So you’ve been dreaming about the retired life ever since the day whatshisname in accounting swiped that leftover slice of pizza you were saving in the office fridge. You’ve probably already got retirement plans (ie, sleep til 10:00 AM most days, acquire roomy sweatpants for every occasion, and become the D.B. Cooper of sneaking burritos into multiplex matinees). But in order to get there, you’re going to need a strategy to make your particular Shangri-La a financial reality.
The best-of-all strategies is a fairly predictable one: make or inherit a pile of money large enough that you can coast 20, 30, even 40 years on the income thrown off by it. If you weren't born rich, this will take significant work. But there are three fundamental steps that will set you on the right path.
Start early — as in right now. Saving like a maniac is great but it's got to happen early. You won’t accomplish a heck of a lot if at 55 you decide it's time to start saving for retirement. Creating a comfortable retirement out of something modest will require your savings to simmer for a very long time in an investment account, experiencing the magical power of compounding year in and year out. Play around with a compounding calculator like this one to get a feel for what time can do to money. Assuming a hypothetical, though historically reasonable 7% annual rate of return on an investment, a 25 year-old who manages to put $5,000 away every year will end up with almost $1.18 million by age 65. Put in that same $5,000 beginning at age 35, and she’ll only end up with $551,000 by 65. In fact, in order for that 35 year-old to end up with the identical $1.18 million by 65, she’d have to put away more than $10,000 a year to catch up to the early bird who started at 25.
Invest in stocks. So what's the best way to harness that miraculous compounding power we reference above? Why, through investing in something that’s going to earn you some significant returns, and historically, the most reliable place for that is the stock market. One big disclosure that our very smart compliance folks insist upon: investing in stocks is speculative, and anyone who tells you otherwise is a big fat liar, so keep in mind that whenever you invest in stocks, you run the risk of losing a significant portion of your investment. That being said, historically, the annualized returns on the S&P 500 over the last 90 years have been just under 10%, which is a pretty stellar rate of return. One particularly effective way to take advantage of the natural growth of the market is by purchasing ETFs that track an entire economic sector or index, like the S&P 500. With such an investment, one price could buy you a tiny sliver of the 500 most valuable companies on the US stock market.
Beware fees, taxes. High management fees and taxes will both decimate your retirement investments, so make sure that you take advantage of all tax advantaged accounts and keep your investment management fees to a minimum. Before investing, take a deeper dive into these issues with an investing guide like this one.
If you've been disciplined from a young age, and retire with a nice chunk of change, you may choose to retire following the famous 4% rule, a guideline introduced by a financial advisor named William Bengen, who ran the numbers and figured out that if you withdraw 4% of your well-invested retirement portfolio annually and adjust for inflation, you will never, ever run out of money. Legend has it, Dracula kept his castle rent paid for 400 years using the 4% rule; it’s also how well-to-do mortals finance their retirement and then pass on their wealth.
So what does the 4% rule mean in real numbers? If you’ve spent a number of years in the workforce, you’ll be eligible to receive full Canada Pension Plan (CPP) and Old Age Security (OAS) benefits at 65, but this will amount to only about $15,000 (more, if your income is below the Guaranteed Income Supplement (GIS) maximum amount to receive benefits.) Financial advisors often suggest that in order not to feel deprived, you should be netting 70-80% of your pre-retirement income. So, if you’re used to making $75,000, you’ll want to have access to about $60,000 annually. If you’re going off the 4% rule, in order to make up that $45,000 your benefits won’t cover, you’d need to have a portfolio of $1.125 million. Used to making $150,000? Using the same calculations, you’d need to retire with a portfolio of about $2.44 million. Easy peasy, right?
As the saying goes, nice work if you can get it—but very few can. Though Canadians figure they'll need $756,000 squirreled away for retirement, a recent poll found that almost a third of Canadians had no retirement savings at all and the average amount we Canucks put away by retirement is $184,000. Don't freak out if you're nowhere near where you need to be. Even if you wake up at 65 without a penny saved, you won't starve; though it's a far from ideal scenario, provided you meet the residency requirements, it's possible that a couple who had saved nothing for retirement could collect $24,000 in mostly tax-free government benefits annually.
