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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Retirement planning is difficult enough without having to contend with misinformation. Unfortunately, much of the advice that is dispensed is either unsubstantiated or betrays a strong vested interest. In The Essential Retirement Guide, Frederick Vettese analyses the most fundamental questions of retirement planning and offers some startling insights. The book finds, for example that:
- Saving 10 percent a year is not a bad rule of thumb if you could follow it, but there will be times when you cannot do so and it might not even be advisable to try.
- Most people never spend more than 50 percent of their gross income on themselves before retirement; hence their retirement income target is usually much less than 70 percent.
- Interest rates will almost certainly stay low for the next 20 years, which will affect how much you need to save.
- Even in this low-interest environment, you can withdraw 5 percent or more of your retirement savings each year in retirement without running out of money.
- Your spending in retirement will almost certainly decline at a certain age so you may not need to save quite as much as you think.
- As people reach the later stages of retirement, they become less capable of managing their finances, even though they grow more confident of their ability to do so! Plan for this before it is too late.
- Annuities have become very expensive, but they still make sense for a host of reasons.
In addition, The Essential Retirement Guide shows how you can estimate your own lifespan and helps you to understand the financial implications of long-term care. Most importantly, it reveals how you can calculate your personal wealth target - the amount of money you will need by the time you retire to live comfortably. The author uses his actuarial expertise to substantiate his findings but does so in a jargon-free way.
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Veröffentlichungsjahr: 2015
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Table of Contents
Title Page
Copyright
Dedication
Preface
Note
Acknowledgments
Part I: The Retirement Income Target
Chapter 1: The Road to Retirement
Detours
Chapter 2: Doubts about the 70 Percent Retirement Income Target
Niggling Doubts
Saving for Retirement Is a Two-Dimensional Problem
The Macro Case Against 70 Percent
Low-Income Workers
Conclusions
Notes
Chapter 3: Homing in on the Real Target
Setting the Ground Rules
Howard and Barb
Steve and Ashley 1.0
Steve and Ashley 2.0
Expressing Consumption in Dollars
Conclusions
Chapter 4: A New Rule of Thumb
Guiding Principles
Retirement Income Targets under Different Scenarios
General Rule of Thumb
Conclusions
Note
Part II: The Wealth Target
Chapter 5: Quantifying Your Wealth Target
A Rough-and-Ready Estimate
A More Actuarial Approach
Note
Chapter 6: Why Interest Rates Will Stay Low (And Why You Should Care)
The Rise of the Savers
The Japan Experience
Applicability to the United States and Canada
Possible Remedies
Implications
Notes
Chapter 7: How Spending Decreases with Age
Doubts
Quantifying the Decline in Consumption
Why Does Consumption Decline?
Next Steps
Notes
Chapter 8: Death Takes a Holiday
Present-Day Life Expectancy
Dispersion of Deaths
Who Is Benefiting the Most?
Why Is Mortality Improving?
The Future
Conclusions
Notes
Chapter 9: Estimating Your Own Life Expectancy
Conclusions
Notes
Chapter 10: Is Long-Term Care in Your Future?
Long-Term Care (LTC)
What Does LTC Entail?
What Are the Chances You Will Need LTC?
How Long Is LTC Usually Required?
Conclusions
Note
Chapter 11: Paying for Long-Term Care
Typical LTC Insurance Contract
Does the Math Work?
The Verdict
The Consequences of Not Insuring LTC
Note
Chapter 12: Putting It All Together
New Wealth Targets
Buffers
Conclusion
Note
Part III: The Accumulation Phase
Chapter 13: Picking a Savings Rate
Historical Performance
Lessons Learned
What the Future Holds
Generalizing the Results
Note
Chapter 14: Optimizing Your Savings Strategy
The Goal
Strategy 1: Simple
Strategy 2: Simple Lifecycle Approach
Strategy 3: Modified Lifecycle
Strategy 4: Variable Contribution
Strategy 5: The SMART Approach
Conclusion
The Third Lever
Methodology
Chapter 15: A Gentler Approach to Saving
Path 1: Pain Now, Gain Later
Path 2: Smooth and Steady Improvement
A Comparison in Dollar Terms
Conclusions
Part IV: The Decumulation Phase
Chapter 16: Rational Roulette
Call to Action
Watch Out for Your Children
Note
Chapter 17: Revisiting the 4 Percent Rule
The 4 Percent Rule
Problems with the 4 Percent Rule
A More Rational Spending Rule
A Monte Carlo Simulation
Conclusions
Chapter 18: Why People Hate Annuities (But Should Still Buy One)
Why Annuities Should Be Popular
The Psychology Behind the Unpopularity
Tontines
The Insured Annuity Strategy
Indexed Annuities? Forget It
Conclusions
Note
Part V: Random Reflections
Chapter 19: How Workplace Pension Plans Fit In
Why Employers Offer Workplace Plans
Getting the Most out of Your Workplace Plan
How a Workplace Pension Plan Affects Your Dollar Target
Online Forecast Tools
Chapter 20: Bubble Trouble
Why Worry about Financial Bubbles?
