Never Retire Profile of the Week
Michael Enright
It would be fair to call Michael Enright a national treasure. With a career in journalism spanning over 50 years, the 77-year-old host of CBC’s The Sunday Edition has seemingly done it all: four highly-regarded CBC shows; managing editor of CBC News; on the editorial board at Time, Quest and MacLean’s magazines; writer for The Toronto Star and The Globe and Mail; and member of the Order Of Canada for his “his contributions to Canadian print and broadcast journalism, and for advocating on behalf of people with intellectual disabilities.” Enright’s passion for justice and commitment to in-depth research on every topic he presents has made him a lively and engaging – and sometimes fierce – conversationalist with guests on his shows. A high school drop out, Enright has been awarded two Honorary Doctorates and – even more cherished – an honorary high school diploma. A passionate advocate for prison reform and the rights of the intellectually disabled, Enright has no plans to retire. While he is leaving The Sunday Edition at the end of this month after a 20-year run, he is embarking on a new CBC programme this fall.
Have I saved enough money to retire? How long will my investments last if I stop working? Has the pandemic deferred my retirement goals? How much money should I save each month? Which investments are appropriate for achieving retirement?
If you find yourself asking these questions – and everyone does at some point in their lives – then you likely want a clear answer by calculating your Financial Independence number.
I don’t call that your retirement number, because I’m the Never Retire guy who doesn’t believe in the traditional and outmoded version of “life after work.” Most of the people I know don’t want to stop working entirely – they want to have choices about how much and what kind of work they do. If you want to read more about what Never Retire means, check out parts 1-3 of my book Live Well, Stay Rich and Never Retire. For convenience, I refer to “retirement” in my title and in the advice below, since that is the common term. But keep in mind that you can “retire” and “never retire” at the same time!
During my 25 years of financial planning, I have witnessed many successful retirements but also a few that went very poorly. As I described in Part 1 of “When can I Retire?” a successful retirement begins by answering three important questions: 1) how much do I spend per month? 2) how much do I save per month? and 3) what type of assets should I invest in? Without answering these questions, you may never know if or when you have saved enough to become financially independent. Not knowing your FI number causes stress at work and home and reduces your chances of achieving the ultimate objective, which is the “Live Well” part of the equation.
In part 1, I explained that calculating your FI number required a detailed projection based on several assumptions for the next 20-40 years. Of course, a projection covering such a long span of time is bound to have several mistakes, but I stressed that although the projections will have assumptions that prove to be incorrect, that doesn’t mean they are useless.
The projections can help determine the long-term implications of increasing expenses (such as sending children to private schools, moving into a bigger house, or increasing your spending when your income rises) will have on your FI number.
The objective of this blog is to explain the challenges of calculating your own FI number by using traditional projections generated by retirement calculators.
Most retirement calculators start with assumptions on inflation rates, expected investment returns, sequence of investment returns, life expectancy, pension benefits and a bold prediction on the amount you will spend in retirement.
Let’s have a look at these assumptions:
1. Inflation rate
If a Starbucks espresso costs $2.50 in 2020, how much would the same espresso cost at the beginning of 2050? The answer depends on the inflation estimate over the 30-year period. If we assume an inflation rate of 4%, the same espresso will cost $8.11. If we assume an inflation rate of 2%, the espresso costs $4.53.
I use the example of a Starbucks coffee to prove an especially important point: the assumed inflation rate has a major impact on the amount of money needed to achieve FI. If we assume an inflation rate that is too low, the retirement portfolio will have difficulties lasting until second death. In other words, we will have underestimated the amount needed to achieve FI. If we assume a higher inflation than reality, we will have saved too much money, consequently overly sacrificing current expenditures for future expenditures.
According to the Bank Of Canada website, Canada’s inflation rate for the last 25 years has averaged about 2%. In fact, in 1991, the Bank of Canada stated that it would employ its resources to maintain the Canadian inflation rate in a target range of 1-3% and it has been successful at achieving this objective.
However, during the 1970s, the Canadian inflation rate was about 8%. At this rate, money doubles in nine years, making a $2.50 coffee then cost $5.00. OUCH.
In short, when estimating the inflation rate, it best to have a range of assumptions. For example, project your Financial Independence number with a 2% inflation rate but also try 3%, 4% and 5% to see how different figures impact the required savings.
2. Expected investment returns
Part of calculating your Financial Independence number requires estimating the expected investment return for each asset class in your retirement portfolio.
