Friday, December 20, 2013

Budget Statement



Question:

When I have $0 in expenses for Spouse 1 and 2 in the pre-retirement budget, the report takes the Net Income amount and puts it in the Total Expense amount.

Answer:

In cases where you  and your spouse are not yet retired, if there is no budget, the program tries to create a budget based on net income, assuming all funds are spent or saved.

In other words, the "budget" for someone without a budget is:
expenses = gross income - taxes - annual savings.


CPP Sharing



Question:

What does "years of common CPP coverage while married" mean?

Answer:

CPP can be shared between spouses when the pension is paid. The sharing formula is based on the years of common coverage. For example, suppose you are the same age. If you contribute from age 25 to 65 (40 years) and your spouse contributes from age 25 to 55, there are 30 years in common. So only the pension accrued during these common years will be split equally between spouse.


Properties



Question:

1. For the principal residence, I have entered the same amount for each of us for market value and mortgage.  Please confirm this is correct.

2. We both own rental real estate properties.  I entered this value, the purchase value, and the mortgages against them in my spouse's data only.  Is this ok?  Should I divide all the numbers in half and enter for each spouse?

Answer:

1. You should put a share for each spouse or all under one spouse. The amounts are additive. If your plan provides that your spouse will live longer, you can put the personal residence under her if you never intend to sell.

2. Yes, if she will be taxed on it at disposition for the capital gains. Otherwise, you should split the amounts.

Templates



Question:

Are there templates to assist in gathering data? I can't see to locate any templates for this.

Answer:

The worksheets are inside the help files. Open the Help window, expand the 'Other' menu and click 'Worksheets'.

Disposition of Property



Question:

In the detailed cash flow table, there is one year of high income tax in the year I sell my investment property. Why is that?

Answer:

It is because the capital gains tax applies in the year of disposition.

Plan for Both Spouses



Question:

I tried creating two files (for my wife and myself) and requested combined calculations in both files. 

However when I try and get a report it appears I am doing something wrong. 

After a calculation I see the projections are using my numbers but the reports I can see either ignore all of my wife's assets.

Answer:

If you select a combined calculation for both spouse, it creates a new file. It does not pick up another file created in the File Manager and make it the spouse file.

You enter your spouse's data by selecting to include your spouse in your plan in 'General Information' on the Forecast page.

Use of TFSA



Question:

Why is the TSFA not used as income?  It accumulates a large balance but there aren't any withdrawals ever from the account.

Answer:

Your TFSA is never required, as the goal is met from RRSPs and LIFs, which require minimum withdrawals during retirement, and non-registered assets, which have a higher withdrawal priority than the TFSA.

Mortgage Debt



Question:

We entered a $260k mortgage for our rental property. When is this debt paid?

Answer:

The balance of the mortgage is paid in the year of disposition of the rental property.

Retirement Income Objective



Question:

I plan to retire in 2018. Why is the retirement income objective set at about $110,000, when I entered only $50,000 for each spouse?  Is this for inflation?

Answer:

Yes, numbers show in nominal dollars, the $110,000 represents $100,000 in today's dollars.

Results



Question:

I'm struggling to interpret the results.  On one hand it looks like we our plan is in good shape.  But why is our probability of success so low?

Answer:

It is possible to have a situation in the simulation where bad investment returns cause shortfalls before you dispose of an asset such as the personal residence.

If you assume disposition slightly earlier, then these funds will be available as a source of retirement income.

In real life, if you became broke and owning a home debt-free, you would sell to access your equity.

Monte Carlo Settings



Question:

In the Monte Carlo settings, I checked the box to "Use Rates of Return as specified in the Economic Outlook". Why are the rates that shown in the Monte Carlo settings different from the economic forecast and the fields disabled?

Answer:

When you select to use the economic basis (either the standard forecast or custom rates), these fields become disabled, as you need not make any selections in that location.

When to Sell



Question:

If I have a rental property, how can I use RetireWare to determine the right time to sell.

Answer:

Your circumstances , life events and the real estate market will be the deciding factors on when to sell. 

For modeling purposes, use an approximate year. Selling a few years earlier or later generally will not make a big difference unless you run out of retirement funds.


Quantifying Risk


Lightning and lotteries

According to the National Oceanic and Atmospheric Administration, the odds of becoming a lightning victim in the United States in any one year is 1 in 700,000. Your odds of winning the jackpot at Lotto 6/49 is 1 in 13,983,816. So you are 20 times more likely to be struck by lightning than winning the jackpot. If you paid $3 for your ticket and the jackpot is $5 Million, your expected gain is $0.36 and your net expected loss for your $3 investment is $2.64.

We tend to think that we will almost certainly will never be struck by lightning, while today may just be our lucky day for Lotto 6/49.

Getting struck by lightning is a risk with known odds and outcome. If you walk in an open field during a thunderstorm with an umbrella pointing upwards, your odds become considerably higher. Knowing the danger, most of us avoid this risk by staying out of harm's way.

There is also a risk of loss with the lottery ticket purchase. The loss is quite small ($3.00), and it may be viewed as a harmless entertainment expense. But the point is that you are trading a small loss for a very unlikely gain that can have a large impact on your life.

By definition, a risk carries uncertainty. In exchange for a potential payoff, we take a chance of incurring a loss. Each risk has its own odds and the impact can be small or large if it occurs.

Why think about risk?

When it comes to retirement planning, we must consider that our livelihood will come from invested assets, public and private pensions. We are no longer counting on indefinite and renewable employment income.

Examining each of the potential risks can help us make decisions on how we can minimize the odds of running out of money under all potential situations that may unfold in the future.