Examples of Recent Financial Bubbles
Common Characteristics
The Everything Bubble
Notes
Chapter 21: Carpe Diem
The Numbers
Healthy Life Years
Trends
Personal Genome Testing
Notes
Chapter 22: A Life Well Lived
Retirement and Happiness
Final Thoughts
Note
Appendix A: Similarities between the United States and Canada
Social Security Programs
High-Level Comparison of Retirement Vehicles
A Tax Comparison
Appendix B: Social Security in the United States and Canada
Name of Social Security Pension Plan
Purpose of Social Security
Earnings Base for Pension Calculation
How Pension Is Calculated
How the Plans Are Funded
Normal Retirement Age
Early Retirement Age
Delayed Retirement
Indexation
Other Government-Sponsored Pension Plans
Taxability
Appendix C: Retirement Income Targets under Other Scenarios
Appendix D: About the Assumptions Used in the Book
Thoughts on Conservatism
Assumptions Used to Estimate Personal Consumption
Assumptions Used to Calculate Future Retirement Savings
Assumptions Used to Estimate the Historical Accumulation of Savings
Couple Contemplating Long-Term Care Insurance
Assets Needed to Cover Long-Term Care (LTC)
About the Author
Index
End User License Agreement
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Guide
Table of Contents
Begin Reading
List of Illustrations
Chapter 1: The Road to Retirement
Figure 1.1 The Fragility of Life
Chapter 2: Doubts about the 70 Percent Retirement Income Target
Figure 2.1 Breakdown of Expenditures in a Steady Saving Scenario
Chapter 3: Homing in on the Real Target
Figure 3.1 Expenses at Age 42
Figure 3.2 “Investments” Keep Personal Consumption Low
Figure 3.3 Save Early and Party at 60?
Figure 3.4 Steve and Ashley 2.0
Figure 3.5 Real Personal Consumption Doubles Between 34 and 60
Chapter 6: Why Interest Rates Will Stay Low (And Why You Should Care)
Figure 6.1 Saver Ratio
Figure 6.2 Saver Ratio
Figure 6.3 China is Next
Figure 6.4 Worker to Retiree Ratios Plummet
Chapter 7: How Spending Decreases with Age
Figure 7.1 Consumption Change for US Married Couples
Figure 7.2 Consumption Pattern of Canadians
Figure 7.3 German Household Spending (2014)
Chapter 8: Death Takes a Holiday
Figure 8.1 When Death Occurs for 60-Year-Old Men in 1950
Figure 8.2 When Death Occurs for 60-Year-Old Men in 2015
Figure 8.3 Death in 1950 Rates vs. 2015
Figure 8.4 Future Drivers of Mortality Improvement (male 80)
Chapter 9: Estimating Your Own Life Expectancy
Figure 9.1 Gain or Loss in Life Expectancy
Figure 9.2 Distribution of Future Deaths for Women Age 50
Chapter 13: Picking a Savings Rate
Figure 13.1 Retirement Income if 8% is Saved for 30 Years
Chapter 15: A Gentler Approach to Saving
Figure 15.1 Personal Consumption Under Path 1 (Steve and Ashley)
Figure 15.2 Smoothing Personal Consumption (Path 2)
Figure 15.3 Personal Consumption (Constant Dollars)
Chapter 17: Revisiting the 4 Percent Rule
Figure 17.1 Historical Income from 4 Percent Rule
Figure 17.2 Average Real Return on a Balanced Portfolio
Chapter 18: Why People Hate Annuities (But Should Still Buy One)
Figure 18.1 Summary of Retirement Income Enhancer
Chapter 21: Carpe Diem
Figure 21.1 Risk Between Ages 50 and 80—Male
Chapter 22: A Life Well Lived
Figure 22.1 Maslow's Hierarchy of Needs
List of Tables
Chapter 3: Homing in on the Real Target
Table 3.1 Defining Personal Consumption
Chapter 4: A New Rule of Thumb
Table 4.1 Retirement Income Targets under Scenario 1: Homeowners
Table 4.2 Retirement Income Targets under Scenario 1: Renters
Table 4.3 Retirement Income Targets under Scenario 2: Homeowners
Table 4.4 Difference in Targets, Scenario 2 vs. Scenario 1
Table 4.5 Size of “Investments” Made
Table 4.6 New Rule of Thumb for Retirement Income Target
*
Chapter 5: Quantifying Your Wealth Target
Table 5.1 How Wealth Target Varies by Income Level
Table 5.2 How Income Needs Change after Divorce
Table 5.3 How the Wealth Target Depends on Age (Target at age 64 = $400,000)
Chapter 6: Why Interest Rates Will Stay Low (And Why You Should Care)
Table 6.1 Saver Ratios in 1990
Chapter 7: How Spending Decreases with Age
Table 7.1 Spending Drops More than 50% on These Items
Table 7.2 Spending Increases More than 50% on These Items
Table 7.3 The Rate of Decline in Consumption (US and Canada)
Chapter 8: Death Takes a Holiday
Table 8.1 Modern Death Probabilities (for a 60-year-old)
Chapter 9: Estimating Your Own Life Expectancy
Table 9.1 Estimating Life Expectancy
Table 9.2 Life Expectancy Zones
Chapter 10: Is Long-Term Care in Your Future?