The best news of all is that all the anxiety about not having enough might be unnecessary. A recent investigation undertaken by the Employee Benefit Research Institute suggests that retirement needn't be expensive and retirees are actually pretty good at not running out of money. The study showed that those who retired with less than US$200,000 still had 75% of that amount 18 years later. Toronto-based financial planner Jason Heath dismisses any one-size fits all dollar amount that you'll need to retire; it all depends on your personal circumstances. He also thinks the 4% rule and other plans that strive to never touch capital are kind of dopey. “It’s a noble aspiration in theory, but in practice, what’s the point?” he writes, noting that retirees should worry a little less about their heirs and rather enjoy the fruits of their labor with the time they have left.
Early retirement strategies
You don’t want to wait until you're 70 to start hustling your fellow retirees at shuffleboard? Great, why not retire at 60, or even 50. Heck, the only impediment to keep you from retiring on your 30th birthday is having enough money to keep you afloat for 60 or so years. Life’s expensive, and the earlier you retire, the less time your retirement savings will have to experience the magical power of compounding. Here are a few of the major points for those aiming to exit the rat race early.
Save like a mofo starting right now— and invest much of it in stocks. We went over the power of saving and compounding above, but you'll need to put that into overdrive. Again assuming a hypothetical, though not unheard of 7% annual rate of return on an investment in US equities, a 25 year-old who puts away $20,000 away every year will end up with almost $1.38 million by age 50. And what with that whole eggs-in-one-basket thing, diversification is incredibly important, and you should never invest solely in stocks. That being said, stock market history shows the short-term risk of investing in the S&P 500 dissipated over time, so if you’ve got a twenty-plus year investment horizon, the stock market’s a pretty appealing place to park your money. Be warned, though: Investments are speculative and it’s important to understand that past results should never be understood to be guarantees, but rather imperfect predictors of future performance. Again, you must keep your fees low, and max out all tax-advantaged accounts before investing elsewhere. A deeper dive on these issues can be found here.
Other ways to retire earlier? Eliminate credit card and other consumer debt. Consider renting over buying a home. Hold your head high while giving the valet the keys to your 2005 Honda Civic. Commit to a cheapskate lifestyle. Plan to retire in a country with a lower cost of living, ideally one with plentiful rum and coconuts.
Tax-free retirement strategies
Unlike the coworker in the next cubicle who lived to recount to you her previous nights dreams in great detail, taxes unfortunately don’t disappear when you retire. Most of the income you take—from the government, from pensions, 401(k)s, and traditional IRAs, is taxable. There are a few strategies that will help you legally outfox the tax man during retirement.
Game your RRSP withdrawals, consider waiting to take CPP
Paying absolutely no taxes in retirement would be dreamy, right? But if you’ve accumulated any significant retirement savings, the CRA will absolutely figure out a way to take a cut. So, the best strategy is to figure out how to draw income on a timeline that will cost you the least.
If you’ve contributed anywhere near the maximum amount into your RRSP over the years, you’ve probably reduced your tax bill by thousands, even tens of thousands of dollars over your working years. But unfortunately RRSPs are not tax-free, they’re tax-deferred, and the CRA has devised a couple ways to make sure that it gets its cut of tax revenue before you exit planet earth. The first is by forcing you to turn your RRSP into an RRIF by the end of your 71st year and requiring you to withdraw escalating annual percentages of the account’s value for the rest of your days, beginning with 5.28 percent at 71. If your account is significant, this withdrawal may even force you into the dreaded 50% marginal tax rate found in some provinces for the duration of your seventies.
Is there anything you can do to prevent this? According to some experts, the answer is breaking open that RRSP a little earlier than perhaps you imagined you would, especially if you’re earning less in the years leading up to your retirement than you were when you socked the money away in your RRSP. Here, Ontario-based retirement income specialist Doug Dahmer recommends that for most people, putting off collecting one or both Old Age Security (OAS) and Canada Pension Plan (CPP) benefits to age 70 while converting your RRSP into an RRIF early and withdrawing some of those funds will result in an overall major tax savings. Not only will you get 8.4 percent more for every year you delay taking CPP, taking early RRIF withdrawals will reduce the OAS clawbacks you’ll eventually be subject to if your income is too high. And what are “clawbacks” but just a creepy horror movie way of saying taxes?
