The 5% Ask: A Common Misconception for Sustainable Retirement Income | August 9th, 2021
You’ve worked hard for many years and likely have some retirement plans that you’ve been looking forward to for just as long. Part of planning for retirement is understanding your personal financial situation: what are your retirement income needs and how can you ensure you have adequate savings to carry you through retirement?
There is a lot of confusing and contradicting information out there, and one common misconception is the ’5% retirement income ask.’
What is the 5% Retirement Income Ask?
As wealth advisors, we are commonly asked by those planning their retirement if they will be able to keep their nest egg intact while drawing an income from it. It’s a question we’ve heard it many times:
“I have $2 million saved for retirement and I want $100,000 (5% of capital) of pre-tax annual income, — can I take that income without encroaching on my capital?”
The logic behind this question is that if a retiree could expect an average return of 5%, and they only withdraw 5% annually, it is assumed that they would be left with their initial capital intact throughout retirement. On the surface, this seems logical, but is not necessarily true. Let’s take a closer look at an example together.
Example – the misconception:
Retirement capital available: $2,000,000
Retirement average return (%): 5%
Retirement average return ($): $100,000
Retirement income ($): $100,000
In this example, if the portfolio returned $100,000 every year someone could theoretically expect that same amount in retirement income without encroaching on their retirement capital.
So why is this approach flawed? There are three main factors that challenge this simple approach:
- Sequence of returns in a variable market
- The impact of inflation on your income requirements
- Anticipated longevity to ensure adequate funds
Sequence of Returns in a Variable Market
An average return of 5% does not mean that every year the portfolio returns 5% as market returns are variable.
Three different scenarios are shown in the graph below to help visualize the variable outcomes for the same initial retirement capital. The first where the market returns are 5% every year. The second and third scenarios both show the same variability of returns, but inversed from each other (year one is -18% for scenario two, whereas year 10 is -18% for scenario three). Both average an annualized return of 5%, however, their outcomes are significantly different.
In scenario two, due to negative returns in the earlier years, the portfolio is not able to recover. With a -18% return, the portfolio drops by $360,000 due to the markets in year one. Additionally, the retiree withdraws $100,000 that same year bringing their portfolio down $460,000. It takes years for the portfolio to recover but it never regains the $2,000,000 initial capital.
Contrast this with scenario three, where through good fortune, this retiree starts retirement with positive returns. After 10 years of an average annualized return of 5%, this retiree has more money than they started with.
The sequence of returns in retirement matter. A prudent retirement plan should take into consideration “what-if” scenarios should the markets correct earlier on in retirement.
Impact of Inflation on Your Income Requirements
Inflation has been low for years due to long term productivity gains and global outsourcing trends. There has been much debate lately about whether the current signs of increased inflation are transitory or whether they will be more persistent. Regardless, inflation strains portfolios as income requirements need to increase as inflation does. For example, with 3% inflation, a $100,000 retirement income will need be $130,477.32 in ten years. In twenty years, this income will need be $176,055.19 to compensate for inflation. Imagine the portfolio is still returning 5% per year on average, the income needs are now significantly exceeding the growth of the portfolio on average and putting further stress on the retirement pool. When compensating for inflation, it makes sense to reduce retirement income expectations.
Anticipated Longevity to Ensure Adequate Funds
Many Canadians should plan to live in retirement for 30 years or more, depending on when they retire. With an increased life expectancy, it is appropriate for a retirement plan to assume that an individual may live to age 95. The longer this individual requires income in retirement the more risk there is to the portfolio. A simple example to explain this is to imagine our retiree knows they only need income for five years. They have $2,000,000 invested and require $100,000 of income annually. This goal would be considered very practical and achievable, in fact, it would be challenging to find a scenario where this client would have any difficulty in accomplishing this goal. However, imagine this client needs the same income (with inflation adjustments) for 40 years (for example, if they retired when they were 55). This becomes much more challenging and the risk of running out of money significantly increases.
So, How Do You Make Your Plan Considering These Factors? We Can Help.
The Tall Oak Private Wealth proprietary Retirement VIEW model was specifically built to stress test retirement by looking at 10,000 different potential market outcomes. It presents the ability to model different time frames and different inflation expectations. We work with our clients to assist them in knowing their retirement number and ensuring we manage it along the way. Let’s redirect the question from the 5% retirement income ask, to be every retiree’s main concern: “Am I okay?” – With our help, you’ll be able to answer that question by confidentially saying “YES.”
If you would like to hear more about our Retirement VIEW, please click here to schedule a no pressure complimentary discovery call.
Tall Oak Private Wealth (Written by Mehendi Kamani, CFP®, CLU, CIM®)
This material is provided for general information and is subject to change without notice. Although every effort has been made to compile this material from reliable sources; no warranty can be made as to its accuracy or completeness, and we assume no responsibility for any reliance upon it. Before acting on any of the above, please contact Tall Oak Private Wealth of Raymond James Ltd., for individual financial advice based on your personal circumstances. Raymond James Ltd. - Member - Canadian Investor Protection Fund. Insurance offered through Raymond James Financial Planning Ltd., not a member - Canadian Investor Protection Fund.