Monday, November 23, 2015

How Much Do You Need to Save to Retire?

Just poke around the internet for a while looking for answers to how much money you need to save before you retire and you’ll get answers ranging from next to nothing up to $3 million or more. It looks like some of them must be wrong, but it all comes down to your spending and pensions.

Let’s take an example. A Canadian couple, Mary and Bill, are both 65, have no debts, have no workplace pension, and are about to retire. They both worked enough to get maximum CPP benefits. Together they can expect CPP plus OAS of $3200 per month rising with inflation.

Suppose that $3200 is enough to cover their spending. Then the total savings they need is zero. Nada. Zilch. It can be dangerous to count on being able to work until age 65, to count on maximum CPP benefits, and to assume you can live on $3200 per month, but now that Mary and Bill have made it to 65, they need no savings beyond a modest emergency fund.

What happens if Mary and Bill have a more expensive lifestyle? Let’s say their spending is double their government pensions, $6400 per month after income taxes. Based on a series of assumptions, I work out that they need about $1.1 million in savings. This is hugely different from the first case where they needed no savings.

Let’s take it one step further and see what happens if they want to spend triple their government pensions, or $9600 per month after income taxes. Again, based on several assumptions, I calculate that they need about $2.4 million in savings.

No doubt others would calculate different amounts of savings needed to support the larger spending levels, but the point is that the need for millions of dollars in savings to retire comes from spending more than your pensions.

If you can live on your available inflation-indexed pensions, then you don’t need savings. If you need more money than this, your savings needs climb quickly. How much you need to save is so sensitive to how much you spend that we should never expect consensus among experts on how much you need to save.

Friday, November 20, 2015

Short Takes: Stock Return Expectations, Bond Index Criticisms, and more

Here are my posts for the past two weeks:

Enough Bull

Retirement Spending Stages

Choosing Investments You Understand

Taking My Investment Decisions Out of the Loop

Here are some short takes and some weekend reading:

Jonathan Clements explains why stock investors should expect about 6% return per year and 2% inflation for the next 10 years. A 4% real return sounds just fine to me. I’m not sure why we “need to save like crazy to compensate for the market’s likely modest gains.” However, I’m definitely with him that investors “should make sure they capture as much of those gains as possible, by opting for low-cost market-tracking index funds.”

Canadian Couch Potato explains why certain criticisms of bond indexes are wrong.

Larry Swedroe explains how some funds “juice” their dividends to exploit some investors’ preference for dividends over other types of returns.

Tom Bradley at Steadyhand adds to my list of complaints about index-linked GICs.

Jonathan Chevreau explains that Real-Return bonds aren’t as safe as they appear because it’s difficult to match their maturities to when you’ll need to spend your money.

Dan Hallett has an optimistic view of what will happen when new disclosure rules for financial advisors kick in. I hope he’s right.

Squawkfox uses her foray into gourmet olives to motivate us to track our spending. It can be an eye-opener to see where the money goes.

Big Cajun Man explains the latest step he’s had to take so that CRA will continue to recognize his son’s disability.

Million Dollar Journey says the easiest way to save money is to examine your biggest expenses.

Gail Vaz-Oxlade summarizes what you need to do to be ready to begin investing. Once again I meet all of her criteria except for “If you’re not living on a budget you’re not ready.”

Boomer and Echo helps a reader deal with RRSP over-contributions.

My Own Advisor tests himself on Gail Vaz-Oxlade’s 9 major money mistakes. He definitely gets a passing grade. But, like me, he doesn’t have a budget. I’m always torn talking about this because I see no need to have a budget myself, but I know others who desperately need one but don’t have one.

The Blunt Bean Counter has a guest expert explaining estate planning for blended families who have a marriage contract and others who don’t have a marriage contract.

Wednesday, November 18, 2015

Taking My Investment Decisions Out of the Loop

All the evidence says that the vast majority of us aren’t good active investors. Our choices tend to be worse than random, and we pay investment costs on top of this. Even index investors can have these problems. Here I explain how I’ve tried to automate my investment decisions as much as possible to take myself out of the loop.

Investors have many worries. Is now a good time to be buying stocks? Should I be selling now? Are there better mutual funds than the ones I own now? Should I shift more money into bonds? Less?

Unfortunately, the evidence shows that most of us make worse than random choices when we try to answer these questions. It’s tough to admit that we can’t beat a coin flip.

My response to this dilemma is to ignore my opinions on the market and invest in indexes. And as long as I’m not trying to beat the market, I maximize my returns with low-cost highly-diversified index ETFs.

But even after making this decision, investment choices can creep back in. For example, when adding new money, which ETF should you buy? I automate this choice using a fixed asset allocation. I have a target percentage of my portfolio for each ETF I own. When I have new savings to invest, I buy those ETFs that are below my target percentage.