Table 10.1 Probability of Needing LTC for First Time
Table 10.2 Cumulative Probability that a 55-Year-Old Will Need LTC
Table 10.3 Likelihood that LTC Will Persist for 5 Years
Chapter 11: Paying for Long-Term Care
Table 11.1 LTC Insurance Premiums versus Payouts
Table 11.2 Couple's Financial Situation
Table 11.3 Claim Occurs at Age 71
Table 11.4 Claim Occurs at Age 86
Table 11.5 Provision for Long-Term Care
Chapter 12: Putting It All Together
Table 12.1 Process for Finding the Wealth Target—an Example
Table 12.2 Neutralizing Risk of Premature Retirement
Table 12.3 Level of Confidence that Inflation Risk Is Covered
Table 12.4 Wealth Targets if the Intent Is to Retire at Age 65
Table 12.5 Wealth Targets if Intent Is to Retire at 60
Chapter 13: Picking a Savings Rate
Table 13.1 Assumptions for the Historical Estimates
Table 13.2 Savings Rate Needed to Hit the 50% Target
Table 13.3 Assumptions for Projecting Pensions 30 Years
Table 13.4 Savings Target
*
for Homeowners with Children
Chapter 14: Optimizing Your Savings Strategy
Table 14.1 Constant Asset Mix, Constant Contribution Rate Approach
Table 14.2 Asset Mix in Target Date Funds (in 2015)
Table 14.3 Strategy 2 (Simple Lifecycle)
Table 14.4 Strategy 3 (Modified Lifecycle)
Table 14.5 Strategy 4 (Variable Contribution)
Table 14.6 Strategy 5 (SMART Approach)
Table 14.7 Summary of Results
Chapter 17: Revisiting the 4 Percent Rule
Table 17.1 How the 4 Percent Rule Works
Table 17.2 High Returns on Equities
Table 17.3 Scenario B: Spending the Nominal Return
Table 17.4 Scenario C: Accelerated Withdrawals
Chapter 18: Why People Hate Annuities (But Should Still Buy One)
Table 18.1 Long-Term Economic Assumptions
Table 18.2 Annuity vs. Drawing Income from an Investment Portfolio
Table 18.3 Annuity vs. Drawing Income
Chapter 20: Bubble Trouble
Table 20.1 Other Financial Bubbles
Chapter 21: Carpe Diem
Table 21.1 Percentage of Healthy People Who Develop a Critical Illness or Die
Table 21.2 Prevalence of Critical Illness versus Death (Male)
Table 21.3 Number of Disease-Free Years Americans Can Expect
Table 21.4 Changes in Health—1998 to 2006
Table 21.5 Changes in Health—1998 to 2006
Appendix A: Similarities between the United States and Canada
Table A.1 Single Person, 5-Year Average Earnings of $60,000
*
Table A.2 Single Person, 5-Year Average Earnings of $100,000
Table A.3 Married Couple, 5-Year Average Earnings of $60,000 and $30,000
Table A.4 Married Couple, 5-Year Average Earnings of $100,000 and $60,000
Table A.5 Marginal Income Tax Rates (federal only)
Table A.6 Tax Burden by Country
Appendix B: Social Security in the United States and Canada
Table B.1 Summary of US and Canadian Earnings-Related Social Security
Appendix C: Retirement Income Targets under Other Scenarios
Table C.1 Scenario C1: Child-Related Costs Continue (at 10%) until 65
Table C.2 Scenario C2: Retiring at 60
Table C.3 Scenario C3: Start Saving at 40
Table C.4 Scenario C4: Divorced at 50 and No Remarriage
Table C.5 Scenario C5: Participated in a Workplace Pension Plan
Appendix D: About the Assumptions Used in the Book
Table D.1 Actuarial Assumptions Used in the Historical Simulations
The Essential Retirement Guide
A CONTRARIAN'S PERSPECTIVE
Frederick Vettese
Copyright © 2016 by Frederick Vettese. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
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Library of Congress Cataloging-in-Publication Data:
Vettese, Fred, 1953–
The essential retirement guide : a contrarian's perspective / Fred Vettese.
pages cm
Includes index.
