If you are not currently retired or approaching retirement, it is important for you to know how much you need in order to retire. That amount is called your retirement number, or financial independence number. This number is based on a host of things, including your age of retirement, your retirement lifestyle, your annual income, and any additional expenses you expect to incur in retirement such as renovation, vacation, helping family members, etc. Retirement is a dream for many, some wishing to attain it sooner rather than later. Retirement is a matter of income and not of age, so first, you must know how much income you need monthly, sometimes called your withdrawal rate. Once you have an idea of how much you need each month, you should make sure that you have set aside a sufficient emergency fund of at least 6 months of your monthly withdrawal rate. You may draw from this emergency fund to cover unexpected expenses.
Second, you must plan for where the money required for your retirement will come from. You can start by considering how much you will receive in pensions (e.g., company pension(s), Canada Pension Plan, and Old Age Security). You may request a Statement of Contributions from Canada Pension Plan. Once you have that amount, add it to your own investments such as stocks, bonds, guaranteed investment certificates (GICs), mutual funds, etc. Generally, you can expect your pensions and investments to generate between 4% and 6% income annually. However, this rate depends on your risk tolerance, time horizon, and how long your money lasts. For example, if you had $500,000 and got a 5% rate of return, that means you would be generating $25,000 annually, or $2,083.33 monthly. Here, you want to know what the minimum rate of return you need annually is, and to track this against your actual returns in order to make sure things are going according to the financial plan. Finally, look at real estate and business. Do you plan to sell off real estate and downsize, or generate income from rental real estate? Do you plan to sell any businesses or generate income from them?
The income stream
Whatever means of income you are receiving, it is important to consider the stability of the income stream, whether it is indexed for inflation, and whether it is predictable. For example, income from a business or a trust may be discretionary and not guaranteed, while income from an annuity is steady and indexed for inflation. Also, other sources of income outside of pensions, and investment sources such as part-time income alimony or child support, may not last for the entire period of retirement. Should one of these sources vanish, this creates a gap in your retirement income, putting your plan at risk. Generally speaking, the longer the retirement period you are planning for, the more risks there are.
Now that you have identified and quantified all your sources of capital, ask yourself: What percentage of capital would I like to have left at the time of my death (based on your own life expectancy)? Do you want 100% of your money, 50% of your money, or do you want it all spent by then? This will help determine your time horizon, as well as your estate wishes. Remember to retire to an income and lifestyle, and not an age; otherwise, you risk retiring with an income that does not adequately support your needs, and a lifestyle that falls short of your expectations.
Can I afford to retire?
Once you have looked at these numbers, ask yourself: “Can I afford to retire?”. It is not unusual to have a retirement number in mind, then see that number change; for this reason, it is strongly recommended that you review your cash flow statement regularly. This review should happen before retirement, after retirement, and once you have started to receive your benefits (CPP/QPP and OAS). A cash flow statement measures how much money is going in, and how much is going out of your account; ultimately, it tells you how much net cash you will have over a specific period of time. The cash flow statement should reflect your current situation and any upcoming changes in your financial plan. It is necessary to determine the monthly disposable income you have now and in the future. Make it as specific as possible, knowing that it is just an estimate, and that it may change depending on what actually happens when you retire. The website mymoneycoach.ca provides great tools to track your monthly and yearly cash flow.
These cash flow statements will allow you to see whether your resources will suffice, or whether you need to reduce any of your planned spending to properly meet your cash flow requirements. Additionally, having a cash flow statement will provide you with clarity about when you should start to withdraw.
Alternatively, if you do not have time to do a cash flow statement or you just want to get a sense of what your income looks like in the interim, you may want to calculate your after-tax income using the following steps:
- What are your guaranteed income streams (employment pensions, Canada Pension Plan, Old Age Security, Guaranteed Income Supplement, annuity etc.)?
- How much will you withdraw (5 – 6 %) from your personal assets (non-registered, RRSP, TFSA)?
- What is the total income from all sources?
- What tax minimization strategies can you implement to lower your total income?
- Once you find out the estimated total income, you will then reduce this amount by your average tax rate.
This does not take long to calculate and will not provide you with dependable numbers. Nonetheless, it provides you with a sense of what your situation will look like going into retirement.
If you have a look at your financial independence number and you realize that you are unable to retire in the timeframe you desire, then there are options: retiring at a later date, lowering the retirement income you need, reducing expenses in order to save more, increasing income (including working during retirement), assuming more risk in an investment portfolio with the anticipation of getting a higher return, or considering a reduction of the legacy that you leave after you die. Generally, there are many things to consider, and the outcome will differ depending on the individual’s specific needs.
