Mindful Spending Plans and the 4% Rule
Do you have the means to do what you want to do and how do you figure that out? Well, in order to know if you have the money to do what you want to do in retirement, you have to know what you’re going to spend doing what you want to do.
When someone comes to me for advice for the first time, it’s usually to ask me when can they retire...can they retire now? To which, I reply, I don’t know. Can you?
Now, that may seem to be a flippant remark, but my point is this: So often, we hear in the media, “Oh, everyone needs a million dollars to retire, or 2 million.” No, they don’t. Everyone’s journey --after they’ve spent years raising their children and working various careers--their journey is unique to them. And the only way to know if they have enough money to fund that journey, to pay for their new life in retirement, is to find out how much they are going to spend, right? Just like, if you’re calculating how much money you need to save for your children’s college or trade school education, you look at the cost of tuition for the school they want to go to, you look at the room and board, you start with those costs, then you figure out how much you need to save and go from there. So, if someone tells me they have a million dollars saved and asks me can they retire, I don’t have enough information yet to give them an answer.
So, let’s figure out the answer together.
What’s Inside?
Prefer to Listen?Here’s the podcast episode!
Rather Read All About It?How much will you spend in retirement?
One rule of thumb that has been used in the past to estimate the amount of money you’ll spend in retirement is to take 60 to 80% of the monthly income you have before retirement and use that as the monthly income figure you’ll need after retirement.
However, there’s been new research to show you may not even need that much. Do you remember Bill Morneau, the former Finance Minister? Before he became Finance Minister, he co-wrote a book with Actuary Fred Vettese called “The Real Retirement.” Their research debunked the myth that most Canadians need to create a retirement income that is 60% to 80% of the monthly income they earned when they were working. They found that most Canadians can maintain the same lifestyle with only half of the monthly income they earned when they were working.
Now, why is that? Let’s consider a few things: When you are working, you spend a lot of your earnings on expenses you won’t need in retirement. Long commutes, child rearing….hey, hockey and soccer camp are expensive! You don’t need work clothing and other business expenses.
Many of us experienced this first hand during the pandemic, when we started working from home and not going anywhere. Many Canadians started saving a lot more money because they weren’t going out for lunch or commuting to a job. In retirement, you also likely have a mortgage that will have been paid off or at least paid down by the time you retire and generally, you’re in a lower income tax bracket because you aren’t earning money anymore, so you have less taxes to pay. Plus, when you’re working, you’re putting away money for savings...And what are you saving for? For your retirement! That also goes away once you’re retired. So, for most people, many expenses will go away or be greatly reduced after retirement.
So, you may very well be able to live comfortably in retirement on half the earnings you had when you were working. But, let me make this clear...estimates and percentages aren’t a good method to use when you’re thinking of downsizing and retiring in the next few years. That might work if you’re not retiring for 20 years but when you’re retiring next year, you really need to get more specific data.
A wise client once told me, “I’ve finally come to the realization that I can have anything I want in life, I just can’t have everything I want.”
Now, let me say as an aside here…When describing your expenses, I prefer to use the term “Mindful Spending Plan.” rather than using the word “budget.” That term isn’t just spin, it emphasizes the fact that you have power over your future. It speaks to the fact that you have choices in what is important in your life and therefore what you spend your money on.
A wise client once told me, “I’ve finally come to the realization that I can have anything I want in life, I just can’t have everything I want.”
Start with one month of expenses
Let’s use the example of my client, we’ll call her Maria. Maria was planning on retiring the following year.
[Group yay]
I know, it’s very exciting! So, since she’s retiring the following year, she doesn’t have 20 years until she retires, so she needed to get some specific data. She wanted to know if she had the means to do it. What’s it going to cost for her to live in retirement? The first thing I had her do before we could figure out when she’d be able to cut the cord and retire was to figure out what her current annual household expenses were. And, as we will see later, it’s important to break down your expenses into categories, like, food, utilities, transportation. And total the categories, rather than having all your expenses lumped together--- You don’t want to do that. Break them down because you’ll need that later.
So, I sent her home with homework. She was to come back with a list of one month’s worth of household expenses.
Now, there’s a lot of tools that can help Maria do this. She can use a tool such as the Ontario Security Commission’s Get Smarter About Money budgeting tool. She can use the online version, or just print it out and fill it in by hand.
She can use an app such as Mint.com, that’s a tool made by the same company that offers TurboTax. I like this tool a lot, it automatically tracks your expenditures and categorizes them for you.
Most of my clients simply print out the Get Smarter About Money worksheet and fill it in by hand by going back into their banking statements and credit card statements and putting all their expenses into categories. Or, they create their own, that’s fine.