ISBN 978-1-119-11112-2 (hardback) – ISBN 978-1-119-11114-6 (epdf) – ISBN 978-1-119-11113-9 (epub)
1. Retirement–Planning. 2. Finance, Personal. I. Title.
HQ1062.V48 2015
332.024'014–dc23
2015029018
Cover Design: Wiley
Cover Images: Tug of War © Mark Evans / iStockphoto;
grasshopper © songqiuju / iStockphoto
To Michelle
Preface
The grasshopper watches the ant working diligently all summer long, making a home and gathering food for the winter. Thinking the ant a fool, the grasshopper spends his summer days playing in the sun and consuming whatever food comes his way. When winter arrives, the ant is cosy and well-stocked in the shelter she has constructed while the ill-prepared grasshopper starves in the cold.
Aesop's fable of the Ant and the Grasshopper
A recent study by the Employee Benefit Research Institute (EBRI) reports that 20.6 percent of Americans who died at age 85 or older had no housing assets at the time of death and 12.2 percent had no assets at all. Corresponding percentages for Canada are not available but would probably be comparable.
It seems there are two ways to spin these data. The obvious conclusion is that the 20.6 percent group or the 12.2 percent group were classic Aesopian grasshoppers who failed to prepare adequately for retirement and received their comeuppance at the end of their lives. If this is the spin I thought you should put on it, this would be yet another retirement book exhorting you to save more.
There is another way to interpret the same facts. Given that fewer than 70 percent of Americans or Canadians own their home, it is remarkable that only 20.6 percent had no housing assets when they died. Some would have been too poor to own a home and would have been lifelong renters; there is no shame in that. Others, in King Lear fashion, would have given up their home to their grown-up children years earlier. Finally, some would have sold off their home to finance long-term care in their declining years. And yet nearly 80 percent had housing assets at the time of death. Equally amazing is that nearly 88 percent of all persons dying after age 85 had not exhausted their assets yet; many of them would not have expected to live that long.
What I take away from this is that we are not as ill-prepared for retirement as some people would have you believe. The majority will be more or less retirement-ready. Still, there is no question we can do better and do so with less pain and uncertainty during the accumulation process.
If we revisit Aesop's fable, maybe the real moral is more subtle than it appears. Nobody in his right mind would want to suffer the grasshopper's fate, but how appealing was the ant's life, really? She had no time for fun when the days were long and the sun warm—that is to say, during her youth—and while she may have been comfortable in the winter of her life, she was also old and stiff, with a diminished capacity for joy. The grasshopper, on the other hand, had enjoyed his days in the summer sun and yes, he did eventually die in the cold, but at least he had the solace of fond memories to assuage the harshness of approaching winter.
This is not to suggest that you do not need to prepare financially for retirement but it helps to be aware of the mindset you are bringing to the act of preparation. The very fact you are reading this book suggests you are more likely to be an ant than a grasshopper. In fact, both statistical and anecdotal data indicate that the majority of Canadians are ants (Americans apparently less so). As an ant, you are apt to oversave, to be unduly anxious about your retirement prospects, and to accept too readily any news story declaring the country is headed for a full-blown retirement crisis.
In this book, you will find a variety of evidence that, for the most part, should make you feel better about your retirement prospects. You will learn that your retirement income target is less daunting than you might have been led to believe; that government sources of pension are not going to vanish when you need them; and that if you make any reasonable effort at all to save, you will most likely find that finances are going to be the least of your worries in retirement. The trouble is, you will have a difficult time believing the evidence. There are three reasons why.
First, as the ant that you probably are, you are naturally inclined to give credence to pessimistic forecasts while regarding good news with a great deal of skepticism.
Second, the good news I will present—though I should warn it is not all good news—runs contrary to the vast majority of newspaper articles you will read on the subject. It is hard to change perceptions. This brings to mind an observation by Daniel Kahneman in his book, Thinking Fast and Slow,
A reliable way to make people believe in falsehoods is frequent repetition because familiarity is not easily distinguished from truth.
The astute reader will be quick to point out that even if Kahneman's remark is true, frequent repetition alone does not make a statement false. In the context of whether our retirement anxiety is unfounded, that case still needs to be made.
The third reason why you will find it hard to believe in a positive prognosis for retirement is that supporting evidence for the most part is statistical in nature, whereas refutation tends to be anecdotal. Unfortunately, our brains are wired such that anecdotes carry more weight than statistics, even though the latter are no more than a compilation of the former. “When one man dies it is a tragedy; when thousands die, it's statistics.”1
I have encountered this phenomenon myself many times. A woman once told me she would never wear a seatbelt because she had an uncle who escaped from a car accident virtually unscathed; he wasn't wearing a seatbelt at the time and had the good fortune of being “thrown clear.” (I have always wondered how that works.) My pointing out to her that not wearing a seatbelt is 50 times more likely to end badly failed to change her mind. Indeed, any statistic seems less compelling than a pithy anecdote to most people, male or female. My hope is that the reader is not most people.
