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For more than 30 years, Mary and Dan (not their real names) consistently invested 10 per cent of their incomes in RRSPs and an unregistered retirement portfolio that's grown substantially, but they're still worried whether they can live comfortably in retirement.
She left the work force two decades ago to raise their two girls and a boy and he has only a small pension because most of his jobs in the entertainment industry had no pension programs.
Living modestly in suburban Toronto, they've managed to build a portfolio worth close to seven figures, but they're still not sure whether Dan can comfortably retire next year at 62 and they can do the travelling and activities they hope to enjoy.
She's considered the 4-per-cent rule, a widely known guideline that dates back to an era of higher interest rates. It says retirees who withdraw no more than 4 per cent of their initial retirement portfolio annually and adjust the dollar amount for inflation in succeeding years will have a consistent stream of income that will last at least 30 years.
Returns are low and Mary questions how much they can safely cash out each year to supplement Dan's small defined-benefit plan payments and their Canada pensions and Old Age Security and still have a financial cushion later in life.
It's a dilemma that retirees and those planning for retirement face these days, retirement counsellors say.
"While the 4-per-cent rule of thumb may be a good place to start, it's hardly a place to end for determining how much you will need to draw on during retirement," said Nancy Grouni, a certified financial planner with Objective Financial Partners Inc. in Markham, Ont.
"With projected returns for stocks and bonds lower than in the past and continued low interest rates, it is possible that a 4-per-cent spending rate may be too high," she said. "On the other hand, a 4-per-cent withdrawal rate may be too low if you plan on spending more during your earlier years of retirement on things like travel and recreation when you are likely to enjoy greater health.
"The better approach then, isn't likely to be a rigid one, but rather a flexible one that adapts and changes to the current market climate and your changing lifestyle needs. Doing regular updates of your financial plan will go a long way to helping you achieve the right withdrawal rate for your circumstances," Ms. Grouni said.
In addition to the likelihood of lower than normal portfolio returns, there are other serious concerns with the 4-per-cent rule, said London, Ont.-based Talbot Stevens, author of The Smart Debt Coach: Secrets of the Rich to Increase Your Wealth and Security.
Increased lifespans
The 4-per-cent rule is based on not outliving money over a 30-year withdrawal period. However, a couple who are 65 years old have a 50-per-cent chance that at least one of them will live past 95. This means that most need to plan on their retirement funds lasting to at least age 100, just to have a reasonable chance of success, Mr. Stevens said.
"And this naively assumes that no medical advances will increase lifespans further. The bottom line is that with many people retiring at 60 or before, retirement money must be planned to last at least 40 years, not 30."
Sequence-of-returns risk
If someone has the misfortune of retiring just before a major market crash, the portfolio setback will significantly decrease sustainable retirement income.
Potential support changes
Most governments have underfunded social security and future health-care commitments. Demographics will make this situation even worse with the increasing ratio of retirees drawing from public coffers to workers who are filling them. If governments can't afford to deliver on these payouts, then more must be covered by individuals.
"Any combination of these realities increase the chance of running out of money," Mr. Stevens said. "Therefore, extra caution is warranted in designing a sustainable retirement plan. The 4-per-cent rule with the accompanying assumption that you need to build a portfolio that is 25 times the annual income you need in retirement needs to be reconsidered."
A 3-per-cent rule would be safer as a starting point today and adjusting up or down as conditions change in the future is a safer and better strategy, Mr. Stevens now advises.
"I suggest that retirees plan for the expected, and prepare for the possible. Percentage withdrawal rules are popular because they are simple, but they are not optimal in normal markets and can't survive bad ones."
As a case in point, someone in Japan who retired in 1989 when the Nikkei index peaked at almost 40,000 but collapsed the next year would have been out of cash years ago. More than 25 years later, the Japanese stock market is still down about 50 per cent, he noted.
"Unfortunately prudent advice is a tough sell in an era of record-high debt levels and low savings rates. If Canadians only had as much interest in borrowing for retirement [after the market drops] as they had in borrowing for lifestyle enhancements, their future would be bright," Mr. Stevens said.
Mary and John have decided not to count on more than a 3-per-cent withdrawal. In addition to their pension funds (both government and Dan's defined-benefit pension) along with their required minimum RRIF withdrawals, they calculate they can count on a total of about $60,000 in income annually.
Their TFSA deposits and other investments in GICs and preferred-share ETFs have been growing at about 3 per cent a year and will serve as a cushion for unplanned expenses and to be able to fund things such as gifts to their children, Mary said.
"I'd rather be conservative with what we expect to take out and be pleasantly surprised if we have more, than be shocked that we won't have enough to live on as we get older."
Retirement red flags
The most significant retirement pitfall is failure to plan ahead and adjust as the market changes, certified financial planner Nancy Grouni said. Here are some common missteps:
– Failing to regularly save funds for retirement in a tax-efficient manner.
– Underestimating future expenses by forgetting to factor in all lifestyle expenses such as home maintenance, renovations and future car purchases.
– Failing to account for inflation. Assume that all expenses will go up annually because of inflation. Failure to do so will grossly underestimate your future needs and lead to poor decision making – not to mention early depletion of funds.
– Overestimating rates of return. It's best to be conservative. That way anything above and beyond is gravy. "Nothing creates stress like feeling you absolutely need to achieve a higher rate of return to meet your retirement needs."
– Overestimating your ability to keep working.
– Not staying healthy. An unhealthy lifestyle can result in increased health-care costs and impact your ability to work prior to retirement.