Blessed by the Potato

Be sure to look at the first two posts in this series introducing the retirement spreadsheet, and discussing the details of the inputs and how it works.

Here, I want to stress the importance of using this spreadsheet to look at a large number of potential scenarios. It’s good to have an idea of what you think would be the most likely outcome, and with a bit of conservatism, what would be the most likely base scenario (where things would be that good or better for you). But it’s also important to know how the factors will affect your ability to stay retired, in part so you know what to watch for as retirement unfolds. Keep updating the plan every year or so, and watch for any changes in the world that will require a course correction on your part.

When looking at this with my friend, I went through something like 25 different scenarios. I’ll outline a few for you below, but it’s important to do the exercise yourself: come up with your own range of reasonable values for all the various inputs, and understand how they’ll impact your retirement.

What might be an important factor can depend on circumstances. For instance, if a large part of your spending needs are met by a pension (plus CPP/OAS), then above-indexed personal inflation can have a massive impact on your ability to meet your expenses, while you may be ambivalent about market returns.

Let’s take the example in the default spreadsheet: someone who has $540k in assets, $45k in spending needs, and $43k in pre-tax pension income. They should be set up for a pretty secure retirement: only a small portion of the assets need to be used to pay for expenses — basically just the taxes and for the occasional big-ticket item every 5 years.

If their personal inflation rate matches the CPI rate that the pensions and government subsidy are indexed to, this person could expect to live to 92 on their assets even assuming conservative investment returns (-0.25% real return on fixed income, and 3.5% real return on stocks). Even after the money ran out, they’d only have to cut their spending by about $10k/year to live off the guaranteed pensions (it sounds like a lot, coming off $45k, but perhaps not so tough when you’re 92, and not the end of the world).

Even really poor investment returns don’t change that answer too much: lowering stock and fixed income returns by a full percent lowers the out-of-money age to 84; lowering stock returns right to 0% only brings it down to 80 — younger than many may expect to live, but zero nominal stock market returns for that long is, IMHO, needlessly pessimistic. So in that scenario you’re fairly insensitive to market returns.

Inflation, however, can be a killer. If your personal inflation rate is just 1% above that the pensions are linked to, your capital gets burned through at 80 instead of 92. At a personal inflation rate of 2% above the indexed rate someone in this situation may not want to consider taking retirement at the age 60 assumed in the scenario, since they’ll be facing shortfalls by age 75.

For someone without the pension, more personal assets might be needed to fund retirement. Let’s say that we had a similar base case: $45k/year spending needs, same CPP/OAS for the couple, but put off retirement until age 65, and an extra $100k of assets (all in the RRSP, for a total of $400k there). In this case, the person would make it to age 95 with their assets using the base assumptions (2.5% inflation for both inflation boxes, 6% nominal stock returns, 2.25% nominal fixed income). Personal inflation changes still have an effect: a 1% increase over CPI reduces the age of security to 87, and 2% to 82; but the effect is not as severe as when you were watching the buying power of your pension disappear under those inflation assumptions. And, if your investment returns increase by even half the increase in your personal inflation rate (e.g., by investing in companies based in the sectors that make the things you spend most on), then there’s hardly any pain at all.

If even more of your income is tied to the market, then so too will be your ability to retire.

I made a little document with a paragraph or two for each scenario, gave them names, and also discussed how likely they might be to occur — or perhaps more importantly, to work out that way or better. I focused mainly on the scenarios I thought were less likely: for instance, I think 2% real returns on stocks will likely be on the low side, but it’s more important to have a conservative plan for poor returns like that than it is to focus on more likely cases (say, 4+%/year) and be disappointed by reality. The next decade may very well bring extraordinary investment returns, following this previous decade of underwhelming ones. But hope and optimism are not a plan.

Since selling the house to fund retirement was not to be part of the plan for taking early retirement in my friends’ case, I didn’t explicitly build it into the tool. But if you’re close to retirement and using this tool, you could easily consider the case where you sell the house right away (either to downsize or rent): just adjust the annual spending budget accordingly, and increase the investments. Or, to consider the case where you sell it (or some other personal asset like a cottage) you can go to the calculations tab and change the line for the age where you sell it, and add in the extra assets. For instance, if the calculator says your retirement will be squeezed by age 78 under some scenarios, you may think that’s a perfectly fine outcome since the tool isn’t taking into account other assets that you have the option of selling at that point.

Also remember that financial planning isn’t a one-and-done exercise: it’s important to review your plan periodically to see how well you’re sticking to it, and how the world around you is unfolding relative to what you assumed. Then to make course corrections as necessary to keep moving towards your target.