It seems that every financial study today suggests that Canadians are not saving enough money for retirement. One of the biggest fears for anyone especially retirees is the fear that you will run out of money.
This was a real outcome for Peter who retired with $1.2 million in RRSPs and investments back in 2007. At the time, Peter’s small pension along with his early CPP would be far from enough money to create retirement income. He went to a broker who suggested that he could invest into some income trusts, dividend stocks and income mutual funds to generate an income of $72,000 per year. That translated into a 6% withdrawal rate.
Things were going OK until the financial crisis hit in 2008 when his portfolio took more than a 30% drop to about $850,000. His broker wrote a letter to all his clients telling everyone to “hang in and sit tight” until the markets recover. The problem is this advice might work for people who are not withdrawing money from their portfolio. Volatile markets hit retirees like Peter the hardest because they don’t have the same ability to recover from significant market downturns.
The devastating math
At 6% withdrawal rate, the theory is if the portfolio earns 6% and you take out 6%, then you should be able to preserve your capital and earn a decent income. The problem is the 6% return is an average return as opposed to a straight line guaranteed return. Retirees really need to think more conservatively in retirement.
Unfortunately for Peter, after the market dropped 30%, he continued to take out the $72,000 per year. The problem is at $850,000 a withdrawal of $72,000 translates to an 8.5% withdrawal rate instead of 6%. Despite the recovery of the markets 2 years later, Peter’s portfolio is still only $850,000. After visiting other financial advisors, Peter is now considering reducing his withdrawals to $40,000 per year or less, which is a 4.5% to 5% withdrawal rate on the $850,000 and he is also pondering the possibility of going back to work part time to try and make up some income.
Peter’s situation is not new and unique. There are many Canadians who went back to work after retirement because of the stock markets. Others delayed retirement because of the stock markets. To avoid this situation from happening to you, consider some key thoughts for retirees to help avoid running out of money too quickly in retirement.
Check your withdrawal rate – slow the burn rate
There was a time when a 6% withdrawal rate was considered conservative. Today, that same withdrawal rate is considered unsustainable and experts are promoting a 4% or 5% withdrawal rate. You can debate the proper withdrawal rate as much as you want but the bottom line is if you need to increase the longevity of your money, a lower withdrawal rate is better.
Remember too that a drop in asset value means a corresponding increase in the withdrawal rate.
Watch your expenses
Unfortunately for Peter, to prevent running out of money, he not only has to look at lowering his withdrawal rate but he also needs to take a look at his expenses and the cost of his lifestyle.Common sense says less money means less income.
Watch the lump sum withdrawals
One of the things that made things worse for Peter was he had some bigger expenses and needed to take out lump sum withdrawals. Lumps sums are common but they need to be factored into the plan. In Peter’s case, he should have set aside an amount for emergencies or contingencies. Instead of calculating a 6% withdrawal rate on the $1.2 million it would have been more prudent to calculate the withdrawal rate on lower number like $1.0 million for example. That would mean less income but more future flexibility.
Too much risk in your portfolio can be devastating
As you can see from Peter’s situation, too much risk in a portfolio can really work against you when you are taking income from the portfolio . The more downside volatility in the portfolio, the greater the risk that you will deplete your asset.
Not enough risk in your portfolio can be devastating
So it’s also important to highlight the other side of the coin. With interest rates at significant lows, it’s difficult for any investor to rely solely on GICs and Fixed income to create enough retirement income. Many retirees can't afford NOT to take risks. For most retirees, it’s a case of Goldilocks investing: Finding that balance of not too risky and not too conservative.
Tap in to the equity in your home
For many people, their home has significant equity in retirement. This equity can be turned into a retirement income resource through reverse mortgages, home equity lines of credit or downsizing.
Running out of money is the last thing anyone wants. The solution from many financial advisors and institutions is to be a little more aggressive to earn higher rates of return. The irony is that too much volatility and risk in a portfolio works against you when retired and taking income. The best advice I can give is to know your options to help you avoid running out of money.