The article “How To Save For Retirement At A Time When Most Aren’t Saving Much At All” was originally posted on Financial Post on August 29, 2019.
Of course, regular saving is a good way to plan for retirement, but how much to set aside and how to set your targets are up for debate.
There are different ways to establish how much you should be saving for retirement. Most people would agree that regular saving is a good way to plan for retirement, but how much to set aside and how to set your targets are up for debate.
Rules of thumb
Registered Retirement Savings Plans (RRSPs) were introduced in 1957, and the maximum contribution limit as a percentage of earned income was 10 per cent, up to a $2,500 maximum. The percentage limit was doubled to 20 per cent in 1972. In 1991, it was decreased to the current 18 per cent of annual earned income for the previous year, to a maximum of $26,500 for 2019. Unused RRSP room from previous years accumulates each year as well.
Based on the RRSP contribution limit, one could assume that saving between 10 and 20 per cent of gross, pre-tax income may be a reasonable target.
David Chilton’s classic, The Wealthy Barber, proposed a 10-per-cent solution, whereby the barber’s wealth was accumulated by saving 10 per cent of his income — amongst other smart money choices.
According to a World Economic Forum’s white paper, We’ll Live to 100 — How Can We Afford It, “to support a reasonable level of income in retirement, 10-15 per cent of an average annual salary needs to be saved.”
The so-called four-per-cent rule, coined in 1994 by financial planner William Bengen, provides another indirect way of setting a savings target. Using back testing, Bengen determined that four per cent was a sustainable withdrawal from a balanced investment portfolio for a 30-year retirement even if stock markets subsequently had a bad 30-year run. This assumes that the initial dollar withdrawal (four per cent of the portfolio value at retirement) gets indexed to inflation and increases annually.
But a 2017 paper, Safe Withdrawal Rates for Retirees in Canada Today, written for Morningstar, suggested that three to 3.5 per cent may be more appropriate than four per cent after accounting for investment fees and expected lower future rates of return.
If you assume a 3.5-per-cent withdrawal rate, you can work backwards from retirement. For example, a 65-year-old who needs $35,000 per year of withdrawals indexed to inflation would need to save $1 million. And a 45-year-old starting from scratch to save towards that same $1-million target in 20 years would need to save about $25,000 per year indexed to inflation (assuming a return of four per cent and two-per-cent inflation).
Is your head spinning yet? Even if it is not, these numbers mean nothing without context.
Build a retirement plan
Even if you could safely withdraw $35,000 per year from your investments, there is a big difference between withdrawing from a Tax Free Savings Account (TFSA) and a tax-deferred RRSP. The former is not taxable while the latter is taxable. Accumulating $1 million in TFSAs will fund much higher retirement spending than $1 million in accumulated RRSPs, which could materially impact your required monthly savings up or down. Also, $1 million in an RRSP would result in more tax payable to a single retiree than a retired couple who can reduce tax by pension income splitting.
What about pensions? Canadians may be entitled to both Canada Pension Plan (CPP) and Old Age Security (OAS) payments, but many close to retirement are not even aware of the terms of these pensions. Although fewer workers are covered by workplace defined-benefit (DB) pensions, understanding the potential future entitlement may reduce required savings as well.
The average CPP retirement pension is currently $8,150 per year and the maximum OAS pension for a longtime or lifelong Canadian resident is $7,290. According to Statistics Canada, the average household headed by a person aged 65 years or older had expenditures including income tax of about $58,121 per year in 2016 ($61,362 if we adjust for inflation to 2019 dollars). But, of course, everyone is different.
Going back to our notional $1-million saving target at age 65 and $35,000 of sustainable withdrawals, it should be noted that $35,000 of expenses today for a 45-year-old could be about $52,000 at age 65 due to inflation. Also, $35,000 in 20 years is the same as about $23,500 in today’s dollars.
The point is that tax, inflation and pensions, let alone extraordinary income (inheritances, home downsizing) and expenses (debt, kids), all make any rule of thumb a tough way to set a retirement savings target. Building a retirement plan on your own or with a professional can help set some relevant personal targets. Mind you, since life is not linear, even a retirement plan needs reviews and revisions as life changes. It depreciates like a new car driven off a car dealer’s lot.
Save what you can
Spending first and saving whatever is left over is not a proactive approach. Saving first and spending the rest is obviously preferable.
But high real estate prices and a fear of missing out (FOMO) lifestyle may be squeezing savings rates. The current Canadian household savings rate has fallen to just 1.1 per cent, which is approaching an all-time low. A falling savings rate is somewhat expected with an aging population, but the rate has been less than five per cent for most of the past 20 years and has not been as high as 10 per cent since 1993.
Saving for retirement is not an algebraic equation. There is not just one answer, and the answer constantly changes. This is a frustrating financial fact at a time when we are used to getting answers on demand and making decisions based on short, sweet social media posts.
Rules of thumb are better than nothing, as is saving whatever you can. Setting automatic monthly savings targets based on your personal circumstances and at least a bit of long-term planning could be something that old you thanks young you for in the future.
Jason Heath is a fee-only Certified Financial Planner (CFP) and income tax professional for Objective Financial Partners Inc. in Toronto, Ontario.