What if you could spend more now, knowing your retirement is secure
Brendan Greenwood, CFP, CIM, B.Comm | January 16, 2023
Most of us need to save something for retirement, but do we really need to save as much as the financial industry often states? How much we save now in anticipation of our needs in the future really is a balancing act. If you save more now, you sacrifice your current lifestyle for a more comfortable future. But maybe you want to live a little better now and are not sure how that might impact your tomorrow. Having an idea how much of your pre-retirement income you’ll need in retirement will give you better idea of how much you need to save. We call this the pre-retirement gross income replacement ratio.
Financial institutions have traditionally targeted a 70% pre-retirement gross income replacement rate for retirement income. The 70% replacement rate approximates the income needed to sustain a 100% consumption replacement rate in retirement. But skeptics question if this target goes well beyond what is generally spent or needed by retirees.
There is evidence that Canada’s major banks along with some pension managers are over stating gross replacement rates needed. The Fraser Institute, in a paper titled, The Reality of Retirement Income in Canada, notes that public service pension plans are generally more richly funded than private sector plans, with the majority replacing 70% of pre-retirement gross income. This level of funding has led public servants to retiring on average 4 years earlier than their private sector counterparts, suggesting a replacement rate that is higher than necessary.
It’s not a mystery why Canada’s major banks and pension fund managers would inflate the level of replacement income retirees need. It’s self-serving for them to do so. A higher ratio leads to greater funding for their plans with more assets to manage and income earned.
The chart below from Bonnie-Jeanne MacDonald, PhD and director of Financial Security Research at the National Institute of Ageing, at Toronto Metropolitan University reviews annual earnings of an individual from age 55 to 64 and how the money is typically spent. Income gradually rises throughout their peak earning years from just over $100,000 to about $135,000 just before retirement. In analyzing the chart there are two major costs, child-related costs and mortgage payments that consume about a third of all earnings while children are in post secondary programs. These costs disappear in retirement, and in this example at age 62, increasing the amount available for regular spending and ultimately raising the individual’s lifestyle. In looking at the final bar at age 64 before retirement, work-related costs, CPP & EI deductions and saving will cease. Taxes will be lower due to lower spending needs in retirement.
For middle to upper income individuals, earning $120,000 to $150,000, the pre-retirement gross income replacement ratio is closer to the 50 – 60% range. The chart below published in a research paper by Jack M. Mintz on Retirement Income Adequacy displays estimates of income replacement rates based on average savings for Canadians with different levels of income. The key takeaway is that those earning less in their pre-retirement years will have a higher pre-retirement income replacement ratio with most of the replacement income coming from government benefits. As the level of pre-retirement earnings rise the ratio of replacement income needed in retirement falls and at $150,000, it is closer to 50%.
Why your pre-retirement income replacement ratio could be even lower..
There is evidence that on average consumption declines in the later retirement years. As we get older priorities may change. While travel may be more important in early retirement, spending time with family and grandchildren may become a greater priority in your golden years, reducing consumption. Malcom Hamilton in his paper, The Financial Circumstances of Elderly Canadians and the Implication for Canada’s Retirement Income System, documented that older seniors save more than younger seniors revealing that they may have the income to maintain spending, but choose instead to save more. Looking at a Statistics Canada Survey of Consumer Spending, he notes that people over 85 years old saved or gave away 18.6% of net income, a substantial cushion to absorb unexpected financial shocks without impacting their standard of living. This frugality in old age could be the result of lower mobility, worries about future medical costs and perhaps the desire to pass on an inheritance.
The evidence above suggests a declining income replacement rate as we age, which would result in a lower overall average income replacement rate for retirees, possibly lower than 50% depending on how much you were earning pre-retirement. The goal of this article is to provide you with a realistic benchmark for how much of your pre-retirement earnings are needed to maintain your standard of living in retirement. Your income replacement ratio may increase depending on your goals. A good financial advisor can help develop a balanced plan that considers your desire to live well both now and in the future.
Brendan Greenwood is an Investment Advisor and Financial Planner with Worldsource Securities Inc. focused on improving the lives of his clients and their families through holistic planning. He specializes in tax advantaged personal pension strategies and leveraging technology to provide progressive institutional style investment solutions for professionals, incorporated individuals, business owners, retirees and their families.
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