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Sudden Wealth: Retirement Thumbnail

Sudden Wealth: Retirement

Insights Sudden Wealth

You can spend as much as you want in retirement, as long as you don't run out!  But it's not a game...


Have you noticed that retirement comes with a whole new set of responsibilities? As surprising as it may be there are several ways in which retirement can lead to sudden wealth. 
 
Pay Yourself First
Your whole life you've been told to "pay yourself first."  Now you have no choice - you're the only one who's going to pay you.
The first source of sudden wealth is the simplest, if not the most obvious. As soon as you retire you have 100% control of your income. You can create the income that you need to live the life that you want, the only concern is that if you get carried away you may run out of money in the long run. When you were working your employer was more or less responsible for your financial well-being. At the very least they offered you a pay cheque and decided whether you received a bonus. they may have also offered a benefits program, pension, group RRSP, stock options, and other forms of compensation. Now that you are retired all of these things become your responsibility. 

In the time leading up to retirement many people stress about how they will create their pay  cheque, so to speak. They're used to receiving a regular amount of income on a regular basis, and there's some question about how to continue that as retirement approaches. You have to choose when to start your Canada Pension Plan (CPP), Old Age Security (OAS), and which of your retirement accounts to start drawing money from. All of this has tax consequences, and uncertainty about what you are really able to afford without running out of money later. 

Theoretically you can create as much income as you want, but spending with abandon has been known to leave people scraping by in their later years.  As a result, people tend to fall to rules of thumb to estimate how much income they are able to take without running out of money. This can be dangerous because it fails to take into account that your wants and needs are not necessarily related to the amount of money you can withdraw from your portfolio, and that they will change in scale over the course of your retirement. We often talked with our clients about the Go-Go, Slow-Go, and No-Go years of retirement. In the early years you tend to travel a lot and are focused on experiences, many of which cost money. Then in the middle period, the slow-go period, you tend to travel less  and spend less. Then we define the no-go period as the tail end of your life where you might need some assisted-living support or face additional medical expenses.

The 4% rule

Rules of thumb can be a very dangerous financial planning method.  Let me demonstrate.  

Let's say you have a $500,000 portfolio.  The 4% rule is an assumption that you should be able to remove 4% of your portfolio without drawing down on your capital.  4% of $500,000 is $20,000 per year.  Add to that your Canada Pension Plan (CPP) of perhaps $20,000 for you and your spouse, and Old Age Security (OAS) of approximately $14,400 for you and your spouse, and you have a family income of $54,400, plus a nice nest-egg of $500,000 to leave to your children.  

Assuming an average tax rate of 20%, you are left with $43,520 to spend.  But what happens if you spend a bit too much? Maybe the roof needs repair, or the furnace fails, or your car unexpectedly needs to be replaced.  Let's say you spend an extra $10,000 that you weren't counting on.  Now you're no longer redeeming 4% of your portfolio, suddenly it's a 6% redemption and your nest-egg is on the decline.  We used the example of unexpected expenses, but often enough these spending decisions are intentional.  "Spend it while you can enjoy it" and "you only live once" are two dangerous mantras, as only a few thousand dollars in extra spending beyond your means can have drastic and catastrophic effects on the success of your retirement. 

What are your "means" then?

If you can create your own pay cheque then how do you decide how much to pay yourself? Honestly, there's no good rule of thumb in this instance. This is where financial planners really earn their money. Human beings are terrible at estimating what the future is going to look like.  Historically we only had to consider the next year or two at the most and the whole concept of retirement is a relatively new concern. We're pretty good understanding the decisions that we make now and their immediate outcomes, but what understanding the results of our current decisions might be in 10 or 20 or 30 years is something that we're not very well equipped to handle. 

A good financial model prepared by a financial planner can help you understand what the long-term consequences of your decisions will be. A particularly well prepared plan can show you the effects of what we call the go-go, slow-go and no-go years of retirement. In the early years of retirement you tend to spend more money on things like travel and experiences. Then in the middle of retirement there tends to be a lull in your spending when you don't travel as much and the kids come to you at Christmas time. Then in the later stages of retirement you face the risk of increased health care costs and long-term care costs which can drive up your spending again.  
Clarity today is better than regret tomorrow
Additional to this ebb and flow of spending in retirement you must also acknowledge that year-to-year variation will occur in your spending needs. When you were working it was easy to adjust your spending based on the income you earned; you would probably go on the big vacation or buy a new car in years where you made more money. In retirement you still need to do those things but you don't have employment income as a guide for when is a good time to make those expenses, and whether there will be long term pain as a result.  Don't give disaster a chance to sneak up on you.