For example, if 50% of your portfolio is invested in Canadian equities, you might assume a forward growth rate equal to the S&P/TSX index’s 10 year compounded annual growth rate, which is currently 5% (as of May 26, 2020 as per CPMS). If the other 50% is invested in US equities, you might make the same assumption here and use 11.7% (the 10 year compounded annual growth rate of S&P 500 as of May 26, 2020 as per CPMS).
Of course, the estimated rate of return makes a noticeable difference on the amount of money that must be saved in order to achieve Financial Independence. As with inflation, pick an investment return that is higher than the actual return and you risk outliving your retirement portfolio.
In short, when estimating the investment returns, I suggest assuming a low estimated rate return and establishing ranges of possible outcomes. For example, run the projections using 4%, 5% and 6% and calculate a range for your retirement portfolio.
Here’s an example of how much of a difference various expected returns can have: $50,000 of retirement spending requires a retirement pool of $1,250,000 at 4%, $1,000,000 at 5% and $833,333 at 6% (using the Present Value of a perpetuity formula: spending requirement/expected return after inflation). Note that I am ignoring taxes and employing a perpetual formula to emphasize the range of the Financial Independace number when the expected return is increased or decreased.
3. Sequence of investment returns
Traditional retirement calculators assume the same investment return each year of the projection, but stock market returns are anything but static. For example, if the retirement portfolio value drops in early years of retirement because of weak equity markets, you may find that the portfolio lasts less than initially projected. The opposite is also true: if you experience greater than forecasted returns early in retirement due to strong equity markets, the Financial Independace pool may actually last longer than forecasted.
Again, the suggestion is to understate the investment return of each asset class, because no-one can predict the sequence of the returns. Err on the side of caution and lower the expected return estimate.
4. Life expectancy
In 1980, the historical life expectancy in Canada was 74.9 years and in 2019, it was 82.37 years. When preparing projections, should we assume a life expectancy of 82 years or do we choose a higher number? Given the history of longer life spans each year since 1950, I suggest using a higher number, perhaps even as high as 90 or 100 years.
Again, the consequence of underestimating your life expectancy is outliving your retirement pool, so select a conservative number.
5. Retirement expenses
Perhaps the most difficult projection to make is the estimated amount of money you will spend in retirement.
Many traditional calculators assume 75-85% of working income to support lifestyle expenses during retirement. The calculations assume that retirement expenses are constant. In my personal financial planning practice, I noticed that many retirees spend more money during the early years on travel and “Bucket List” goals and less money during the later years. However, even this pattern often changes due to unexpected family issues (such as children requiring financial support) or health problems (such as the cost of long-term care).
I suggest you calculate your current annual lifestyle expenses and then adjust for expenses that will not occur during retirement (mortgage payments on the principle residence or private school tuition) and add costs that may increase in retirement (perhaps travel or club memberships).
Once the budget is set, be flexible and adjust the estimate as you get closer to retirement and have a better picture of what it will look like.
6. Pension benefits
Canada has two main pension benefits: the Canada Pension Plan, which is calculated based on employer and employee contributions (the current maximum CPP payment is $1175.83 per month as per Canada.ca), and Old Age Security, which is available to most Canadians (max benefit is $613.53 per month and is fully clawed back at $128,127 of individual income).
In addition, many large employers provide pension plans for their employees. There are two major plans: a defined benefit plan and a defined contribution plan.
In a defined benefit plan, the employer promises a regular income after retirement and calculates the pension by applying a formula (for example, 2% of final year income * number of years of service). The risk of underperformance is borne by the employer.
In a defined contribution plan, the employer contributes to the plan (and in many cases the employee also contributes) and, at retirement, the plan is transferred to the employee at the current market value. The risk of underperformance is borne by the employee.
When calculating your Financial Independence number, the expected employer and government pension must be estimated and included in the projections. If the pensions are safe, I suggest reducing the Financial Independence number by the value of the pension. For example, if lifestyle expenses are $50,000 per year, and the cumulative pension income is $25,000, then your Financial Independence number must produce $25,000 of annual income.
Retirement planning is not a “one and done” exercise. It requires updating assumptions, re-running projections, and creating ranges of possible outcomes. Make your retirement plan a dynamic process and minimize errors connected to long-term assumptions.
Once you have calculated your Financial Independence number, it becomes easier to focus on your savings objectives while controlling lifestyle expenses.
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source https://richarddri.ca/when-can-i-retire-part-2-calculating-your-financial-independence-figure/
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