Retirement planning: start with the right approach
September 24, 2014 by InvestingForMe
When selecting the right approach to retirement planning, it’s important that you know what retirement planning actually is and how it differs from financial planning. There is a difference!
Financial planning: definition
Financial planning involves the process of identifying your long-term goals such as the following (including the idea of a secure retirement!):
- saving for a home
- saving for a child’s future education
- paying off your mortgage
- saving for a vacation property
- starting your own business and
- saving for your retirement
The Financial Planning Standards Council officially defines financial planning as
a process that sets you on a course toward achievement of your life goals through the proper management of your financial affairs. It is a disciplined, multi-step process of assessing your current financial and personal circumstances against what you desire for the future and developing strategies that help meet your personal goals, needs and priorities in a way that aims to optimize your financial position.
In other words, financial planning provides a kind of big picture plan that typically looks at a long-term time horizon – giving you 10, 20 or 30 years for you to realize your goals.
Retirement planning: definition
Retirement planning, on the other hand, is different from financial planning in that it only deals with your retirement, and covers a much shorter time frame. You usually only begin to tackle it as you get closer to your actual retirement date (typically 3 - 10 years prior to your retirement), after you’ve already purchased a home, paid for your children’s education and, hopefully, paid off your mortgage. It focuses on where you want to spend your family’s financial resources for retirement.
In more specific terms, your retirement plan assesses your readiness-to-retire given your current financial situation and a desired retirement age and lifestyle, and it identifies specific actions (income, spending, saving, investing, etc.) you can take to improve your readiness-to-retire. The result is a detailed plan that lets you hopefully avoid having to work into your retirement.
Start by focusing on your day-to-day expenses
There are a lot of different approaches to retirement planning. Some retirement planning approaches like to focus on how much money you earn before retirement– you know, where they tell you that you’ll need 70% or 80% of your pre-retirement income. While basing your retirement plan on a quick and simple income calculation may seem attractive, it’s way too simplistic and can often lead you to make faulty and costly! saving and investing decisions. For example, if you make $70,000 a year, using this kind of 80%-income-formula says you’ll need $56,000 a year in retirement. In reality, a more common annual expense in retirement would be $30,000 per year. Now that’s a huge difference! While there may be some people that can afford the costly 80% retirement formula, most of us cannot. Thankfully, for most of us the percentage of income needed for retirement is much, much lower than 80%.
Instead, most of us would be better off using an approach that focuses on our day-to-day expenses. Why? For two simple reasons:
- It’s what you have the most control over!
- It can typically help you predict just how much income you’ll really need. (And that’s likely closer to $30,000 for most of us, or more if you have more expensive interests or obligations.)
Your expenses: the foundation for your saving and investment decisions
So, as we’ve stated, once you have an accurate and detailed snapshot of your current lifestyle expenses, you can easily determine your expenses in retirement. And by calculating your retirement expenses you can build the foundation for your retirement plan. By then calculating how much
- retirement income you’ll need (i.e., from pension, Old Age Security (OAS), Rental Income, investment income, etc.)
- savings you will need for your retirement (i.e., do you need $100,000 saved and invested or do you need $1,000,000?), and
- risk you need to take when investing your savings. (i.e., can you retire by investing conservatively in Guaranteed Investment Certificates, or do you need to invest more aggressively like 100% in the stock market?)
Note: Yes, these last two items are the more difficult parts of retirement planning! We’ll get to that!
Calculating you retirement income needs
To help you see how an expense-based retirement plan actually works, let’s imagine a retirement scenario where you hope to retire comfortably at age 65 with $30,000 in expenses – a common estimate for retirement expenses.
Next we need to take a look at your retirement income. Let’s say that in retirement you will receive the following average pension payments:
|Total Pension Income||$1,400.56||$16,806.72|
|Pension Income||Average Monthly||Each Year|
|Canada Pension Plan (CPP) Payments:||$611.85||$7,342.20|
|Old Age Security Pension Payments:||$558.71||$6,704.52|
|Union Pension Payments:||$230.00||$2,760.00|
That means that the basic math for our sample retirement so far looks something like this:
|Less: Pension Income:||($16,806.72)|
|Retirement Income Short-fall:||-$13,193.28|
So, here we see that your pensions will cover $16,806.72 of your expenses in retirement, but you have a shortfall of $13,193.28. This shortfall will need to be made up from your accumulated savings. But how much do you need to accumulate in savings? Now, that’s the million-dollar question!
Calculating the how much
How much money you’ll need in total accumulated savings to pay the expenses not covered by your pensions is the tricky part to retirement planning, no doubt about it, and here’s where lots of people want to pull their hair out!
Well, to begin with, it will depend on a couple of your investing assumptions going into retirement, so you need to think about that carefully. You need to consider two things:
- your investment approach in retirement. (Are you an aggressive or conservative investor?)
- the amount of investment risk you need to take on. (Most people are asked to define their risk tolerance and not their risk needs. We’ll delve into that important difference later in this series of articles.)
For now, let’s just try to keep things simple as we continue on with our sample retirement calculation. So, how much will you need from your savings to make up for that $13,193.28 shortfall in your retirement income?
Let’s assume that you’re like most Canadians, that you’re a fairly conservative investor, and that your current savings and investments have been able to earn an average rate of return of 4.0% per year. So if, in your retirement, you plan to continue investing with the same approach and level of investment risk, then by simply dividing your retirement income shortfall ($13,193.28) by this 4.0% rate of return, we can calculate that you’ll need the magic number of $329,832.00 of invested savings to support your retirement without using up any of your capital.
Using your magic number
Finally, once you have calculated your magic retirement savings number ($329,832.00 in our example), the last step in this approach involves using that number to benchmark your successful planning. When you look at this number and compare it to the actual total of your current planned savings, are you winning or losing your race toward retirement?
If your accumulated total savings, to date, is
- greater than $329,832.00, well, then, congratulations! You’ve won the race! The numbers demonstrate that you have in fact arrived and that your retirement is within your grasp.
- less than $329,832.00, well, then this exercise can by used as an important warning signal that you’ll need to make some changes to your retirement planning by either continuing to work, or start to save more and investing a little more aggressively, depending how short you are in your current planned total savings.
A sensible approach
So, there you have a smart, do-able approach to retirement planning in a nutshell. It involves looking at your current living expenses and doing a few simple mathematical calculations to put you on track to a successful retirement plan that can guide your current and future saving and investing decisions. // But, of course, like everything else in life, there are more details to this approach that we should examine further!
In the next article for this series, we’ll outline the steps above you’ll need to take in more detail if you want to create a comprehensive and failsafe retirement plan.
Click the link to read the next article in this series - Retirement planning made easy: a step-by-step approach
Click the link to read the first article in this series - Boomer retirement planning: not everyone safely on board!