Saturday, July 21, 2012

The 4% Solution


The infamous withdrawal rate

A lot of research has been done in the last decade on determining a "safe" withdrawal rate.

Basically, how much can you take from a fund each year so that the odds of running out of money (the "Probability of ruin") is almost zero over the period of retirement, often taken as 30 years, that is from age 65 to age 95.

The withdrawal rate is not static. It increases each year by the rate of inflation, so your spending power remains the same throughout retirement. If you have $100,000, and the expected rate of inflation is 2.5%, the first year withdrawal is $4,000 in year 1, $4,100 in year 2, $4,202 in year 3, and so on.

There are a few ways to determine the "safe" withdrawal rate, but most often it is the withdrawal rate that has a probability of 95% or more of not running out of money over 30 years, based on assumptions as to the expected annual return and volatility of the investments.

Why invest in equities?

In order to make the numbers more compelling, it is often assumed that funds are invested in equities -- with their higher expected returns and higher volatility.

Investing in equities is wise for the long-term, but with higher returns come higher risk and more chance of failure. Unless you withdraw such a small amount that any adverse investment outcomes will not wipe out your assets. And this is the idea behind the 4% withdrawal rate.

While taking low withdrawals minimizes your risk, it also can be a lost opportunity to enjoy the fruits of your savings. If you leave most or all of your capital untouched at a ripe old age, your inheritors will be grateful, but you could have ticked many more items off your bucket list.

How about bonds?

Is it possible to withdraw more than 4% without taking less risk and have a near zero odds of running out of money?

Consider the following. What would happen if I invested all my money in a bond exchange-traded fund (ETF) such as the iShares DEX Universe Bond Index?

First I can get some appreciation over time, as it did in the last few years, but let's ignore this for now. This ETF (and comparable funds offered by other suppliers) pay monthly dividends. The yield at the date of writing is 4.95%. It has hovered in this area for the last several years.

If I take a 4% withdrawal rate at age 65, earn no appreciation but get a 4.95% yield, I will run out of money after 40 years, at age 105!

Let's look at other possibilities

Withdrawal rate
Years after which money runs out
3%
72
4%
40
5%
29
6%
22

If I take a 6% withdrawal rate at age 65, but earn a modest (and historically occurring) appreciation of 1% plus my 4.95% yield, I will run out of money after 27 years at age 92.

Shortcomings

Here are a few other shortcomings with most safe withdrawal analyses.

They ignore income tax: in real life investment income and withdrawals from registered funds are taxable. What counts is how much after-tax is left for spending. Without a model for income tax, the withdrawal rate is just a number.

Withdrawals also come from various types of accounts: non-registered funds, RRSP, locked-in funds and tax-free savings account (TFSA). Each type of account has its own withdrawal constraints and income tax treatment.

In addition, our needs vary over time: we need more in some years, for example if we don't yet collect Government pensions, and less in others, if we earn income during retirement.
Our needs vary also for each period of retirement: the active, the sedentary period and end of retirement.

Last, withdrawal order from the various types of account is also ignored. It has a significant impact that cannot be ignored.

A few words about GMWB

A segregated fund is a mutual fund packaged with an insurance contract that provides a guaranteed return and a death benefit.

Some insurance companies offer a "guaranteed minimum withdrawal benefit" (GMWB), which is an option to provide an income for life, usually between 3% and 5% of the initial capital. The amount upon which the withdrawal rate is based is usually reset every few years, so if there is good investment returns, the income can grow (but never decline).

The income for life provided falls within the range of easily achievable withdrawal rates, considering the GMWB withdrawal are not increasing unless the investment experience is good enough to cause a reset. Nevertheless, several insurance companies have thrown the towel and suspended sales of these products in the last few months. Those who haven't suspended sales have reduced the lifetime income payout from 5% to 4% or even 3%.

The insurers blame the suspension or benefit reduction on the low interest environment.  There is also another cause: despite high fees, increased capital requirements and volatile capital markets made these products unprofitable for the insurers. For the consumer, the value proposition is not nearly as attractive as it once was.

Course correction

I have a few conclusions to draw from my arguments.

  • Make the early withdrawals reasonable if you have significant exposure to equities to minimize your sequence of returns risk.
  • If you decide to take higher withdrawals, monitor your rates of return and take corrective action by taking smaller withdrawals for a few years after a year or two of bad returns.
  • Use this analysis in your decision to purchase an annuity or segregated fund that provides a guaranteed minimum withdrawal benefit (GMWB). What withdrawal rate does the annuity or GMWB provide?

Last words

The mathematics behind the safe withdrawal rates is clever and sound. But perhaps there is a (small) elephant in the room: money can stretch further with less risk and little effort.

Am I suggesting following the above strategy: it is your decision. I am mostly using the above as a counter-example to disprove the conventional wisdom of the 4% withdrawal rule.

