Some of the posts made by Canadian Dream on early retirement got me thinking about how much of an nest egg Gen-Xers (and younger people) would need to retire early. I just turned thirty-three myself and I have a vague notion of retiring some time after I turn fifty but to be honest I haven’t given it much thought.
In calculating my retirement number, I would not count on receiving any benefits from Old Age Security. OAS is paid out of general government revenues and who knows in what form the program will survive (if at all) three decades from now.
It is a fairly good bet that the Canada Pension Plan will pay out some benefits, but again I would prefer not to count on it. First, early retirees are unlikely to get full CPP benefit. Second, it is possible that some future government will raid the CPP to the detriment of beneficiaries.
Many financial planners recommend a 4% withdrawal rate for people who retire at the traditional age of 65. For early retirees, this rate would be far too optimistic, as their capital should withstand the ravages of inflation for up to 40 years.
Let’s assume that retirees need a capital of 25 times annual expenses for the traditional retirement at 65. Early retirees need to bridge the gap between their retirement age and 65 and let’s conservatively estimate that living expenses are paid by consuming capital (assuming no growth). Under these assumptions, if my annual expenses is $x and my average tax rate is ATR, a rough stab at the nest egg required would be (assuming a 3% actual rate of return over inflation and discounting 25 by 10 years):
Nest Egg Required = (18 + [65 - early retirement age])*x / (1 - ATR)
Let’s say I want to retire at 55 and my average annual expenses in retirement would be $40,000 (in future dollars) and my average tax rate is 15%, then I would need a nest egg of $1.36 million. Of course, it is a big number but it is probably a bit on the conservative side. Note that you might need less if you plan to work a little bit during retirement or if you are more confident than I am that government benefits are ironclad.
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20 responses so far ↓
1 Chris // Dec 5, 2006 at 7:59 am
CC,
Since we’re close in age (I’m 32), I’ll share what I have done. I just paid off the family home only because of a strict saving and investing policy I started at age 18. Although I am facing a modest tax bill this year for CG, I felt it was worth doing as the market feels optimistic and I don’t see it that way. The next step will be to use my old mortgage payment plus the former savings rate for retirement investments. Although, I will not retirement permanently, I am going to start working part-time at age 45. My wife is still raising the kids and will likely continue part-time work as well. To reach this goal, I need to achieve 750,000 in funds. I only buy dividend growth stocks from across the world. Foreign stuff is in the RRSP and Cdn content outside. The dividend income will supplement our lifestyle. Everything is held in joint tenancy to prevent the CCRA from getting their share if someone passes on.
2 StingyJoe // Dec 5, 2006 at 8:09 am
Chris, sounds like you should have a blog of your own.
Capitalist, great post by the way. Very informative. In terms of retirement, I always just used the 4% or multiply desired earnings at retirement by 25. I never really thought about the extra requirements if you retire early.
Joe
http://www.StingyFinance.com
3 JD // Dec 5, 2006 at 9:32 am
$40K in future dollars means what exactly?
4 0xcc // Dec 5, 2006 at 9:52 am
(JD: $40k in future dollars means $40k after accounting for inflation. So if inflation is 2.5% a year and the ‘future’ is 1 year away $40k in today’s dollars would be 2.5% less than $40k or $39k, 2.5% of $40k is $1k)
I think Chris has it nailed. I’m 34 (as of two weeks ago) and I am planning to have the house paid off in 4 years (although I could sell about 50% of my non-RSP investments today, pay capital gains on them and pay off the mortgage, the 4.55% I’m paying on the mortgage is less than what I think I can make in the market). After that the former mortgage payments will be going into investing.
I also think that if you have your portfolio structured properly you should be able to withdraw 3% a year and have that withdrawal amount grow with inflation without drawing down capital. If you do what Chris is doing (and what I am doing) and have Canadian diviend paying stock outside your RSP and everything else that gets treated as income (interest, non-Canadian dividend paying companies, some income trust distributions) inside your RSP the income your portfolio generates should grow at a rate higher than inflation and you should pay less tax than if you were taking all your income out of your RSP.
5 0xcc // Dec 5, 2006 at 10:11 am
My inflation calculation was a little bit off, a 2.5% inflation rate would mean that what $40k buys a year from now would cost about $39,024.40 today, not an even $39k…
6 Canadian Dream // Dec 5, 2006 at 10:30 am
Chris - WAY TO GO! Your further along that me in my plan to at least semi-retire at 45.
CC - My goodness that is a US style retirement calculation and a bit too conservative for my taste. I think that you ignoring CPP is a bit of mistake. The government can’t raid the money, because the moved it to a separate fund with its own board. Also in my Retirement Calculations Part I post I have a link to an online calculator which allows you to calculate a CPP pension with a person stopping work at age 45. So my numbers do reflect the fact I’m going to stop working 20 years early. Also that 4% withdrawal rate does work well for a 40 year time frame. Try playing around with the calculator at http://www.fireseeker.com, you can have fun trying to kill off your nest egg with the great depression. I know that my retirement calculations are not perfect and I’m assuming some risk, but I think you took yours a bit too far the other way. Thanks for your post, you’ve given me a few ideas for a couple of posts.
