Each retirement plan is unique, based on a member’s specific personal and financial situation. The member’s specific retirement objective must be clearly defined prior to developing a retirement plan.
Retirement planning is complicated, and a substantial amount of time and thought must be given to the parameters that shape the retirement plan. A small change in any one variable can have a dramatic effect on the overall result of the retirement plan. This is particularly true of assumptions made about rates of return that compound over many years. The key retirement planning parameters are:
Lifestyle (both before and during retirement)
The specific lifestyle decisions members make in their 20s or 30s often affect the achievement of financial planning objectives throughout their working years. Members need to prioritize retirement savings and attempt to balance their existing lifestyle with their desired retirement lifestyle. Most members want to continue to live in a manner similar to their pre-retirement lifestyle. The level of retirement expenses determines how much money members must accumulate before they can retire with confidence.
Life expectancy (for both spouses)
The life expectancy of the average Canadian is increasing each year and each succeeding generation is living longer than the previous generation. In fact, members may spend a longer period in retirement than they spent working. Therefore, the biggest risk that members may face during their retirement years is the risk of outliving their money. Ideally, members should plan for a retirement period of at least 25 years, and perhaps as long as 40 years, in order to minimize the risk of outliving retirement assets.
Inflation rate (both before and during retirement)
Inflation is the general increase in the price of goods and services over time as measured by the consumer price index (CPI). As inflation increases over time, the purchasing power of money decreases. Inflation has a dramatic effect on a retirement plan because inflation occurs both when members are planning for retirement and continues during the entire retirement period. For the past 50 years, inflation in Canada has fluctuated between 2% p.a. and 14% p.a., with the average annual inflation rate being approximately 4.09% p.a. for the period. Because the retirement planning period is long, we recommend using an inflation rate of at least 3% p.a. to 4% p.a.
Rates of return on investments (both before and during retirement)
Determining the rates of return to use in a retirement plan both before and during retirement is critical. It is essential to be conservative and not to overestimate future investment returns, especially during retirement. Ideally, it is best to complete the retirement plan using very conservative rates of return, such as a real rate of return of 5% before retirement (8% nominal less 3% inflation) and 3% during retirement (6% nominal less 3% inflation). (We use lower rates during retirement because retirees generally have a conservative income-oriented investment portfolio.) Thereafter, a range of “what if” scenarios should be completed to illustrate how a member’s plan would change, based on different rates of return.
Income tax rates (both before and during retirement)
When planning for retirement we need to use different rates of return for registered investment assets and non-registered investment assets.