Another investment choice that can creep back in relates to rebalancing. If my ETFs have different returns, my portfolio’s percentages can get out of balance too much to fix when I add new money. However, if I use my judgment on when to rebalance, I’m effectively making an active decision. So, I have a method to compute rebalancing thresholds. If my percentages get outside a range computed in my portfolio spreadsheet, then I rebalance.

This leads us to the next subtle form of decision-making. If I bury my head in the sand instead of paying attention to my spreadsheet, I’m effectively overriding the spreadsheet’s decision and substituting my own active decision. This is a common problem because many of us can’t bear the thought of selling an investment that has gone up to buy one that has gone down recently. I deal with this problem by having my spreadsheet send me an email with rebalancing instructions. I get these rarely, but always act on them.

The next area where my own discretion sneaks in is with new money. Over time I accumulate dividends and build savings in the various accounts that make up my portfolio. I have to decide when to invest this cash. In this case, I again let my spreadsheet decide. I have a formula for balancing trading costs against the opportunity cost of sitting on cash. This results in a cash-level threshold for each account. If the spreadsheet tells me the cash level in any account goes over its threshold, it’s time to buy.

I don’t believe the advice to “trust your gut” works well in investing. The evidence says your gut isn’t worth much. No doubt there are other subtle ways that my own decisions worm their way into my portfolio, but I believe I’ve managed to keep myself almost completely out of the loop, just the way I want it.

Monday, November 16, 2015

Choosing Investments You Understand

Some very common advice is to only invest in things you understand. It’s certainly a good idea to avoid investments you don’t understand, but it’s all too easy for a salesperson to give you the illusion of understanding. For this reason, I doubt it helps people much to tell them to choose investments they understand.

Let’s take the example of mutual funds. Suppose a financially naive young couple hear the following pitch:
“A mutual fund is a pool of money invested by expert money managers in stocks and bonds. We have a collection of 5 diversified funds that returned 9% per year over the past 5 years. If you start contributing $500 per month into your RRSP and increase this as your pay increases, then a 9% return will give you over a million dollars in 30 years.”
What’s not to understand about this? Our young couple will feel safe checking off the “make sure you understand the investment” item on their checklist. More experienced investors will know this couple doesn’t really understand, but the couple won’t know this.

Let’s try pitching an even more dubious product, index-linked GICs:
“The stock market has the potential for big gains and GICs provide safety. We’ve found a way to combine them to get the best of both worlds. If stock markets perform well, our index-linked GICs give higher returns than regular GICs, and if the stock markets crash, your principal is 100% guaranteed.”
Again, this explanation gives the illusion of understanding to naive investors. More sophisticated investors know that there is hidden bad news in index-linked GIC interest formulas, but naive investors don’t know this. They have a nice tidy story that feels easy to understand.

The sad truth is that a lot of advice like “invest in what you understand” and “get a good financial advisor” is difficult to follow without more financial savvy than most people have.

Wednesday, November 11, 2015

Retirement Spending Stages

It’s definitely true that most people’s retirement spending declines as they age. Financial Planners tell a story of how this reduction in spending is natural and that you should plan for it in your own retirement. Here I tell a different story that leads to a different conclusion.

Certified Financial Planner Roger Whitney captures the usual story of the three stages of retirement clearly:
“In the ‘go go’ years of retirement, your spending may be at its peak. This is the time for travel, activities, adventures and family.

In the ‘slow go’ years, your spending may slow as you become more settled.

In the ‘no go’ years, you may spend even less as you settle in even more.”
This sounds so logical that it’s easy to accept the advice to spend a lot in your early retirement years. But let’s analyze this a little further.

Let’s call these stages, the 60s, 70s, and 80s. Will you really want to start cutting spending when you’re only 70? It’s true that, on average, people do begin to spend less when they’re this young, but why? I can understand being less adventurous at 85, but why only 70?

Let’s try a completely different story to explain the drop in spending:
In the ‘dumb-dumb’ early years of retirement, people see their big pots of savings and spend too much. Even if they try to stick to a reasonable spending level, they tend to dip into principal for larger items like fixing a roof, replacing a car, or helping an adult child.

In the ‘uh-oh’ years, people realize they’re spending too fast and begin to cut back.

In the ‘oh well’ years, there is little money left and people live on their government benefits and any pension streams they may have.
Obviously, this narrative doesn’t apply to everyone, but it does apply to many, which skews all the spending statistics. If spending less were a common choice, then planning for it would make sense. But if it’s forced on retirees because of overspending, then it makes no sense to bake it into your plans.

The next time someone tells you to be like everyone else and plan for peak spending in early retirement, what you should hear is that most other people spend themselves poor in early retirement, so you should too.