Conventional retirement planning

Conventional retirement planning describes methods used explicitly or implicitly by many DIY investors, including on the Financial Wisdom Forum (FWF), by many financial advisors, and by most retirement calculators (e.g., ). This article gives a step-by-step explanation of the process, then provides two examples, and finally discusses the strengths and weaknesses of this approach.

Step by step explanation

Conventional retirement calculations go something like this:

Step 1: Retirement age and final planning age

Pick a retirement age (e.g., 65 years old) and a final planning age (e.g., 95 years old).

You can get an estimate of your life expectancy based on your age, gender, level of physical exercise, diet, smoker status, etc. at Project Big Life. Make sure you add a buffer to your life expectancy to decide on a final planning age.

Vettese (2016) uses the 2014 Canadian Pensioners’ Mortality table (with adjustment for size and income) from the Canadian Institute of Actuaries to calculate that a 60 year old male has a 16% probability of dying after age 95. The figure is 24% for a 60 years old woman. Unless your life expectancy is very low, using 95 as the final planning age therefore looks like a minimum, and some people will want to pick later ages.

Step 2: Retirement income target

Calculate how much gross income you need/want every year during retirement. There are two possible methods here, an approximate one and a more accurate one.

2a. Replacement rate method The first method is a rule-of-thumb that says that a certain percentage, typically 70%, of your final salary, in today’s dollars, will do (e.g., ). This is because retirement spending is typically less than spending during work years. This is known as the Income replacement rate method. Depending on income levels, household size, home ownership status, etc., some households will only need to replace 50-60% of their final incomes, whereas others may need to replace up to 90%.

You don’t know your final salary, but you can guesstimate it from your current salary, and an estimated real (after inflation) salary growth rate.

If you are several decades away from retirement, this is a "quick and dirty" initial approach.

2b. Retirement budget method The more accurate method to figure out how much gross income you will need every year during retirement is to actually make a retirement budget, in today’s dollars. This will be easier to do closer to retirement than several decades ahead.

The easier method is to start with what you are spending now. Add new expenses such as those related to extra time available for leisure. Subtract expenses that won’t be relevant during retirement, such as saving for retirement, payroll deductions, other work-related expenses, and perhaps things like mortgage payments or children education, if applicable. Other budget methods are discussed under Retirement budget models.

Income taxes should be part of this budget. Play with an income tax software, pretending to be a retiree, and proceed by trial and error until the gross income is enough to cover both retirement consumption and taxes. Note that some sources of income are taxable (e.g., Registered Retirement Savings Plan (RRSP) withdrawals, pensions, Canada Pension Plan (CPP)/Québec Pension Plan (QPP), Old Age Security (OAS)) and others are not (Tax-Free Savings Account (TFSA) withdrawals, GIS).

Step 3: Portfolio withdrawal target

Simultaneously with step 2b, examine your sources of retirement income. Potential sources typically include OAS/GIS, CPP/QPP, any workplace pensions, and portfolio withdrawals. See Canada's retirement income system for an overview. Determine how much you will be getting, or need to extract, from each source.

Portfolio withdrawals must cover the shortfall between planned expenses and income from other sources. (If you are planning a very high retirement income, consider the OAS clawback issue.)

Step 4: Portfolio size

So, how big does your portfolio need to be upon retirement, to provide the required income, indexed for inflation, until death? This is also known as the "wealth target". Two methods can be used to calculate this, based on the size of the portfolio withdrawal target.

4a. Safe withdrawal rate method The conventional approach often relies on another rule of thumb called the safe withdrawal rate method. An often used number is 4%: you can supposedly withdraw 4% of your initial portfolio every year, increase this withdrawal amount every year to cover inflation, and your balanced portfolio should last 30 years based on US historical data and Monte Carlo simulations (e.g., ). Read the safe withdrawal article for issues with this method, including the part on “sequence of returns risk”.

A 3% withdrawal should be safer based on historical data, although not completely failure-proof, and requires a larger portfolio.

4b. Annuity method Even if you are not planning to buy an annuity upon retirement, you can use annuity pricing to estimate the amount of capital needed to produce a certain income for life. For this exercise, use your planned retirement age when getting annuity quotes, not your current age. Couples will probably want to use "joint and survivor" quotes. If you want inflation-indexed income, use quotes for inflation-indexed annuities, or annuities indexed by a fixed percentage (e.g., 2%) every year.

