Inflation’s going to eat away at the buying power of your retirement savings. How do you make those savings last?
By Olev Edur
Great, so you’re retiring soon—the start of an entirely different lifestyle! Among many other changes, this will mean that instead of a single paycheque, your income will likely derive from a variety of sources: government programs (Old Age Security (OAS), Canada Pension Plan (CPP)), perhaps an employer pension, and hopefully some savings tucked away in registered (RRSPs, TFSAs) and unregistered accounts.
Once you start collecting a pension, you’re generally locked into fixed payments for life and there are no more decisions to be made (although you can alter the size of CPP and OAS payments by deferring or advancing your start-up date). When it comes to your savings, though, how do you decide how much to take out every year? After all, you may be around for a long time to come and need to make your money last.
Indeed, Canadians’ life expectancy has risen dramatically over the past 50-odd years as a result of better lifestyles and diets, as well as improved access to advanced medical care. Statistics Canada data for the 2014–16 period indicates that in most parts of Canada, 65-year-olds can expect to live at least another 20 years on average; in large urban areas, the average for women is closer to 25 years.
As noted, those are averages, meaning that some of us will live longer, sometimes much longer. And unless you are fortunate enough to have very ample resources, this increased longevity poses the risk that you could eventually outlive your savings; according to a Sun Life Financial poll published in November 2019, 47 per cent of Canadians think there’s a “serious risk” it could happen to them.
The big villain is inflation: even at a seemingly benign two per cent a year, you’ll be paying 50 per cent more for everything in 20 years’ time.
“Inflation historically has been accepted at around two per cent, so expenses keep climbing,” says Aurèle Courcelles, an assistant vice-president at IG Wealth Management in Winnipeg. “You have to face the fact that inflation will put a huge damper on your purchasing power over the long run.”
The prospect of having to finance another 20, 30, or even more years of retirement can therefore be daunting at the best of times. Yet with interest rates seemingly stuck at historical lows (even declining lately in the United States and several other countries), finding solutions can be a challenge, especially as everything else keeps going up in price.
Are You Saving Too Much?
Still, while inflation undeniably is a potent force, there also may be a tendency towards saving too much. In his 2018 book, Retirement Income for Life: Getting More Without Saving More (see “Spending What You’ve Saved”), former Morneau Shepell Chief Actuary Fred Vettese argues that many retirees are scrimping now to meet future needs that will probably never materialize. “Some retirees outlive their money,” Vettese writes in his book’s preface. “An even greater number deliberately underspend for fear of outliving their money.”
While acknowledging the importance of allowing for inflation throughout retirement, Vettese points out that we tend to budget for retirement as if we were planning to go golfing or travelling regularly for the next 30 years, whereas the reality, as he cites from the results of various US studies, is that retirement spending steadily declines in one’s 70s and 80s. The phenomenon is sometimes referred to as the go-go, slow-go, and no-go phases of retirement, and this declining activity serves to offset the impact of inflation.
“Salary is not the driver of your retirement income needs,” says Bradley Eizenga, a portfolio manager and investment advisor with BMO Private Wealth in Windsor, ON. “So many things change. I know a retired lawyer who said he was saving $400 a month in dry cleaning. My wife retired six years ago and she now spends one-third less on clothing.
“There are other savings, too,” Eizenga adds. “If you were making $150,000, 25 to 30 per cent of that would have gone to taxes, and you’re no longer saving for retirement. The driver of retirement income isn’t your preretirement salary, it’s what life actually costs. In retirement, it can be less than you think.”
Looking further ahead, Vettese points out that once familial and charitable obligations have been met, any money left in your personal-use account reflects unnecessary restraint. The ideal should be a zero balance, a sentiment echoed by Eizenga.
“Good retirement planning is when the cheque to the undertaker bounces,” Eizenga says. “If you don’t live life and enjoy yourself simply because you want to preserve your assets and end up with a huge pile of money when you pass on, that’s bad planning, in my opinion.”
However, Eizenga adds, it can be very hard to let go of the savings-oriented mindset that’s been a part of your entire career: “It’s hard to shift from being a saver to being a spender; there’s a lot more emotion involved than you may realize and it makes us do weird things. People stumble and make bad decisions.”
In addition, while a slowdown in activity can ease the impact of inflation, Courcelles points out that other costs can rise over time, and not just due to inflation. “Yes, in your go-go phase of retirement, you’re playing golf, travelling, doing all the fun stuff, but as you slow down, you can run into higher medical costs. You need to pay for that, and afterwards you may have a spouse who still has living expenses. Each stage comes with its own challenges.”
Building a Retirement Plan
So how do you deal with all these considerations? Some people just avoid the issue entirely and simply spend a fixed amount of their savings every year. But that approach can be risky because if the investment markets don’t behave as expected or an unforeseen expense crops up, you may deplete your money prematurely.
The more realistic solution is to have a well-constructed, comprehensive retirement plan that takes into account the numerous variables involved: several different income streams with differing tax implications, some fixed and some not, and all must be combined to meet your changing retirement needs, discretionary and non-discretionary, in an unpredictable future. Then there are beneficiary arrangements and possibly other financial or health factors to consider, as well.