In case the reader is wondering, the author himself is a closet ant. Yes, I ended up saving much more for retirement than I will realistically ever spend. In my defense, it happened because of fortuitous circumstances that I could not have foreseen. One event in particular that occurred in the latter part of my working life markedly improved my financial situation at a point when it was too late to “un-save” in an orderly fashion. By the way, our tendency will always be to err on the side of caution, and not just because we are more like ants than grasshoppers. We do so because we need to protect ourselves if the downside risk is high, but we cannot afford to do nothing merely because we can see some upside potential.
If you are a fellow ant, I hope the information in this book will alleviate your anxiety about your financial future without tipping you over into outright profligacy. If, by chance, you are one of those rare grasshoppers who got a hold of this book (maybe as a gift or you picked it up in a dentist's office out of boredom), I hope it will mitigate the guilt you may have felt up until now and help you to mend your ways without fundamentally changing who you are.
This book makes no claim to being a beginner's guide, but at the same time it attempts to avoid professional jargon. While some of the ideas explored are fairly sophisticated, I try to describe them in layman's terms.
One distinguishing characteristic of this book is that it is intended to be equally relevant to both Americans and Canadians. This precludes delving into the details on retirement vehicles or tax strategies, and I am happy to acknowledge that there are many other books out there already that do this admirably well. What this book can do is address the perennial retirement questions such as how much you need to save and how fast can you draw down those savings. These big retirement questions transcend borders.
Finally, the reader may be wondering about how the contrarian perspective promised in the title manifests itself within the book. When it comes to some of those perennial questions, my conclusions can differ markedly from many others in the field. Fortunately, corroboration from certain experts I respect has reinforced my own convictions. The challenge is in explaining how I got there without being too ponderous. I leave it to the reader to judge whether I have been successful.
Frederick Vettese
Note
1
Attributed to Stalin. From the book,
The Time of Stalin, Portrait of Tyranny
by Anton Antonov-Ovseyenko.
Acknowledgments
I want to thank the senior management team at Morneau Shepell—Alan Torrie and Bill Morneau in particular—for giving me the time, the resources, the encouragement, and the intellectual latitude to write this book. The book literally would not have been possible otherwise.
I am also grateful to my many colleagues at Morneau Shepell for their help, especially the actuarial team in Montreal consisting of Jerome Dionne, Philippe Guay, and Maude Trudeau-Morin. Using their stochastic modeling tools, they provided invaluable insights regarding asset mix and investment risk. Francine Pell and Martine Vadnais also helped by frequently pointing me in the right direction when I needed information, and Micheline Bougelet produced some wonderful graphics.
Sun Life Financial, a Canadian leader in insurance products, played a critical role in helping me to understand the state of the art with respect to annuities, longevity, critical illness, and long-term care. A team of specialists at Sun Life—most notably, Paul Fryer, Eric Hafeman, Jeffrey Gomes, and Laurel Pederson—were exceedingly generous with their time and knowledge.
There were many others who contributed ideas, time, and expertise:
My good friend, Haviva Goldhagen, for planting the idea of writing a retirement book that could transcend borders,
Rona Birenbaum, the most trustworthy financial planner I know,
Malcolm Hamilton, the undisputed retirement guru in Canada, who offered useful comments on some key chapters, which assured me I was on the right track,
Fabrice Morin of McKinsey & Co., who has shown leadership on the subject of the retirement readiness of Canadians and who was generous in sharing his findings on post-retirement spending habits,
Franco Barbiero and the research team at RBC Phillips Hager and North, who diligently researched some investment themes,
Bob Francis, founder of Medcan, for opening the doors to Medcan's expertise in the exciting area of personal genome testing, and
Alex Melvin of Cannex Financial, for his insights and data on the annuity market.
Part IThe Retirement Income Target
Chapter 1The Road to Retirement
Take a good look at Figure 1.1. For those of you who have had to watch a loved one succumb to a critical illness, this chart might not surprise you. For others who assume they will sail through their first decade or two of retirement with no problem more serious than how to pay for the next Caribbean cruise, the chart may be a wake-up call.
Figure 1.1 The Fragility of Life
Source: Canadian Critical Illness Tables (2008), reconfigured by Morneau Shepell
In a time when we are constantly being told that we are living so much longer than we used to, it may be hard to believe that the average person has little better than a 50–50 chance of making it from age 50 to age 70 without dying or incurring a critical illness. By critical illness, I mean something really serious, such as a life-threatening cancer, cardiovascular disease, or kidney failure. (The full list is given in Chapter 21.) We might be living longer, but we humans continue to be a fragile species.