Step 5: Savings target

How much do you need to save every year to achieve your wealth target (required portfolio size) at retirement age? It depends of course on the expected real return from your portfolio. Here you can use historical returns, or return forecasts, for each asset class. You then blend these returns into an expected real portfolio return, based on your chosen asset allocation (e.g., see Norm’s asset mixer). The yearly savings required to reach the desired portfolio size can then be calculated in a spreadsheet or online retirement calculator. The required savings divided by your current salary, expressed in percentage terms, is your savings rate.

If that savings rate seems too high, you can start your calculation from the top and change some parameters. You can either:

1. delay the retirement age (more contribution years to build up your retirement portfolio, fewer retirement years to fund, and increased yearly amounts to be received from OAS and CPP),
2. decrease your retirement budget or replacement rate (which will yield a smaller required portfolio size), or
3. change your asset allocation (increase stocks to increase the expected return).

The latter strategy is not necessarily recommended as it increases the risk of missing the target, in case expected returns from stocks don’t materialize.

Step 6: Regular updates

You should review your planning every three to five years to take into account any changes in employment or workplace pension prospects, marital status, desired retirement age, retirement budget, investment return expectations, asset allocation, required savings rate, etc.

Monte Carlo simulations

There are many variables in retirement planning calculations. Assigning a constant value to each variable (e.g., future portfolio returns) simplifies the calculations, but can be highly misleading. Monte Carlo simulations are computer algorithms that can take into account various sources of uncertainty and determine the distribution of outcomes. The models rely on the past (e.g., past investment returns) to determine a distribution of possible future outcomes (e.g., portfolio values). This allows probabilities of reaching a goal to be calculated, where the goal could be obtaining a certain wealth target by age 65, or not outliving your money during retirement.

The Ameriks et al. paper on withdrawal rates, referenced above, is an example of this. The authors generate possible future portfolio returns by "randomly drawing return and inflation data one month at the time" from the US historical record, and "using these draws to construct a large number of possible return sequences". They then test the effect of a 4.5% withdrawal rate to see if it is sustainable. For a 40 year-long retirement, the calculated failure rate (the probability of running out of money) is 97% for a "conservative" portfolio, 55% for a "balanced" portfolio, and 27% for a "growth" portfolio. Investors will not be comfortable with such failure rates, so they will want to use a withdrawal rate that has a much smaller probability of completely depleting the portfolio.

Financial Wisdom Forum member ghariton writes that "in a well-conducted Monte Carlo for financial planning, you don't run variations just for rates of return or drawdowns. You run them for every significant factor, from life expectancy to losing a job to divorce to major health problems."

Conducting Monte Carlo simulations is probably beyond the expertise of most DIY investors, but they are mentioned here to explain how adherents to the conventional school of retirement planning approach the problem.

Two examples

Step 1: Retirement age and final planning age

We look at two married couples, the Aggs and the Cons, who have aggressive and conservative attitudes, respectively, in financial matters. They are all aged 30, want to retire at 65 and the final planning age is 95.

Step 2: Retirement income target

For simplicity, the retirement income target is set at $60k per couple, in today’s dollars.

Step 3: Portfolio withdrawal target

OAS and CPP/QPP will be taken at age 65. Let’s say that OAS will be $7k (in today’s dollars still), that CPP will be $13k, and that there are no workplace pensions. That means $20k of guaranteed inflation-indexed retirement income per person, or $40k per couple (gross). The shortfall for each couple, to be covered by portfolio withdrawals, is $20k (gross), all coming from their RRSPs.

Step 4: Portfolio size

The Aggs are willing to take their chances with a 4% withdrawal rate, so their portfolio needs to be $500k ($20k divided by 0.04) upon retirement.

The Cons feels better about a 3% withdrawal rate, so their portfolio will need to be $667k upon retirement ($20k divided by 0.03).

Both couples also try the annuity quote method to estimate portfolio size. They see that $100k of registered funds buys then a joint indexed (2%) annuity of $336.98 per month at age 65 (Feb. 2018). That’s an income of $4044 a year, but they want $20k of income. So they need $100k * $20k/$4044 = $494.6k of capital at age 65, a bit less than the 4% rule says. This surprises the Aggs and the Cons, but they stick with their previous estimates.

Step 5: Savings target

The Aggs are boldly forecasting real returns of 6% on stocks and 2% on nominal bonds, so they expect their 75-25 portfolio to have an annualized real return of 5%, from age 30 to age 65.