Saturday, July 14, 2012

Going for the Long Haul


Withdrawal order

Life is not a sprint, it's a marathon. So you must pace yourself and spend just the right amount during retirement in order not to run out of money.

This is where more saving, more investing, and less spending will improve your odds. Your withdrawal strategy can also help stretch out your savings.

Here are a few ideas on planning your retirement income.

There are a few schools of thoughts, but I am a fan of withdrawing money in the following order:

  1. Taxable account (non-registered investments)
  2. Tax-free savings account (TFSA)
  3. Locked-in Retirement Account (LIRA)
  4. Registered retirement savings plan (RRSP)

Essentially, the strategy is to take money first from accounts where the withdrawals are non-taxable or minimally taxed withdrawals.

The idea is to that investment income from a non-registered account is taxable, so your net after-tax rate of return is lower than the tax-free rate of return from a registered account. Since investment income compounds over time, you achieve greater compounding with higher returns and it makes a big difference over time.

Registered funds enjoy tax-free growth but are taxed as income when withdrawn. You can withdraw just enough to meet your needs and minimize taxable withdrawals. These taxable withdrawals will be partially offset with age and pension income deductions, and possibly higher medical expenses deductions.

Your RRSP has to be converted into a registered retirement income fund (RRIF) by the end for the year during which you turn age 71. A minimum withdrawal must be taken each year from a RRIF, based on age-related factors. Similarly, if you have a LIRA, it has to be converted into a life income fund (LIF) at the same time. Depending on the provincial jurisdiction for the LIF, withdrawals will be typically limited to the RRIF's age-related minimum, but may not exceed a maximum amount as well.

So you have to take the minimum RRIF withdrawals to avoid penalties. It is a good idea to take the maximum LIF withdrawals, and save any excess not required for your budget. This will speed up access to locked-in money, so it will be there when you need it. You can invest the funds in a tax-effective manner to defer tax on investment income on these newly released funds.

If you have large unrealized capital gains from a taxable account, the deferral of taxation in such cases is Going for the long haulsimilar to the registered account, so the benefit of withdrawing from non-registered first may not matter as much.

Stretching money a few more years

Here's an example to illustrate my point.

Suppose you have $200,000, half in a registered retirement income fund (RRIF) and the other half in a non-registered account.

You want to receive 4% of your assets after-tax each year. So you'll need to take 5% from the registered account to get 4% after-tax based on the assumptions below.

Here are the assumptions:

  • Investment return: 5%
  • Tax rate on investment income from non-registered account: 40%
  • Tax rate on withdrawals from RRIF account: 25%
  • Non-registered investment income fully realized each year

The chart below shows the outcome if you withdraw all your registered assets first and then dip in your non-registered assets.

You run out of money in 2037.




The second chart shows the outcome of withdrawing all non-registered assets first and then using registered assets. In that case, money runs out in 2040.



All other things being equal, what happens when you use non-registered assets first?

You get leverage from compounding tax-free investment returns as opposed to the lower compounding of after-tax investment returns.

And this will make your money last an extra three years in our example.

TFSA or RRSP first?

I tend to favour withdrawing funds earmarked for retirement in a TFSA before going to the RRSP or LIRA.
The TFSA is a flexible vehicle, but you need contribution room to take advantage of the flexibility. You create more room as withdrawals from a TFSA restore contribution room.

So in years you actually have to withdraw more than you need from a RRIF because of the minimum annual withdrawal, you can at least deposit some or all the funds in the TFSA to continue earning tax-free investment income on the excess money.

Also, as most of your assets will be concentrated in an RRSP or LIRA, the more you defer, the more compounding you earn when you minimize withdrawals and have all your money invested.

TFSA at a Glance

Here's a quick overview of how the TFSA works.

  • Starting in 2009, Canadians age 18 and older can save up to $5,000 every year in a TFSA.
  • TFSA contributions are not deductible.
  • Contributions to a TFSA are not deductible for income tax purposes but investment income earned in a TFSA (including interest, dividends and capital gains) will not be taxed, even when withdrawn.
  • You can withdraw funds from the TFSA at any time for any purpose.
  • Unused TFSA contribution room can be carried forward to future years.
  • The amount withdrawn can be put back in the TFSA at a later date without reducing your contribution room.
  • Neither income earned in a TFSA nor withdrawals will affect your eligibility for federal income-tested benefits (such as the Old Age Security, Guaranteed Income Supplement and the Canada Child Tax Benefit) and credits (e.g. age credit and GST credit).
  • Contributions to a spouse’s TFSA are allowed and TFSA assets can be transferred to a spouse upon death.
  • Maximum TFSA contributions increase each year in line with the inflation rate, to the nearest $500.
  • TFSA contributions are independent of (and in addition to) RRSP contribution limits.

Use of TFSA

One last comment on the TFSA. It's a great vehicle to hold funds for emergency. You can invest in low risk fixed income and pay no income tax on investment income.