So why dwell on the morbid? These statistics are an important part of one's retirement planning. If we can change our focus from how many years we will live to how many years of healthy living we have left, it will better inform our actions while we still have the time and ability to act.
If you are age 50, for example, you might be thinking you have 35 to 40 years to go and possibly more. On the other hand, if you can expect to enjoy only 20 more disability-free years (or less), it might very well affect when you retire, what you do in your 60s and how quickly you draw down your retirement savings. Healthy life expectancy is just one of the issues we will consider in this book. But I am getting ahead of myself.
I will let you in on a little secret. Retirement planning can be as straightforward as following these six steps:
Save 10 percent of your pay each year.
Invest it in low-cost pooled funds, weighted toward equities.
Keep the asset mix the same, through good times and bad.
Apart from the mortgage on your home, avoid going into debt.
Pay off your mortgage by the time you retire.
Buy a life annuity at retirement.
This road map sounds rather simple, and it is. If you are able to follow it to the letter for your entire working lifetime—and experience no long-term unemployment or critical illnesses along the way—you will not go far wrong. In fact, you will fare better than most of your contemporaries. So why do you need this book, or any book on retirement planning, for that matter?
If arriving at your retirement goal was analogous to traveling to a destination, then the above six steps might get you to the right country but possibly not the right state or province. Moreover, the route may not be the cheapest, the shortest, or the most pleasant way to get there. At the risk of beating this metaphor into the ground, you might not be able to recognize the potential hazards along the way without a little more knowledge to guide you.
In this book, I try to define your retirement goal as well as the possible ways to reach it. I will use the following process to do so:
Define your retirement income needs as a percentage of your final employment earnings. We will call this your retirement income target.
Using your retirement income target, determine how much money you will need to have saved up as of the day you retire. We will call this your wealth target. Knowing this figure makes it much easier for you to monitor your progress toward becoming retirement-ready.
Having established your personal wealth target, consider the possible savings strategies that will get you there.
Assuming you arrive at your wealth target by the time you are ready to retire, you now need a strategy for drawing it down in a sensible and sustainable fashion throughout your retirement years.
My intent is not so much to be prescriptive as it is to provide useful and hopefully interesting, information. Along the way we will learn these realities:
Saving 10 percent a year is not a bad rule of thumb if you could follow it, but the odds are, it will be too difficult to maintain in the early stages of your career and it might not even be advisable that you try.
Retirement planning is as much about how you manage your cash flows during your working career as it is about accumulating wealth for your retirement.
Most people never spend more than 50 percent of their gross income on themselves before retirement, which is why the retirement income target is usually much less than 70 percent.
Interest rates will probably stay very low for the next 20 years or longer, which will affect how much you need to save.
A constant asset mix for your retirement savings such as 60 percent equities and 40 percent bonds is not bad, but you can improve the odds of reaching your wealth target with a more advanced strategy.
Your lifestyle can materially affect how long you will live and how many healthy years you can expect.
You can withdraw 5 percent or more of your retirement savings each year in retirement, even if your total investment return is a little less than 5 percent.
As people reach the later stages of retirement, they become progressively less capable of managing their finances, even though they grow more confident of their ability to do so.
Annuities have become very expensive, but they still make sense for a host of reasons.
Detours
Although it is important to optimize your retirement planning strategy on the basis that everything goes smoothly, you will also need to be able to deal with adversity. When the preparation process takes as long as 30 or 40 years, you are bound to encounter some problems along the way. Below are a few of the events that can complicate your life:
Losing your job and not finding another for a prolonged period
Incurring a significant investment loss
Suffering a business setback that forces you to draw down your life savings
Being exposed to high inflation after you retire
Having to help a family member in financial need
Experiencing a serious illness or an accident involving yourself or someone within the immediate family
Getting divorced, requiring you to split your assets
I wish I could tell you how to avoid trouble, but the truth is that we are not in as much control of our lives as we think. Yes, we can insulate ourselves from some of these calamities, but ultimately, success in retirement planning is best measured not by how adept or lucky we are at avoiding trouble, but rather, how we respond to trouble when it arises. Your best protection against misfortune is knowledge.
Of course, unforeseen events are not always bad news. Sometimes, good things happen that bring you that much closer to your retirement goal. It could be a big promotion, an inheritance, or an unexpected capital gain from an investment. It could even be something less dramatic like joining the pension plan in your workplace, which you might not think of as good news when you are 25, but you will eventually come to appreciate it.
Just as negative events in life call for a change in retirement strategy, so do the positive events. Either way, the key is to modify your planning appropriately whenever something happens. The better you understand the science behind retirement planning, the greater your chances of success.
Chapter 2Doubts about the 70 Percent Retirement Income Target
You will no doubt have heard that one's retirement income target should be 70 percent of final pay, if not more. This widely accepted target was already common knowledge more than 30 years ago when I was starting out in the pension consulting industry.
