A False Sense of Planning
Your life isn’t fixed so why is your plan? Financial Plans can be misleading creating a false sense of reality. Read about solutions to take the guesswork out of retirement planning.
KEY TAKEAWAYS
- The historical techniques for financial planning need reworking as financial plans often rely upon outdated assumptions.
- Research has shown that spending patterns in retirement do not occur in a straight line, but rather in distinct phases.
- TruSpend builds plans and gauges expenses with a higher level of accuracy, and offers a robust solution geared towards mitigation of lifestyle and longevity risk.
Questions about our financial future often keep us up at night. Will I save enough today to enjoy retirement tomorrow? How much can I spend in retirement without running out of money? Do I know how much money I’ll need when I retire?
The purpose of retirement is often to pursue activities that were postponed during working years and to enjoy life in a different way. Lifespans have been increasing over time, which puts additional pressure on individuals to figure out how to plan their lives accordingly. By 2031, average life expectancy in Canada is projected to have risen from 78 to 84 years for males and from 83 to 86 for females, with the gap continuing to narrow1 Yet according to a 2014 Canadian Financial Capability Survey (CFCS) Canadians who are 55 - 64 years old are only 49% certain that they have the necessary savings to carry them through retirement. Shockingly, 12% of the participants in the survey did not know what their primary source of income in retirement would be.
There are unique challenges when planning for retirement, such as generating the required income from savings, ensuring your capital supports your lifespan, while balancing the desired legacy to leave to your family and philanthropic interests. In fact, the Survey of Capital Accumulation Plan (CAP)3 shows only 21% of participants have a formal plan outlining the age at which they’ll retire and the amount of money they’ll need.
Historically, retirees were advised to follow “the 4% rule” - a rule of thumb often relied upon to determine the sustainable level of annual portfolio withdrawals. The rule sought to provide a steady stream of income, while also keeping an eye on your account balance to ensure your assets last throughout retirement. In our opinion, this concept should be questioned as we now live in an environment where interest rates are at historically low levels, providing little support for risk free income. On the flip side, this has forced a higher weighting towards equities in an effort to boost required returns without measuring the impact of unexpected capital drawdowns.
T. Rowe Price recently conducted an enlightening study on drawing portfolio income under different market conditions. The study looked at a 30 year retirement scenario starting January 1, 2000 with an account balance of $500,000. The study focused on those with a conservative investment mix of 55% equities and 45% bonds, where the retiree withdrew 4% (with a 3% inflation factor) of the portfolio value each year for 30 years. After simulating 10,000 market scenarios the study found a success rate of 89%, in other words, 11% or 1 out 10 times the retiree would have run out of money within 30 years.
It is our view that the techniques used historically need reworking as financial plans have often relied upon outdated assumptions, including:
- Lifestyle expense forecasts that increase in a straight line each year
- All expenses consistently grow at the same rate of inflation during retirement
- Stable investment return assumptions, without regarding the possibility of an unfavorable sequence of returns (i.e. timing of retirement that coincidences with a challenging economic environment)
These assumptions can create a false sense of reality as they paint a picture of linear retirement consumption and consistent annual returns.
We view this challenge differently. In retirement, lifestyle choices often occur in three stages, each impacting lifestyle expenses, healthcare costs and leisure activities. Research has shown that spending patterns in retirement do not occur in a straight line, but rather in distinct phases (i.e. spending on leisure activities tends to be higher in early retirement, while healthcare costs tend to increase later in retirement).
This is supported by research when examining a 30-year retirement period. Lifestyle needs/activities tend to occur in different "age bands"— 65 to 74, 75 to 84, and 85 to 95 and are split into four general categories: basic living, leisure, health care and taxes, each with their own rate of change and inflation rate.
Ignoring the likely pattern of spending habits during the three stages of retirement creates exposure to both lifestyle and longevity risk. Lifestyle risk is defined as a shortfall in income to fund retirement years, while longevity risk assesses the potential of outliving your assets. These risks are more likely to occur when reality does not conform to the planning assumptions, resulting in capital being depleted at a different rate than expected due to an inconsistent forecast. This effect may also compound over several years resulting in undesirable outcomes earlier than anticipated.
Effective planning must be consistent with the likely path of your lifestyle in order to balance the need for income while guarding against the possibility of prematurely running out of money.
At Gerstel Wealth Management, our group has researched this challenge extensively.
We believe it is best to address these issues before they occur and have a solution to proactively and practically plan for retirement. We call it TruSpendSM. TruSpendSM maps retirement income and spending in distinct stages to reflect your likely lifestyle experience. Planning for each phase is segmented according to the age bands as mentioned above or to your likely experience. This allows for your path to be tested and invested according to the period it will be needed. As a result, TruSpendSM builds plans and gauges expenses with a higher level of accuracy, and offers a robust solution geared towards mitigation of lifestyle and longevity risk.
Taking these steps and reassessing how you plan will help guide you towards important retirement goals while making intelligent planning decisions for your future.
Work Cited
- Statistics Canada. Canadian Demographics at a Glance. Catalogue 91-003 Ottawa: 2008.
- Canadian Financial Capability Survey, 2014. (2014). Retrieved November 08, 2016, from http://www.statcan.gc.ca/daily-quotidien/141106/dq141106b-eng.htm
- 19, 2013 March. "2012 CAP Member Survey: Retirement Planning." Benefits Canada.(2014), March 19th, 2013. Web. 08 Nov. 2016.
- Retirement Savings Guide. T. Rowe Price, 1 Dec. 2000. Web. 11 Nov. 2015.
- Age Banding: A Model for Planning Retirement Needs , Somnath Basu, Financial Counseling and Planning, Volume 16 (1), 2005. Web 11 Nov 2015.
- 6 Ways Spending Changes in Retirement, US News Business. Emily Brandon " Web. 8 Nov. 2016. Basic living costs (including transportation, housing and food) were assumed to drop by 30% after retirement, fall another 20% at 75 and another 10% at 85. Leisure activities increased by 50% in the first years after retirement, and then dropped precipitously. Meanwhile, health care posted a rise of 15% at retirement, another 20% at 75 and 25% more at 85. In the last stage, health care costs consume a greater share of a retirement budget—18% for those over 85, compared with 9% for those 50 to 64, according to an analysis by the Employee Benefit Research Institute.
The views of Ryan Gerstel (Gerstel Wealth Management) do not necessarily reflect those of CIBC World Markets Inc. Clients are advised to seek advice regarding their particular circumstances from their personal tax and legal advisors. This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC Wood Gundy is a division of CIBC World Markets Inc., a subsidiary of CIBC and a Member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organization of Canada. If you are currently a CIBC Wood Gundy client, please contact your Investment Advisor.