otherwise be in bonds to buy an annuity, a contract with a life insurance company that guarantees you an income for life.
Annuities are expensive these days because their payouts reflect low interest rates. But Mr. Vettese says they can still make sense for those who are near or beyond 70. He also expects annuity pricing to improve in years to come as interest rates begin to rise.
Looking for a homemade alternative? Consider delaying the age at which you start receiving the Canada Pension Plan.
Mr. Vettese points out that putting off CPP until your 70th birthday increases the payments you get by 42 per cent compared with what you would have received at 65. "Your worry level can drop because you know you can count on that income for life," he says.