As a pension actuary, I have spent much of my career helping organizations establish defined benefit pension plans for their employees. The design process usually started with the 70 percent income target from which one subtracted the portion that was deemed to be the employee's individual responsibility. The balance would then be spread over 35 or 40 years to determine a formula for the amount of pension earned each year. In the case of public-sector plans, for example, the employee was not expected to shoulder any individual responsibility, so it was a matter of dividing 70 percent by 35 years to get an annual pension accrual of 2 percent of final earnings for each year or service.1
When a rule of thumb is so integral to the process of determining the pension for millions of participants, you would think it would be unassailable. Over my career, the 70 percent pension target was rarely challenged, and certainly not by a young actuary like me when I was first starting out in the business. Indeed, no one to my knowledge seriously questioned the 70 percent rule until the 1990s when a few voices in the wilderness, led by pension actuary Malcolm Hamilton, made themselves heard.
Those voices were drowned out, though, as constant reinforcement by banks, insurance companies, financial planners, and investment advisors about the need to save enough to reach the 70 percent target kept the rule alive. It continues to underpin virtually every public-sector pension plan in Canada and the United States, and surely what was built to serve millions of civil servants could not be wrong. Or could it?
Niggling Doubts
For me, the doubts started to creep in a little over a decade ago. In the case of workers who earned above average income, a 70 percent target made less sense the more I thought about it. Not that there was any one smoking gun. My misgivings stemmed from a number of sources.
For starters, consider how a typical hard-working middle-income married couple divides up their paycheck. We will assume that they:
are both working,
raise two children,
buy a house and spread the mortgage payments over their working careers,
avoid going into debt, other than the mortgage,
save 7 percent to 10 percent of pay for retirement every year, in addition to making Social Security contributions, and
retire at 65.
If we broke down their gross income year by year into the major categories, it would look something like Figure 2.1.
Figure 2.1 Breakdown of Expenditures in a Steady Saving Scenario
After paying for all the big-ticket items including taxes, the percentage of their gross pay that remains for personal consumption dips as low as 25 percent during their 30s and never gets higher than 45 percent, something that occurs only in their last 10 years of working. If they wanted to continue spending at the same rate in retirement, they would need retirement income of 50 percent of gross pay to produce after-tax income of 45 percent. That is 20 percentage points less than the conventional target, so something appears to be amiss! Perhaps this example does not fully capture reality, so let us consider other evidence that puts 70 percent into question.
Fewer private-sector workers remain covered by a group retirement arrangement in their workplace, especially in Canada. That arrangement could be either a defined benefit (DB) pension plan or a defined contribution (DC) plan. In the United States, about half of all private-sector workers have no pension coverage at all. In Canada, the figure is closer to 70 percent. That's right. Between 5 and 7 private-sector workers out of 10 have no formal pension coverage other than Social Security, and that is meant to cover only the most basic spending needs. For anyone earning much more than the average wage, the gap between the 70 percent target and the pension from Social Security would be so huge that it makes a disastrous retirement seem inevitable. Why, then, were we not reading more stories in the papers about former middle-income workers being reduced to penury in their retirement years? Yes, the newspapers do report often on a retirement crisis, but almost always from a high-level, abstract point of view, not how Joe the retired engineer is living in a shabby bachelor apartment and eating mac and cheese.
Defined benefit versus defined contribution plan
A defined benefit (DB) pension plan provides a pension benefit that is defined by a formula based on length of service and possibly earnings. The pension does not depend on how the investments in the pension fund perform. The benefit is a predictable amount, at least in terms of earnings. An example is a plan that provides a pension of 1 percent of average earnings in the last 5 years of employment for each year of service.
In a defined contribution (DC) pension plan, the pension benefit is whatever income can be generated after retirement with the account balance that accumulates over the employee's career. Hence, the benefit is uncertain and the employee takes the risk. The employer and often the employees as well contribute a well-defined amount such as 4 percent of pay. A separate account balance is maintained for each employee, who can usually select the funds to invest in. Examples of DC plans are 401(k) plans in the United States and DC pension plans or group RRSPs in Canada.
Social Security
The term Social Security in this book includes basic government pensions whether in the United States or in Canada. A fuller definition is given in Appendix B.
In addition, more workers who are lucky enough to have any workplace pension coverage at all are now covered by DC plans. Actuaries were dismayed when DC plans first took hold about 25 years ago because those plans did not seem to meet the pension adequacy test. The employer contribution to DC plans is typically only half what it is for defined benefit pension plans. This was not nearly enough, the actuaries said, and that was at a time when future investment returns were expected to be in the 8 percent to 10 percent range, not the paltry 4 percent to 6 percent as is the case today. The typical DC plan, combined with Social Security, comes nowhere close to reaching the 70 percent target.