As with lightning and lottery, when assessing risk, we must determine its likelihood and the magnitude of the outcome. Armed with this information we can then decide whether we want to apply techniques to reduce, eliminate, transfer, or retain the risk.

Assessing risk

The likelihood of a risk is the odds it will happen, and its magnitude is the amount or severity of the loss.

There are several approaches to quantifying risk. Numerous different risk formulae exist, but perhaps the most widely accepted formula for risk quantification is:
Risk = Rate of occurrence X Impact of the event
Three approaches can be used to assess post-retirement risks:

  1. Determining the odds for the occurrence,
  2. Evaluating the impact of a risk to a moderate change in outcome using sensitivity testing, or
  3. Gauging the impact of an occurrence with stress testing.

The risk analysis in RetireWare uses a combination of these approaches, with an emphasis on stress testing.

The importance of the longevity risk
"Longevity: The Underlying Driver of Retirement Risk"
 – Society of Actuaries report
The financial aspect of a successful retirement depends on the level of spending, available capital and sources of guaranteed income to finance expenses over the retirement period. Spending, initial capital and guaranteed income are predictable.

Investment returns can be managed to a degree with diversification, conservatism and hedging, but still carry significant uncertainty and can wreck wealth if poor returns prevail at the onset of retirement. Longevity for an individual is completely unpredictable, but life expectancy is rising and this is expected to continue with improvements in lifestyle and medical care.

Appropriate levels of spending ultimately depend on the duration over which they apply. This makes longevity in our view the most important factor to which other risk factors are subordinate.

Looking at the possibilities
“All models are wrong, but some are useful.”
– George Box, Professor Emeritus of Statistics
A risk cannot be evaluated in a  vacuum in the real world. It interacts with other factors and other risks. In other words, more than one adverse risk event can take place at the same time.

We developed a mathematical model to assess and quantify exposure to post-retirement risks. An objective function quantifies the success of the retirement plan with respect to each risk under consideration by looking at demographic and economic scenarios where a particular risk occurs and measuring the impact on the retirement budget.

The quantification of risk follows a stress testing approach that considers the odds of each economic and demographic scenario, and the set reproduces all possibilities to closely match the expected outcome and volatility used for the model.

Risks under consideration are: longevity, market, inflation, sequence of returns, long-term care and loss of spouse. For each risk, the risk success value depends on the degree to which expenses are covered where the risk occurs in  a subset of the economic and demographic scenarios.

Scenarios combine different end points of life expectancy and economic environment for equities, bonds, interest rates and inflation. Each scenario applies to one or more risks. The success measure is based on the present value of the shortfall of assets required to meet retirement income goals.

The degree of success values for each risk is an average of the results obtained for the applicable scenario subset. Results are rated on a scale from 0% to 100%, with 100% being the perfect rating, where the risk is completely managed.

Based on the individual’s retirement financial needs and aspirations, each risk's index value evaluates how the risk is managed. Taken together, the risk measures provide an overall evaluation of the current post-retirement risk strategies in place and highlights areas of weakness that need to be addressed.

Two other measures complement the risk analysis results: the expected estate compared to the estate objective goals and the degree to which sources of lifetime income covers essential and discretionary expenses.

The income coverage measurement provides information on "income coverage" and "essential expenses coverage". If there is a detailed budget, the results include the average percentage that sources of lifetime income (annuities, Government and private pensions) are able to cover the retirement income goal. For example, if the goal is $50,000 per year and lifetime income sources are at $20,000 on average, the income coverage is 40%. 

Risk management plan

Once risks have been assessed, strategies can be adopted to improve areas of weakness in the retirement plan. These strategies fall into one or more of these four major categories:

  • Avoidance (eliminate)
  • Reduction (mitigate or control)
  • Transfer (outsource or insure)
  • Retention (accept and budget)

Risk analysis results and management plans should be updated periodically to evaluate whether risk levels have changed or whether the strategies in place are still effective.

Wednesday, December 18, 2013

Retire Happy!



The pursuit of happiness

Researchers at Liverpool Victoria, a UK insurance company, recently assessed the cost of a "happy retirement" at nearly $400,000. Their estimate is for maintaining a fairly ordinary standard of living consisting of essential living costs plus the cost of the "pursuit of happiness".

The calculation assumes a retirement age of 65 and lifestyle expenses lasting for the remaining life expectancy of 17 years. The cost estimate represents funds required in addition to the average state pension payable in the UK.

What is unique about their research is that they conducted a survey to find out what people close to retiring consider necessary to feel content in retirement.

They found a list of recurring themes that led to compiling this list of essential ingredients:

  • Holidays outside the country each year,
  • Time with children and grandchildren, and periodic gifts to them,
  • Socializing with friends,
  • Indulging in hobbies,
  • Retirement at age 65,
  • Living in a house with a garden, possibly outside the city,
  • Living close to children and grandchildren, and
  • Convenient transportation and walking distance to amenities.

I suspect we Canadians are not so different.

Many of these items are at no cost, but others come with a price tag. While the research focused on the "bare bone" cost of happiness, many will find that they need far more to achieve contentment in retirement. For example, holidays are to be frequent and long, hobbies numerous and expensive (golf, cottage, boating, etc...).

Sadly, the survey found that 8% of pre-retirees had no retirement funds whatsoever and almost 30% would fall short of their pursuit. Of those with retirement funds, over a quarter didn't know how much income to expect.

For many, the true shortfall in their pension will not become apparent until they are ready to retire.

And then it will be too late.

What is your list of ingredients to be content in retirement? Drawing up your own list will make it easier to build your post-retirement budget. Planning retirement is not only about figuring out how to keep the lights on and put food on the table, it's also about figuring out the price tag of retirement happiness!

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