How much is enough for retirement?
By James Daw

All over the Internet you will find calculators to help answer the question, when can I afford to retire?

But beware of the answers. The assumptions you supply for average investment returns, inflation and life expectancy may prompt you to make ruinous decisions.

Risk factors to consider were highlighted at a Morningstar Canada investment conference last week. The implications of each factor are more savings and less spending.

Living too long: The average Canadian baby boy may expect to live until 79, and girls nearly 4 years longer. But those who reach 65 should keep in mind that half of men will live past 80, and nearly half of women past 85. For couples who reach normal retirement age, chances are 36 in a hundred that one partner will reach age 90 and 12 per cent that one will live to age 95, according to Paul Kaplan of Morningstar Inc.

Also consider that married men live longer on average than bachelors, and single women longer than wives.

Price inflation: The Canada Pension Plan and Old Age Security and some employer-sponsored pension plans will protect your purchasing power. So will real-return government bonds, which are in short supply.

Moshe Milevsky, a professor of finance at York University, says major life insurers provide true inflation protection for life annuities in the United Kingdom and United States, and will soon have products for Canada.

"There is innovation that will eventually creep up north."

In the meantime, he warns that even low levels of inflation will radically reduce the purchasing power of $1,000 during a 25-year period of retirement: to $780 at 1 per cent inflation, $610 at 2 per cent and $375 at 3 per cent.

Milevsky and others urge that retirees use some of their savings to buy a life annuity to reduce the risk of running out of money before death. The older one gets, the bigger the bump in income a person will enjoy compared with earning interest.

He suggests retirees hold off from buying an annuity temporarily, at least until the inflation-protected products are available for consideration.

Variable returns: Between 1980 and 2005, a portfolio of Canadian stocks (50 per cent), bonds (35 per cent) and treasury bills (15 per cent) would have produced an average, inflation-adjusted return of 6.43 per cent, according to Kaplan.

We cannot assume such a high return will be achieved in future, or that it was possible to achieve in the past after deducting the cost of brokerage or mutual fund fees.

Also, there were losses in five years out of 25 years, and the gains in good years ranged from 2 to 22 per cent. Those retired in 1982 or 1995 got off on the right foot with the longest strings of gains. Those who retired near the start of 1981, 1990, 1994, 2001 or 2002 suffered immediate losses.

Milevsky says a series of gains or losses can mean the difference between success and ruin for any financial plan. So can an unrealistically high rate of withdrawals.

He and colleague Chris Robinson have developed a mathematical formula to calculate sustainable spending rates, taking into account the variability of investment returns, inflation and longevity.

Their papers, available at http://www.cfainstitute.org and http://www.ifid.ca, suggest that a balanced portfolio of investments helps to reduce the risk of running short of money.

But regardless of the percentage of stocks in a portfolio, a retiree aged 65 or younger would need to limit annual spending to 4 per cent of assets or less to keep the risk of running out of money before death to less than 10 per cent.

Milevsky and Robinson do not deduct expenses from market investment returns in the assumptions.

Such an adjustment would probably reduce the advisable level of spending.

Our warped sense of reality: retirees will tend to underestimate the value of a guaranteed pension or annuity for life.

A study published in 2001 found that, during the years 1991 to 1995, the United States defence department saved about $1.7 billion (U.S.) by giving military personnel a choice between a lump-sum payment and a pension.

On average, those who selected a lump sum would have needed to earn a return of 21 per cent on the money to earn as much money as their pensions would have provided.

All this suggests that we would be wise to seek professional advice before deciding when to retire and how much to spend during retirement. Not all advisers have the tools, knowledge or degree of interest in your well being to provide the necessary advice. So, interview carefully, and seek a second opinion.