A gentleman I met recently is retired and spends his winters in a retirement community in Green Valley, Ariz. Last winter, a man in his neighbourhood allegedly fired shots at an acquaintance’s house in a drive-by shooting – from a golf cart. I guess retirement life doesn’t mean a stress-free life. And the truth is, financial matters can often be a source of stress for retirees.
I started a conversation about retirement planning two weeks ago, and focused on eight core strategies, or vehicles, to achieving financial security in retirement. Today, I want to talk about the best approach to figuring out how much you’ll need in retirement.
The approach
I like the concept of a dual-budget approach to retirement planning. Now, I understand that preparing a budget is about as enjoyable as, say, a root canal for most people. And so, the idea of more than one budget sounds unbearable. But this doesn’t have to be a painful process. The dual-budget approach will ensure that your minimum income needs will be met in retirement, while also equipping you to achieve aspirational goals as well.
Here’s how it works: The first step is to create an “Essentials Budget” where you detail all of the expenses you expect to incur on the essentials of life in retirement. These are non-negotiable expenses. You simply have to cover these costs. The sum total of these expenses represents your Essentials Budget and determines your “income floor” in retirement. That is, your income in retirement must be sufficient to cover these expenses as a minimum.
Next, create an “Aspirational Budget," which represents a higher level of spending on things you actually desire. It will include all the expenses in your Essentials Budget, plus additional spending on items that aren’t necessary, but would make your retirement years ideal in your view.
Your spending in any particular year in retirement will generally fall between these two budget amounts. As a minimum, you need to ensure you have enough to look after your Essentials Budget, indexed to inflation each year.
How to get there
Once you know how much you’ll be spending in retirement (with your Essentials Budget as the minimum, or floor), you need to figure out how you’ll meet those costs. In my article earlier this month, I talked about eight potential strategies, or vehicles to pay for these costs: Old Age Security (OAS) benefits, Canada or Quebec Pension Plan (CPP/QPP), a registered pension plan at work (RPP), registered retirement savings plan (RRSP), tax-free savings account (TFSA), non-registered investments, life insurance and real estate.
Let’s consider Jack and Jenny. They’re a couple living in Ontario, both at the age of 45, who plan to retire in 20 years at 65, and want their money to last until 95. They’ve prepared an Essentials Budget of $60,000 annually in retirement, although their Aspirational Budget includes more travel and is higher, at $75,000 a year. These figures are after taxes. So, to have $60,000 after taxes to meet their Essentials Budget, they’d need $70,000 before taxes ($35,000 each), and to meet their Aspirational Budget, they’d need $88,000 before taxes ($44,000 each).
Jack and Jenny each expect to receive $10,000 annually in CPP benefits, plus $7,360 each in OAS benefits. That’s total income annually from government benefits of $17,360 for each of them – or $34,720 in total. To meet their Essentials Budget, they’d need an additional $35,280 annually ($70,000 less $34,720). To achieve their Aspirational Budget, they’d need an additional $53,280 annually ($88,000 less $34,720). So, how much will Jack and Jenny need in a pool of savings at the age of 65 based on these income needs?
The best way to do the math is to use software. Visit a trusted financial adviser if you can’t do this on your own. But to give you some sense of the figures, you can use the “Rule of 30” where you multiply your annual income needs by 30. Using this simplified approach, Jack and Jenny would need about $1,058,400 ($35,280 times 30) in total, on their retirement date, to meet their Essentials Budget in retirement. These figures are all in today’s dollars.
To be more accurate, the $35,280 annual-income need should be adjusted upward by expected inflation, which would make it $57,810 annually (if we assume 2.5 per cent inflation over the next 20 years until they retire). That would mean having $1,734,300 ($57,810 times 30) saved up by the age of 65, to meet their Essentials Budget. Their Aspirational Budget would require savings of about $2,620,000 by 65.
Here’s one more thought: The use of both an Essentials and Aspirational Budget becomes important when you decide how to invest your retirement savings. I’ll talk more about that next time.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at tim@ourfamilyoffice.ca.
Tim Cestnick