The Cons are forecasting real returns of 5% on stocks and 1% on nominal bonds, so their 50-50 portfolio is expected to produce an annualized real return of 3%..

Iterating with a spreadsheet, we find that the Aggs need to save about $5.3k per year, in today's dollars, over 35 years, to reach their required portfolio size. The Cons need to save about $10.7k per year.

Discussion

Note how picking aggressive assumptions during the whole process and using a stock-heavy portfolio can cut the required yearly savings by half compared to picking conservative assumptions and using a balanced portfolio.

But the Aggs are taking a lot of risk here:

• there is no room for any disruption in their plan (divorce, health issues, job loss, etc.): the savings needs to be maintained for the whole 35 years
• their optimistic expected returns needs to materialize to reach the needed portfolio size. The 10 years leading to retirement will be quite dangerous, with their 75-25 portfolio: a stock market crash could devastate their savings
• even if they dial down the risk taking in their asset allocation during retirement, the first 10-15 years of retirement will also be quite dangerous because of the 4% withdrawal rate, and sequence of returns risk
• they are also facing longevity risk. Will their RRSPs (then RRIFs) actually last to age 95, or even longer if needed?

The Cons have a greater chance of reaching their goal, because they are aiming for a larger portfolio, they are using more modest real return assumptions, and they are planning to withdraw a smaller percentage of their portfolio every year. Success is still not guaranteed, however.

Strengths of the approach

• Doing planning according to the methodology described here is vastly better than doing no planning at all
• The rules of thumb and online calculators simplify the calculations
• By keeping all the portfolio in liquid assets and avoiding annuities, the retiree keeps control, which is an "attractive feature given the unknown and uninsurable expenses that can arise during retirement".
• With a "safe" withdrawal rate method (a.k.a. constant real dollar method), the withdrawn amounts are equal from year to year (adjusted for inflation), which is simple and facilitates budgeting

Weaknesses of the approach

• There is no attempt to guarantee a retirement income floor
• Depending on assumptions, the traditional method gives very different required savings rate to reach the same retirement income target, as shown by the examples above
• The target retirement income is based on the current consumption adjusted for retirement conditions, not on a sustainable lifetime consumption; see consumption smoothing.
• A constant retirement budget (in real terms) does not correspond to the typical spending patterns exhibited by retirees. It usually (but not always) leads to an overestimate of the savings needed at retirement.
• Future investment returns are unknown; actual portfolio upon retirement might be too large (over-saving) or too small, leading to a reduction in the standard of living of the retiree.
• The "safe" withdrawal rate method not really safe (might prematurely deplete portfolio); sequence of returns risk
• Longevity risk is not specifically addressed

Probabilistic versus safety-first planning

The approaches described here are sometimes called "probability-based" since "the objective is to develop a plan that will maximize the probability of success for meeting the overall lifestyle goal". Pfau summarizes the probability-based school as follows:

The probability-based school has the most in common with systematic withdrawals. It is most linked to traditional investment concepts such as modern portfolio theory. The idea is to diversify investments based on a client’s willingness to endure market volatility, with an emphasis on managing the total return of the client’s portfolio. Withdrawals can include interest, dividends, and principal, and one seeks a conservative withdrawal strategy that will avoid portfolio depletion.

This investment approach aims to maximize risk-adjusted returns, both during accumulation and withdrawal. This means using a significant proportion of stocks, because they have a higher expected return than bonds and cash, over long time horizons. Also, based on the US historical record, a portfolio with over 50% stocks has a smaller probability of being depleted by constant withdrawals during retirement.

An alternative approach to retirement planning is the safety-first philosophy. An important component of this approach is liability matching.

Other decumulation methods

There are many alternatives to withdrawing a fixed amount from your self-managed portfolio every year during retirement. One of these more flexible withdrawal strategies is called Variable percentage withdrawal (VPW).

Another decumulation strategy is the use of annuities, either for all of one's assets, or for part of them.

See also

• Contingency planning for retirement
• Canadian retirement software & calculators

External links

• Government of Canada, Canadian Retirement Income Calculator
• Financial Consumer Agency of Canada, Retirement and pensions
• Question Retraite, Guide to financial planning for retirement, 2017-2018 edition
• On Monte Carlo simulations: Dirk Cotton, The “Future” of Retirement Planning, and subsequent blog posts