Mitigating retirement income risks
Post- work lifestyles affected by variables including life expectancy, inflation, market risk and health care costs
Retirement income planning is a process, not an event. To effectively deal with it, there needs to be a strategy that can adapt to changing market conditions as well as to personal needs, goals and objectives, any of which may change dramatically over time.
To design an effective retirement planning strategy, you need to understand some of the variables involved; 1) life expectancy, 2) inflation, 3) how much do I need 4) stock market risk and 5) health care costs.
Life expectancy is one of the most misunderstood aspects of retirement income planning – yet, it is one of the most important factors.
Most people assume that life expectancy is the same as lifespan. This is not correct. Instead, life expectancy is a median number of years — such that 50 per cent of a particular age group will die before this number of years, and the other 50 per cent will die after this period.
For example, a male who is 65 years of age today has a life expectancy of 19 years; this means that he is expected to live until age 84.
There is, however, a 50- per- cent chance that he will live longer than 19 years. ( Interestingly, there is also a 30- per- cent chance that he will see his 90th birthday.)
A female who is 65 years of age today is expected to live for another 21.5 years ( age 86.5). But, she has a 50- percent chance of living longer than 21.5 years ( and a 41- per- cent chance that she will see her 90th birthday).
Even more interesting is the result for a couple, both age 65. In this case, there is a 58- per- cent chance that one of the two will survive to see his or her 90th birthday!
Thus, when planning for retirement, it is important to look beyond your life expectancy — because there is a 50- per- cent chance you will exceed it.
The inflation rate is usually measured by the year- over- year change in the Consumer Price Index ( CPI). It measures how much a “basket of commonly purchased goods and services” increases in price over time.
For example, if the inflation rate were four per cent ( the historical longterm average), you would need an income of $ 109,556 in 20 years time to buy the same basket of goods that you could buy today for $ 50,000.
There is a “general principle” that states you will need 60 per cent to 70 per cent of your income immediately preceding retirement in order to maintain your standard of living during retirement. The rationale behind this “rule of thumb” is that in retirement, you are no longer saving, nor would you have employment- related expenses.
It goes without saying that this number will be different for everyone. It depends on what you intend to do with your life in retirement; this will drive your particular income requirements.
In retirement, you should be prepared for a stock market correction every single day.
When you are working and accumulating retirement savings over a long period, stock market volatility is not a concern as long as your portfolio is properly diversified. One of the greatest risks in retirement planning, however, is having the stock market drop substantially just before or just after you retire. Proper diversification techniques alone will not offset this problem.
If you are unlucky enough to retire when the stock market is performing poorly ( and you need to generate income from your portfolio), then you could deplete your capital at an alarming rate.
Ultimately, this will reduce the chances of your portfolio being able to generate your required net spendable income throughout your remaining retirement years.
When you are working, you typically have only one source of income ( your job). In retirement, you will have a mixture of different income sources that need to be integrated. You will probably be entitled to some type of government benefit ( e. g. OAS and CPP), you might have a company pension plan and you may have your own investment assets ( e. g. RRSPS).
It is important to use these income sources in the most effective manner to generate the highest possible spendable ( after- tax, after- inflation) income in your retirement years.
Finally, as the baby boomer generation retires, our health care system will continue to be under increasing strain. It is very possible that you may have to spend a substantial portion of your retirement income on health care costs.
It is very difficult to predict how much of your additional savings you should allocate to health care, but it would be imprudent to ignore this potential problem.
The earlier you start planning for retirement, the more time you will have to monitor and change the results should they prove to be unsatisfactory.