The article “These are the mistakes do-it-yourself retirement planners make most often“ was originally published on Financial Post on June 3, 2021. PHOTO BY CHLOE CUSHMAN/NATIONAL POST ILLUSTRATION FILES
Jason Heath: By planning prudently, you can retire earlier, spend more in retirement, or leave a larger inheritance
When you make a mistake planning your retirement, there is a good chance you will not discover the problem until it is too late. Saving and planning, after all, are lifelong efforts and you may not get a second chance with some decisions. Whether you are considering planning your own retirement or working with an advisor, there are a number of common pitfalls to consider.
One easy mistake relates to how much you need to save to retire. If someone needs $50,000 per year and has saved $1 million for retirement, they may think their savings will only last 20 years. $1 million divided by $50,000 is, after all, 20. However, $1 million invested at a four per cent return will generate $40,000 in the first year, meaning a $50,000 withdrawal will reduce the account balance by just $10,000. Depending how the money is invested, the investment fees payable, and other factors, $1 million may support $50,000 of annual withdrawals for 30 years or more.
There is no easy answer to how much you need to save either. A couple with $500,000 in non-registered accounts and Tax Free Savings Accounts (TFSAs) is much better off than a couple with $500,000 in Registered Retirement Savings Plans (RRSPs). The first couple will pay less tax when decumulating their savings, so they can spend more or retire earlier. A single retiree with $100,000 in savings and 30 years in a defined benefit pension plan may be better off than someone who has saved $1 million. Other factors like age at retirement, downsizing plans and expected inheritances also have an impact.
Pre-retirees tend to overestimate the tax they will pay in retirement. Someone earning $100,000 of salary will generally pay 25 to 30 per cent average tax depending on their province or territory of residence, and 35 to 45 per cent marginal tax on their next dollar of earnings. In retirement, someone with $50,000 of income would pay at most 15 to 20 per cent average tax across the country, and depending on the sources of income, it could be close to zero. Income like eligible pension income, capital gains, and Canadian dividends are eligible for tax credits or reduced income inclusion rates. Married couples can also split income more easily in retirement to minimize their combined family tax.
It is common for people to inaccurately estimate their expenses in retirement. Someone approaching retirement who is still paying off a mortgage, supporting their kids, or saving for retirement may see their overall expenses and income needs decrease as those costs disappear. As a result, $50,000 of income in retirement may cover the permanent living expense portion of spending previously covered by a $100,000 salary, as expenses with a limited time horizon end.
Retirees often make the mistake of starting their government pensions too early. Most people start their Canada Pension Plan (CPP) retirement pension at age 65 or earlier and their Old Age Security (OAS) at 65. A common reason people apply is to avoid having to take withdrawals from their investments. This suggests they are concerned about running out of money in retirement.
Deferring CPP or OAS after age 65 results in an increase in both pensions for every month of deferral. Retirees who live well into their 80s or 90s will receive more lifetime pension income for delaying their pensions to age 70 than starting early. Those who are worried about running out of money are not as likely to deplete their investments if they die at a young age. It is the retiree who lives to 90 or 100 who most needs to worry about running out of money, and ironically, these are the people who would benefit the most from starting CPP and OAS at age 70 instead of 65.
Investors often make asset allocation mistakes in retirement. One such mistake is maintaining a similar asset allocation across all accounts. Depending on the planned timing of withdrawals from various accounts, one account may be better to invest more conservatively than another. There may also be tax benefits to differing allocations.
Investors often decrease their stock market exposure as they age. A common and simple rule of thumb many advisors and investors use is to have a stock allocation equal to 100 less your age, so that a 65-year-old would have only 35 per cent in stocks. In a 2018 paper, Toward Determining the Optimal Investment Strategy for Retirement, Javier Estrada and Mark Kritzman sought to determine the ideal stock market allocation for retirees.
They analyzed 86 rolling (overlapping) 30-year periods to mimic a typical retirement. They chose 11 different static asset allocation strategies ranging from 0 per cent in stocks to 100 per cent in stocks in 10 per cent increments (10 per cent stocks, 20 per cent stocks, and so on). For a Canadian investor, the optimal stock allocation was 100 per cent. 13 of the 22 stock markets considered, including the world market, had an optimal allocation of 100 per cent in stocks with an average of 91 per cent.
This is not to say an investor should be 100 per cent in stocks in retirement. An investor should invest based on their risk tolerance. But holding a low allocation to stocks is unlikely to maximize a retiree’s spending or estate value.
In fact, Wade Pfau and Michael Kitces make the case for increasing stock exposure in retirement in their 2013 study, Reducing Retirement Risk with a Rising Equity Glide-Path. According to the research, “for those looking to maximize their level of sustainable retirement income, and/or to reduce the potential magnitude of any shortfalls in adverse scenarios, portfolios that start off in the vicinity of 20 per cent to 40 per cent in equities and rise to the level of 60 per cent to 80 per cent in equities generally perform better than static rebalanced portfolios or declining equity glidepaths.”
Their reasoning is that if stocks fall early in retirement, having a low allocation to stocks at the outset will lessen the impact on a portfolio’s long-term viability. Increasing stock exposure thereafter would then result in buying stocks while they are on sale. On the other hand, if stocks perform well early on, a retiree may be so far ahead that future asset allocation may not matter.
Finally, life expectancy is easy to misjudge for a retiree. The current life expectancy is age 80 for a Canadian man and age 84 for a woman. However, those are the average ages of men and women at death. A 65-year-old man has a 50 per cent probability of living to age 89, and for women, it is age 91. For a 65-year-old husband and wife, there is a 50 per cent chance that one of them will live to age 94, so at 65, they should plan for a 30-year retirement.
These are just a few common retirement surprises to anticipate before retiring. People planning their own retirement or working with an advisor could benefit from considering the applicability to their own situation. By planning prudently, you can retire earlier, spend more in retirement, or leave a larger inheritance for your beneficiaries.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.