When planning for retirement, one of the most common stresses is trying to figure out just exactly how much money one will need to maintain the desired quality of life upon retirement. In an era where pensions are not common (unless you happen to be a government employee), it is more important than ever to plan for what you will need once you are no longer on a steady source of employment income. While forecasting and calculating your precise post-retirement income is unrealistic, what is essential is to have a rough range of what this income will likely be. Doing so will allow you to formulate a financial plan which can act as guidance in determining how much you need to save during your working years.
If you are one of those from the extremely lucky gene pool that is likely to inherit money and you therefore do not need to worry about retirement, you still need to know how much you require to live off so that you can invest your money appropriately. It used to be that if you inherited a million dollars you thought you had it made in the shade. But with low interest rates, you get low risk free rates of return. So a million dollars at most today gives you around 4% or $40,000 (pre-tax) a year.
In this article, we highlight two common and easy “do-it-yourself” techniques that can be done in order to get an approximation of how much one needs to save in order to support your desired quality of life in retirement. Unlike in your employed years, where income is earned by working and making a salary, in retirement, you must solely rely on your savings and investments to provide you with the appropriate level of income. Ideally, a retired individual should be in a position to only live off the income that their savings and investments generate and not touch the “core principal” that is invested. This means to refrain from having to actually sell an investment (stock or bond) but instead live off the income that these investments provide. That way you can continue to count on their income stream in future years. Consider the below illustration which assumes a retirement investment portfolio of $2,000,000 invested equally in a stock (Stock A) and bond (Bond B).
Example 1: The retiree that only lives off the income generated from the investment portfolio ($60,000) and doesn’t sell any of their stock or bond can count on $60,000 in income each year.
Example 2: The retiree that requires $100,000 in annual income would be forced to make up the $40,000 shortfall ($100,000 in wanted income - $60,000 income generated from portfolio) by selling a portion of their stock and bond. We’ve assumed $20,000 of each. By selling a portion of their investments (core principal) their future annual income has declined from $60,000 to $58,800.
As you will notice with Example 2, a negative reinforcing spiral develops as the less income generated from the portfolio means that an increasingly higher amount must be taken from the core principal amount to cover the difference. This in turn reduces the amount of future income generation potential of the portfolio.
It is important to highlight that while a bond will pay a fixed level of income each year, a high quality dividend paying stock with a fortress balance sheet is very likely to increase its dividend payment each year. As the company gets larger over time and generates a high level of earnings it can afford to pay out more to its shareholders in the form of a higher dividend. Microsoft, for example, has increased its dividend 250% over the past ten years. This is significantly higher than the average salary increase over the past ten years! By not touching your core principal, so long as you are invested in the right companies, the income generated from the portfolio can actually grow substantially over your retirement years.
We will now discuss the two common techniques that can be used to calculate your expected income in retirement.
Method One: Taking a Percentage of Your Current Income
The most common approach in calculating your expected retirement income is to base it off of your current income. It is not uncommon to use 75-80% of your current income as a proxy for retirement income. In some cases that may be a very stressful number to target. It is also important to note that things do tend to change in retirement with the general trend towards minimizing and simplifying your life. All these factors should be taken into consideration. So perhaps, 65-70% of your income may be a more appropriate range to use, especially if your mortgage has been fully paid off. Whatever the number is, you simply multiply it by your current salary to get a rough guide to what level of income you will likely need in retirement. If your current income is $75,000, a 75-80% assumption would result in post-retirement income requirement in the range of $56,250-$60,000.
Method Two: Using the Value of Your Home as a Measure
The second method is based on the notion that the single best indication of what you will require in your post-retirement years is based on where you live today or where you plan on living in retirement. Generally your home is a great indication of the sort of lifestyle you live. For example, if you live in an expensive neighbourhood, you are likely to not only own an expensive house but also expensive cars, go on expensive vacations etc. A simple formula based on GTA home prices is as follows: take the price of your home and multiply it by a factor of 0.1. This will get you a rough approximation of the income you will require in retirement. If the value of your home is $1,000,000 then your estimated income would be $100,000 (1,000,000 x 0.1).
After considering the two methods mentioned above, you can now get an approximate value of the size of the investment portfolio you would need to support that income. A general assumption is that a retirement portfolio earns an annual income of 4%. Therefore, to calculate the size of the portfolio, simply divide your expected retirement income by 4%. Under Method One, you would require an investment portfolio in the range of $1.4-$1.5 million while with Method Two a $2,500,000 portfolio would be required ($100,000 ÷ 0.04).
While saving $2,500,000 may sound like a very high number to achieve, if you downsized your home, you can deduct the difference between the sale price of your home and the purchase price from your new home from this amount. For example, if you downsized and sold your house for $2.0 million and purchased a $1.0 million house you would need to save the difference of $1.5 million ($2,500,000-$1,000,000) in order to achieve your $2.5 million target. If this is not possible, then you probably need to revisit the price and or location of your home. This is why a lot of people end up moving to smaller towns – it is not just for the peace and tranquility, but also the fact that cost of living is much cheaper.
All of this should be intuitive from the standpoint that where you live has certain costs associated with it. A one million dollar condo is going to have much lower carrying costs (maintenance and taxes) than a two million dollar condo. Based on current maintenance fees and taxes in Toronto, the lower priced condo would require around $15,000-$20,000 a year to carry and, after taxes, should leave enough money left over to live comfortably and travel. While it is common to hear people say they prefer houses to condos because they do not have the same carry costs, this is not necessarily the case. The reason for paying a maintenance fee in a condo is to cover those nasty expenses that happen every so many years: new windows, new roof, outside maintenance. You still need to cover those things in a house but most people do not save for them as part of their monthly budget, although they should. If you are on a fixed income of $50,000 per year and you suddenly have to replace your roof that is a big problem if you have not saved ahead for it. Condos are structured so that you are forced to save for these expenses by putting money into a reserve fund every month. If that reserve fund is managed well by your property management company, no surprises should come up and you always know what your monthly costs will be. However unforeseen circumstances are why, even in retirement, one should aim to save 10% of your income and this is especially true if you live in a house.
In the end a successful retirement is based on how much you prepared for it. In North America today the average person has less than $100,000 saved for retirement. Your home alone cannot be your retirement fund because you have to live somewhere. Think about where you would like to live, look at the real estate there today to see the cost of a home versus your current home and figure out the magic number. Then all you have to do is start saving. The sooner you begin to save, the better you will be. The magic of compound interest will do the rest for you.
The Summerhill Team