The consensus was that once these DC plans had been around long enough for a significant number of workers to retire from them, their shortcomings would become self-evident. Actuaries referred to them as ticking time bombs. Yet, here we are, after more than 25 years of living in a DC world, after the perfect storm of 2001–2002 that decimated account balances in DC plans, and after the worst financial meltdown since the Great Depression, and DC plans continue to thrive.
There were other indications that the 70 percent target was unrealistically high. For instance, I have tried more than once to poll retirees in large pension plans to learn more about their spending patterns and financial situation 10 or 20 years after retirement. The intent was to determine what portion of their pension they give as gifts to other family members, how much they continue to save, and what they spend on consumer-durables such as furniture, big appliances, or cars.
The sponsors of the plans that I targeted were sympathetic to the purpose of my investigation, but there was a problem. They needed the consent of the pension plan's retiree association to proceed but the leaders of the association would invariably stonewall the request. Apparently, they were afraid that the data gathered would be used by the employer to justify granting smaller pension increases in the future.
It would seem the retirees knew they had a good thing going and did not want to jeopardize it by disclosing their financial situation. Had their pensions been deficient, which they should have been since most of them retired on considerably less than 70 percent, one would have thought the retirees would welcome a survey to make their plight better known, but this was never the case.
A survey commissioned by the Canadian Institute of Actuaries asked people both before and after retirement how confident they felt about their financial future. You would think the retirees would feel less confident than the pre-retirees because, having retired with retirement income less than 70 percent, they would now be in full panic mode. The survey result, however, showed just the opposite. Only 44 percent of the pre-retirees were confident about their financial future versus 62 percent of those already retired. Among retirees who had paid off their mortgages, 74 percent were confident. In case you are wondering if the people surveyed were unusually affluent, at least 57 percent said they had total investments of under $250,000.2 Could it be that the retirees learned from actual experience what pre-retirees could not yet know—that they would make out just fine with less than 70 percent?
Another survey, this one conducted by Statistics Canada, asked recent retirees how their financial situation had changed in retirement versus the year before retirement.3 Of those retirees, 54 percent said it was “about the same,” 13 percent said “it had improved” and just 33 percent said “it had worsened.” Why wasn't that last group larger?
Even the public-sector pension plans themselves made me question the 70 percent target. To reach 70 percent requires 35 years of participation in a public-sector plan, but relatively few civil servants work that long. Their average retirement age is only 60 and has dipped as low as 58 in recent years. Many of them leave the workforce by age 55. Since they may have had other jobs before settling into public service, this translates into an average of just 25 to 30 years of service by retirement, which suggests their pension is more typically 50 percent to 60 percent of final average pay rather than 70 percent. If public-sector workers are retiring with inadequate pensions, it is curious that no one is making that claim, even the plan participants themselves. They are not demanding higher pensions; they just want to keep what they have.
Saving for Retirement Is a Two-Dimensional Problem
The turning point for me was a paper written by former Bank of Canada governor David Dodge and others4 declaring that people needed to save 10 percent to 21 percent of their income each year over their working careers to be able to retire with a 70 percent pension. I recall having an epiphany while sitting in a conference room and listening to Mr. Dodge explaining this. It was at that moment I realized that saving for retirement was generally tackled as a one-dimensional problem whereas in fact it was two-dimensional.
The one dimension that everyone in the financial industry fixates on is the post-retirement period and the need to amass the necessary retirement income at any cost. The forgotten second dimension is the pre-retirement period where disposable income has to be sacrificed if we are to feed the post-retirement income monster.
When one considers both dimensions simultaneously, saving in order to build up retirement assets is essentially a balancing act; the more one saves to achieve a 70 percent pension, the lower one's disposable income before retirement. Push that far enough and workers do not have enough to live comfortably before they retire. In some exceptional circumstances, disposable income before retirement would dip below 30 percent of gross income in order to save enough to produce disposable income after retirement of 70 percent. As we saw in Figure 2.1, the circumstances may not even have to be that exceptional for this to happen.
The Macro Case Against 70 Percent
If any more reasons were needed to reject the 70 percent target, consider this. Half a century ago, when our grandparents retired later and lived shorter lives than we do now, they used to work 4 to 5 years for every year that they spent in retirement. Today, most people work just 1.5 years or so for every year of retirement. In the public sector, the ratio is closer to 1:1. To keep the math simple in the following argument, we will assume one year worked for each year of retirement.5
Assume that all the money you need for retirement is coming out of your own pocket. In a way, this is what actually happens; it is just that some of that money takes a circuitous route before it is converted into retirement income. Some of it, for instance, will come from Social Security and some more might come out of a company pension plan, but ultimately it is really being funded by you in your role as (a) a taxpayer, (b) a consumer of goods, or (c) an employee who is receiving lower income than he would otherwise.