So, once Maria had this information--a month’s worth of expenses--she went through and crossed off all the expenses that she wouldn’t be spending money on during her first year of retirement. She didn’t have to think about the next 30 years, just what she will need during her first year after she retires. This is why we need those individual expense categories, so she could figure out what expenses she wouldn’t need during her first year of retirement. So, in her case, right away, she knew she’ll be spending less money eating out, less money on petrol, and she went through the list and started cutting those expenses out that she wouldn’t need her first year.
Your first year in retirement
Next, now that Maria knew what she wouldn’t be spending money on during her first year of retirement, what would she be spending money on that she should add to her current annual expenses? She’s not going to be working, but maybe the money she sets aside for hobbies and sports may go up. If she lives in British Columbia and is over 65, she may be able to reduce her property taxes and she plans to have her mortgage paid off before she retires, so those go away, but she may have higher travel expenses. She may not be at home as often. She may need a house sitter.
So, to summarize, Maria wrote down her current annual expenses for the current year, scratched out the expenses she wouldn’t need during the first year after she retires and added any expenses she’d be increasing during the first year after she retires.
What about future years?
Maria now had a spending plan for her first year of retirement. What about all the future years of retirement after her first year?
Research has found that expenses in our late 60’s are usually much higher than they are in our 80’s. In our 60’s and 70’s, we are traveling more, visiting grandchildren and checking off our bucket list as fast as we can. By the time we reach our 80’s, most people--not everyone, but most-- have sort of “been there, done that,” and are content to stay at home more often. However, research shows that out-of-pocket health care costs go up in our 80’s and particularly in our 90’s.
So, to figure out future income needs for Maria, she and I discussed her health, travel plans, planned giving and other goals. Then, we created a spending plan for each year of her retirement, accounting for these goals. We also took into account variables such as inflation and longevity. We don’t need to be perfect. This is not a one-and-done process. She and I and my team will work together over the years with her family as things change.
The 4% Rule
So, Maria now knows how much income she’ll need to last through her retirement. But, did she have enough savings to pay herself throughout retirement? I then returned to my calculator again, examining how much her investments were expected to earn.
Now my analysis takes hours to complete. However, if you want to estimate how much savings you’ll need to fund your retirement, you can try applying the 4% Rule.
What is the 4% rule? The 4% rule was discovered by former financial advisor and aerospace engineer, William Bengen. Assuming you invest your portfolio in half stock funds and half bond funds, Bengen found that if you withdraw 4% from your portfolio the first year of retirement and adjust that 4% by inflation every year thereafter, your money should last at least 30 years.
How can you use the 4% rule to know how much money you need in order to retire? If you were Maria and wanted to use the 4% rule, you would know that your expenses in retirement would be $4,000 per month. You would have some retirement income coming in to help pay for that, she had government benefits plus her teacher’s pension, and those will cover $2,500 of the $4,000 per month she needs. So, you would need to make up the $1,500 per month difference with savings. That’s an annual amount of $18,000. We take that information and calculate how much money you need to have saved before you could retire:
$18,000 ÷ 4% = $450,000
[cash register bell]
So, if Maria just wanted to do a quick back of the envelope calculation, she could try using the 4% rule, and it would show that she needs to have $450,000 saved in order to be able to support her lifestyle in retirement. She could have that in her RRSP, her investment account, GICs, whatever. She just needs to have $450,000 in savings by the time she retires. That doesn’t take into account inflation, personal preferences, estate needs and taxes. It also assumes she wants to pass on $450,000 to her estate. If that’s not important to you, we have a different calculation. That’s another place where a financial advisor can help. But it’s a start.
So, to do this for yourself, take the annual amount of expenses you need that isn’t covered by some other source of income, divide it by 4% and that will equal the amount you need to save in order to retire.
If you go through this exercise yourself and you find you don’t have enough money to create an income for yourself in retirement, don’t fret, there’s a lot you can do to reduce your expenses in retirement. And a lot you can do to save money if you put your mind to it. The right Financial Advisor can certainly help you be accountable to yourself.
Knowledge is power
Here’s the bottom line. Whether or not you have plenty of savings to provide an income for yourself in retirement or you still have more saving to do, knowing where you stand will empower you to prepare for this exciting time of life.
So, how did you do when you calculated your 4%? Are you all set to retire? Or, do you need more time to achieve your goal? Send me an email at hello@womenswealth.ca and let me know what you think.
Next time, we’ll wrap up our Downsizing Series by getting down to brass tacks, making the move and what happens for you in this new chapter. I’m excited for you, you’re doing great!
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