We're all looking for a way to secure a future. It's common to have dreams of a good retirement, with plenty of money to enjoy life. However, you can't expect to just have enough money to live on if you want to be comfortable. You have to plan ahead.
A recent survey from the Employee Benefits Research Institute indicates that more than half of workers in the United States haven't done a retirement needs assessment. It wouldn't be unreasonable to assume that Canadians have similar results. This means that there is a good chance that you might not have figured out how much money you need to retire.
If you don't know what you need to accomplish with your money, there is no way that you will be able to figure out how much you need in the end, or how much you need to set aside each month to reach your goal.
In order to live a comfortable retirement, you need to ask yourself the following question: how much money do I need to retire?
The answer to that question will depend on a number of factors, including when you plan to retire and how much you will need to spend during retirement to maintain your desired lifestyle. Because of this, knowing what you need to retire in Canada is not a simple answer. However, there are a few simple calculations that might help to give you an idea.
The 4% Rule
The 4% rule states that you can withdraw 4% of your investment portfolio in the first year, then adjust for inflation each year after that and not run out of money for 25-30 years. If you are especially careful, your money can last even longer. It's important to note that your portfolio composition does matter. A portfolio of at least 50% bonds at retirement will reduce volatility and increase the odds of this general calculation being reliable.
Another thing to keep in mind is that you can expect some money from the Canada Pension Plan (CPP) and Old Age Security (OAS). While many things can affect the amount you receive each month, including when you start withdrawing from the CPP, as well as OAS clawbacks based on income, a good average for a retired couple is $25,000 per year. Of course, if you have an employer pension you’re even closer to your target retirement income.
Let's say you want to have an income at retirement of $50,000. With a mortgage paid off and children out of the house, this is actually a pretty comfortable amount. As we’ve discussed, CCP and OAS will likely cover $25,000, leaving you with another $25,000 to fund yourself. You can calculate the 4% rule by taking the amount you need, in this case, $25,000, and dividing it by 4%. The result, using the 4% rule, is that you would need $625,000 at retirement.
Since the 4% rule also takes into account inflation, the only time you ever take out 4% in the first year. There will be enough room for you to increase your withdrawal by the amount of inflation. So in the first year, you may have withdrawn $25,000. However, in the second year inflation may have increased 2%, so you would now take $25,500 out of your investments. You then continue to adjust your withdrawal amount each year with the rise of inflation.
Like any money rule, there are limitations to the 4% rule. While the 4% rule is a simple way to calculate for retirement, it may not work out that way in real life. If you retired in early 2008 and watched your portfolio lose 20-40% by the end of the year, you would then need to adjust to a lower withdrawal rate to continue your retirement withdrawals in a way that allows you to outlive your money.
With market volatility, relying entirely on the 4% rule can be risky, especially if you have a large portion of your portfolio in stocks. This is why you should consider having the majority of your portfolio in bonds at retirement, as it might help reduce the odds of such a large loss. You should also consider building in a buffer. Use the 4% rule as a way to provide a general idea of how much you need to save up, but don't assume that it is infallible.
The Rule Of 20
The Rule of 20 states that for every $1 of retirement income you want, you will need $20 saved in your retirement portfolio. At first glance, I thought this might just be a “5% rule”. The extra percentage point is likely due to the fact that this rule already accounts for inflation, where the 4% rule only addresses the first year and then adjusts each year for inflation. Also, The Rule of 20 states that you only need $20 in savings for every $1 of annual retirement income; nowhere does it say you should withdraw 5% each year. So the end result is likely similar to the results you see with the 4% figure. It's just as a simpler calculation for determining your retirement needs.
Just as with the 4% rule, one key thing to keep in mind is that CPP and OAS will cover a substantial portion of most Canadians' retirement income. So if your goal is an annual retirement income of $50,000 for you and your spouse, the CPP and OAS payments will get you half way there since you can expect $25,000 for the average retired couple.
Since you have CPP and OAS to help you out, the amount that you actually have to base your retirement savings on (in our scenario) is $25,000 per year. Using The Rule of 20, you calculate that you will need a retirement portfolio of $500,000 in order to retire comfortably.
This amount is hard to compare to the 4% rule calculation since the portfolio has to be larger to allow the same dollar amount to be withdrawn. Let's look at the comparison another way. Using the 4% rule for $500,000 in savings, you would withdraw only $20,000 in the first year and then increase for inflation each year going forward.
This means that, with the 4% rule, you are withdrawing $5,000 less the first year. By the time you add the $25,000 for OAS and CPP to the $20,000, you only end up with $45,000 a year in income. You either need to adjust your withdrawal, or become used to the idea of dipping into your capital more than you had expected. This is another rule that you need to be careful of. Just make sure that you accurately gauge your retirement needs.
The 10% Rule
The 10% rule simply states that you should save 10% of your gross income. Note that it's gross income, not your net income or paycheque. For example, If you earn $1,500 every 2 weeks and get paid $1,000 after taxes and other deductions, you should save $150 every 2 weeks, not $100.
The issue with the 10% rule is that it only really applies to someone that starts saving in their early twenties and continues until their retirement. If you are over 30, you should consider adjusting this percentage to 15% or 20%.
Using the $150 bi-weekly example above and assuming a 7% rate of return and a retirement age of 65, let's look at how your age can affect the end result of the 10% rule.
- Starting age of 25 would have $804,472 after 40 years of saving.
- Starting age of 35 would have $380,650 after 30 years of saving.
- Starting age of 45 would have $165,200 after 20 years of saving.
Obviously, it's not reasonable to simply say “save 10% of your income” without taking age into account. Wondering how much more you would need to save at ages 35 and 45 to make up for the lost time and still come in at the $800,000+ that the 25 year old would have accumulated?
- Starting age of 35 would need to save $317 bi-weekly, or 21%.
- Starting age of 45 would need to save $731 bi-weekly, or 49%.
That's not to say that if you haven't started saving and you're 40 years old there is no hope for a comfortable retirement. If 10% is all you are currently able to save, then save 10%. You will still be better off than the many Canadians that save less and you'll also have the support of the CPP, OAS and any work pension you may have. Plus, once your mortgage is paid off, save the money that would have gone towards your mortgage payment and you can still retire in style!
The Rule Of 72
You can find out how long it should take to double your money with the rule of 72. For this calculation, you divide 72 by your expected return. A 5% return would take 14.4 years to double your money.
Of course with this rule, you’ll need to have a realistic percentage you expect for a return, you can’t always expect double digits in every single year.
You also need to realize that it works better if you have a lump sum to invest. It's easier to figure out how much money you'll end up with if you've got a large amount of capital to invest for the future.
So, how much money do I need to retire?
Remember that these are just rules of thumb. You don't want to base your entire strategy on these rules of thumb alone. Part of what you need to do is figure out how much money you think you will need during retirement, each year. You can use your current expenses as a starting point and try to figure out what your needs will be during retirement. Keep in mind that there might be tradeoffs. You might no longer have a mortgage payment, but you might travel more. Even though you might think that your expenses will be less during retirement, it doesn't hurt to assume that your expenses will be similar, or perhaps even a little higher.
Hopefully, these retirement calculations will help you see what you’ll need to save to have the retirement you’re looking forward to. Keep in mind that a couple that have worked most of their adult lives and retired at 65 can expect CPP and OAS to pay as much as $30,000 a year. Many people get discouraged about their retirement needs because they forget about CPP and OAS. Work those programs into your numbers and you’ll likely be pretty pleased with how easy it can be to retire comfortably with just a little planning!