In a week where the federal finance minister cut the tax Free Savings Account limit and our central banker talked about the possibility of negative interest rates, many readers have been wondering about retirement savings.
Given a climate of lower returns and a reduction in ways to shelter what they have, they’re asking: How much do I need to live comfortably? How much can I spend every year to make sure my money lasts longer than I do?
It’s an especially tricky calculation, since you need to guess at a few things that are unknowable. Which way will interest rates go? What’s going to happen to inflation? Will stocks return their historic after-inflation average of 7 per cent gains?
The big question is how long you’ll live. It doesn’t help to know that, on average, we’re living longer; an average is hundreds of thousands of numbers added together. An individual could beat the average by a lot or fall way short.
Financial planners sometimes use the 4 per cent rule. It says you can withdraw 4 per cent of your savings every year in retirement, adjust that for inflation and not run out of money. That usually assumes your savings are invested in fairly conservative way, with 60 per cent in stocks and the rest in bonds.
Here’s an example, which assumes 2 per cent inflation and a 4 per cent real rate of return. You have $ 250,000 and withdraw $ 10,000 on the first day of the year — 4 per cent. That comes to $ 833 a month.
That leaves you with $ 240,000. If your investments return 6 per cent — 4 per cent real returns, plus 2 per cent for inflation, you’d have $ 254,400 at the beginning of Year Two.
On the next Jan. 1, you take out $ 15,000 — the 4 per cent, plus 2 per cent more for inflation. It leaves $ 239,000 to grow all year. If that money gains 6 per cent again, you’ll have $ 253,500 at the end of Year Two. And on you go.
If all goes according to plan, you can take out the $ 10,000 ever year, plus an amount for inflation, in perpetuity.
Clay Gillespie, a financial advisor and portfolio manager with Rogers Group Financial in Vancouver, thinks the rule still works in a world with low interest rates. He says you may not need to increase the amount you take out each year for inflation, so the principle will grow even more. And as you age, your financial needs drop, since you tend to travel less and spend less on major purchases.
“We find that client’s income needs diminish over time,” says Gillespie. “The first 10 years tend to be more expensive than the next 10. The only place the income needs tend to increase in later life is because of long-term care needs.”
The Essential Retirement Guide by actuary Fred Vettese devoted a chapter to the rule. I wrote about the book recently and its broad conclusion that demographics are behind low interest rates and inflation. Vettese also argues most of us will be fine in retirement and should worry less about our savings.
He thinks the 4 per cent withdrawal rate may be too low, and that if you’d used it in the recent past, you wouldn’t have spent enough. As he jokes, you don’t want to be the richest guy in the cemetery.
He agrees that spending declines with age, and so you don’t need as much later on. “If you are like most retirees, you will tend to spend a little more each year until about age 70, and then you gradually spend less,” he writes.
Vettese concludes that 5 per cent is a relatively safe withdrawal rate, assuming your investments return an average 4.5 per cent. He says 6 or even 7 per cent “might not be outlandish, depending on your asset mix.”
Like all rules, this one is just a guide, a rough-and-ready thing that gives you a general idea of what to do. If you want to know whether it works for you, do the math or ask a financial adviser for help.
More columns by Adam Mayers