This provides you with a better return and more impact from compounding.

Depending on how much you need for emergencies, any excess can serve as a source of retirement income.

Deciding where to withdraw first

Your circumstances may call for a different strategy than what is suggested here.

But knowing the characteristics and capital available in each type of account, you can start planning for the withdrawals each year in the future.

Friday, July 13, 2012

CPP Pension



Question:

I am having difficulty getting RetireWare to show my expected CPP pension income. I am currently semi-retired, age 56. I have no full-time employment earnings and have checked 'Already retired' in Financial Information. Nor am I currently in receipt of any CPP pension, so I can't enter any in Government Pensions.

Is there any other place I should enter my expected CPP income so that the program will recognize it?

Answer:

If you are semi-retired, select 'Already Retired' in Financial Information as you did, but enter an amount for the earnings. This amount will be used to estimate the CPP.

If you are working part-time, you should enter the part-time income in 'Sources of Income'.

Friday, July 6, 2012

Will I have enough?


The days of being sent off in the sunset with a gold watch, a pension and health insurance for life are gone forever I'm afraid.

We now have to rely on our own savings, the Canada (or Quebec) Pension Plan and Old Age Security. Only a lucky few get an employer-sponsored pension. These savings have to last longer because we are living longer.

The good news is that over your lifetime of accumulating - and withdrawing money - most of the funds will come from investment income, not capital. This is because of the miracle of compounding: not only your capital earns investment income, but investment income continually increases the amount invested that can potentially earn income.

If you are within ten years of retirement there are a few things you need to do to make sure you'll have enough.

Compare your income with your expenses during retirement and see if they match up. Few people will have exactly the amount of money they will need in retirement. Most will have a shortfall. If this is your situation, there are a few ways to close the gap and make your savings go further.

Where will you find additional savings? Here are some suggestions for active workers.

1. Maximize contributions

Make the maximum contribution to your workplace savings plan through payroll deductions. Contribute the maximum to your RRSP. If you have a savings plan with your employer with matching employer contributions, contribute enough to get the maximum matching amount.

Your contributions to an RRSP or defined contribution pension plan earn tax-free investment income and they are fully tax-deductible.

2. Retire at a later age

Staying employed as long as possible has several advantages.

Having an income gives your retirement savings more time to grow. Employment income also means continued savings for a few more years. Your employer also provides life insurance, dental and health benefits, so you don't have to cover these expenses as long as you work.

As well, there is a social benefit to working that is often as important as the income you can draw from your employment.

3. Decide on the best time to start receiving pension income

The amount of monthly CPP will be highest the older you are when you start receiving it. At age 62, your CPP will be reduced by 18%. At age 68 it will be increased by 21%.

If you participate in a defined benefit pension plan, you will have to decide as well on the pension commencement date. Try to meet the conditions for an unreduced pension. If you can't meet the eligibility criteria, try to you minimize the early retirement reduction to your pension by starting it as late as possible.

If you have a spouse, select a pension option that provides for a survivor benefit for your spouse, even though your monthly benefit will be reduced.

If you need the money immediately, you have no choice but to take it. But is you can wait, the increases after age 65 are greater than the reductions before 65.

There is no hard and fast rule. Early retirement will give you a smaller pension but it will be payable over a longer period, while taking it at age 65 or later will give you a higher pension payable a shorter expected period.

4. Control your expenses

You can downsize or relocate so your living costs are in line with what you can afford.

However, the years before retirement are the worst time to take on large debts, such as a home equity loan. And this includes loans to your children. Your retirement money must be left untouched and serve only your retirement needs.

If you run out of money, you will have to ask others to bear the financial burden for your care later on.

Large purchases are also unwise such as a new car or vacation home if you need to save.

5. Invest wisely

Get knowledgeable about investing or get a professional to do this for you.

Your must take on just enough risk to earn a decent return while staying comfortable with your investment strategy. Savings accounts and money market funds earn less than the rate of inflation. So you are essentially losing money with these ultra safe investments.

In the next post, we will look at planning income and withdrawals, in particular when to draw income and what type of account should be accessed first.

Updating Date of Calculation



Questions:

1. When I load my old file, which worked fine before, it says my retirement date is befoe the minimum date allowed? I picked same date from the calendar and got same message?

2. My Date of Financial Information also gives the same out-of-range message. I tried the calendar to pick the date and got the same message again.

3. When I run the calculation without changes to my data file it does not show any CPP income just OAS?

Answers:

1. It's because the program looks in the future. I know it may be an annoying feature, but the illustration starts from today and goes forward. Note that a date of retirement before the date of calculations is accepted.

2. Use today's date or a later date.

3. Even though you are retired, enter a value for income in Financial Information. By selecting 'Already retired' the program will calculate an estimate for the CPP based on your earnings level.

The CPP needs earnings to calculate an estimate unless you enter a monthly amount already in the course of payment.

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