That’s a lot of number crunching, so where do you begin? Fortunately, there are some universally accepted ground rules.
First, begin by ensuring that your basic needs are always covered. The general recommendation is that you cover these essentials with guaranteed income sources, notably government and private pensions, augmented as necessary with fixed-income investments. (Government plans have the added feature that they are all indexed, helping to offset inflation.)
“You need to establish a baseline for food, lodging, and heat, and sometimes cellphones are a necessity,” Courcelles says. “What do you need on an annual basis and how will that be affected by inflation? Some items will go up faster, some more slowly. If your baseline is $50,000, do you have that covered with government benefits and pensions or other sources of fixed income?”
As for discretionary expenses, most advisors recommend that you invest the money for covering these costs more aggressively, typically by investing more in equities. “Once your basic needs are covered by fixed income, your other money can be invested increasingly in other assets that provide more yield than GICs—assets where the rate of return is more than inflation,” Courcelles says, adding that if the stock market goes down, you can always defer a golf game or trip until the market recovers.
The trick is to put all these elements together in a cohesive plan that allows you to adapt to the inevitable unforeseen eventualities. The key is flexibility.
“Variable spending strategies can be situated on a continuum between two extremes: spending a constant amount from the portfolio each year without regard for the remaining portfolio balance, and spending a fixed percentage of the remaining portfolio balance,” writes Wade D. Pfau, a professor of retirement income at The American College of Financial Services in Bryn Mawr, Pennsylvania. (A number of Pfau’s papers on retirement planning are available at the online library at SSRN—formerly Social Science Research Network.) “Variable spending strategies seek compromise between these extremes by avoiding too many spending cuts while also protecting against the risk that spending must subsequently fall to uncomfortably low levels.”
It follows, given the complexity of the task, that a computer-based program can be invaluable.
“Financial planners have specialized software and we can look at all the variables and run what-if scenarios,” Courcelles says. “We can ask, ‘What’s a sustainable withdrawal rate to make sure you don’t run out of money?’ We can change the figures to reflect the reality at different stages of life and increase or decrease them. If you want to travel or you want to keep paying for the cottage and sell it later, we can include all those variables.”
Of course, you can try to do the calculations yourself, and there’s no shortage of self-help retirement planning aids on the Internet these days. “Some of the software is highly technical, some not,” Eizenga says.
One portfolio drawdown strategy making the rounds on the Internet these days, originally having appeared on the Canadian financial wiki site finiki.org and now appearing on a number of other financial websites, is a program called Variable Percentage Withdrawal (VPW).
VPW is more than just theory: it’s a downloadable and interactive package geared to both the accumulation and decumulation phases of retirement portfolio management, and consists of:
(a) a table of withdrawal percentages based on age, similar to the minimum yearly withdrawal table for RRIFs, but with different rates based on the portfolio’s ratio of fixed income to equity holdings, and
(b) a multipage spreadsheet on which you enter information about your retirement income—pensions, investments and types of holdings—to be updated annually (or more often).
You enter your financial information in the spreadsheet and the system will generate a balance figure; then you apply the appropriate percentage from the table to determine your recommended withdrawal amount for that period. The system is structured so that investment performance is reflected in the amount of your withdrawal: bad years mean less income, good years mean more.
Online proponents claim the VPW system improves overall income levels while reducing risk, but while that may be the case, the program also has a number of shortcomings.
“You can’t, for example, use it if your needs are changing over time,” Courcelles says, noting that there’s also no allowance for bequests and other such considerations. And it doesn’t take into account tax implications, including separate calculations for RRSPs and TFSAs. “This works only for non-registered investments—a very specific part of your overall portfolio,” Courcelles adds.
“You can’t predict everything when you set up your investments, so you need to have flexibility,” Eizenga says. “For example, I’ll set up a borrowing facility so if an expense comes up at the wrong time, you can use it to pay the bill and then pay it back to the borrowing facility when the market has recovered.” That kind of strategy also isn’t included in VPW.
Thus, VPW is limited in what it can accomplish, and the danger is that someone may see it as a complete planning solution, missing out on various better opportunities. “This is no replacement for working with a trained advisor with the proper software tools,” Courcelles says.
Not surprisingly, both Courcelles and Eizenga stress the importance of getting professional help, but it’s not just about the math: Eizenga suggests that, given that people tend to have emotional biases leading them to make crucial planning errors, emotional insight is even more important than the numbers.
“I think a financial planner’s most important job is to manage emotions,” Eizenga says. “People are distracted by rates and products rather than focusing on structure. For example, someone sees a GIC paying 25/8 per cent rather than 2½ per cent, but they don’t think of what they’re giving up to get that extra one-eighth of a per cent. If you can’t see the whole picture, that leads to mistakes. Experienced investment advisors will be aware of people’s predisposition for doing things wrong, for shooting out their own tires.”
The bottom line on retirement planning is that probably more than at any other time in life, professional help using proper tools can make a big difference to your prospects. As Fred Vettese notes in his book: “Decumulation is not as straightforward as you might think; by comparison, the accumulation phase is child’s play.”