7 Canadian Capitalist // Dec 5, 2006 at 11:33 am
Chris: Congratulations! You are well on your way. IMO, paying off the mortgage is a huge first step.
CD: We will just have to differ about relying on CPP. Note that the current government has made two attempts to test the firewall between the CPP and general revenues. One, they made a suggestion that surpluses should be plowed into the CPP. If they do it, the money could very well flow in the other direction someday. Second, in the fiscal update, they counted the CPP surplus to arrive at the net debt. My point is it is difficult to raid the CPP but not impossible.
You may need less than my estimate if you plan to work part-time. In my opinion, people underestimate the amount of capital they require when they retire.
0xcc: I agree that Chris and you have the correct method (Dividends tend to keep up with inflation). I’ll also agree with your 3% dividend yield estimate. But guess what? My $1.34 million estimate at 3% will yield $40,200 per year! Focusing on the nest egg or the cash flow is really two ways of looking at the same thing.
8 Canadian Capitalist // Dec 5, 2006 at 12:13 pm
CD: Where can I find the calculator that reflects CPP benefits if I stop working at 45? Thanks.
9 0xcc // Dec 5, 2006 at 12:55 pm
CPP Calulator I think can be found here:
https://srv260.hrdc-drhc.gc.ca/English-App/INT_01.asp
10 Canadian Dream // Dec 5, 2006 at 1:49 pm
Oxcc & CC,
That’s the one. You enter in all your information and the say “Yes” to changing your future earnings on CPP. From there you can play with dates of when you stop working.
CD
11 Rob // Dec 5, 2006 at 1:53 pm
I would say a 33 year old now will receive a CPP pension - but this income will be taxed back similar to how OAS clawbacks work now. Therefore, factor it in at your own risk.
As for your future income needs… Am I following you guys correctly here? $40,000 of income in 32 years time (if you are retiring at 65 and at 33 now, 65-33=32) discounted at an assumed inflation rate of say 3% is…
FV = $40,000
n = 32
i = 3%
PV = 15,533.48
$15,533.48 is not much of a lifestyle - this would barely cover food, property taxes, and some basic utilities - better not need medical care or anything.
At 4% inflation (personally what I feel it will be at the very least), the PV is $11,402.32 - even less. I don’t know anyone who could get by on this.
It is great to be thinking it out and developing formulas but I think the input variables on these formulas require some more consideration. I think a true number may require a more comprehensive spreadsheet as opposed to a factor equation.
12 0xcc // Dec 5, 2006 at 2:19 pm
I would agree that $40k in 32 years won’t be enough to live on. $40k (after tax) in today’s dollars assuming there are no mortgage payments to make or investments to be made (afterall we are talking about retirement) should be enough to live on.
CC: As for the difference between cashflow and nest egg, I think that for the most part they are different ways of looking at the same thing with some minor exceptions. If you have the right companies in your portfolio the income from your portfolio and the market value of your portfolio don’t have to have a direct relationship. So if we have some big 1987 or 1929 size correction in the market if you are relying only on the income from your portfolio (and not taking out any capital) then you should be feeling pretty comfortable in a correction. If you are relying on withdrawing capital then a correction could cause a big problem (depending on the size of the correction and the amount of time you have to make the portfolio last).
I also think it is easier to grow your portfolio’s income than it is to grow your portfolio’s value. Most of the companies that I am investing in have a long history of increasing their dividends. I like to look for companies that over the last 7+ years have increased their dividends on average more than 10% on an annual basis. These companies aren’t too hard to find. In 2006 I have added about 50% to my portfolio in additional cash. The income from my portfolio over 2005 has increased almost 200% which has happened through a combination of companies increasing their dividends and me buying other companies and also re-investing some dividends.
13 Canadian Dream // Dec 5, 2006 at 2:59 pm
Rob - You hit it on the head, you need a spreadsheet to work this one out effectively. I have a crude one that I used to come up with my number, but you will have to build your own to account for your personal assumptions.
Speaking of which I wrote a new post with my assumptions.
CD
14 Canadian Capitalist // Dec 5, 2006 at 4:08 pm
Rob: That would be $40K when I am 55, so it is something like $20K today at 3% inflation. You are right that that’s not very much to live on. Looks like it is much easier to earn a bit of money from a part-time job than to generate income from your capital.
15 Phil S // Dec 5, 2006 at 5:02 pm
I always say that the way to guarantee that you’ll live to be 100 is by NOT saving for retirement. And working people who save millions for retirement seem to die before age 64, probably by working themselves to death. The only indication that you’ve working things out perfectly is when the only cheque you bounce is for the mortuary.
I’m 38 turning 39 shortly and am not counting on CPP or OAS to be in place when I’m done. I am also assuming that I’ll never retire, but I hope to eventually own a small business that I enjoy going to every day (I’m still a working slob right now, though) and earning a modest income. And why should a retirement be reserved for when you’re old? I say you need to enjoy some of your life now while you’re still young enough to be active - you can always work until you’re dead. Because on your death bed, you’ll regret not having lived your life to its fullest. Ask any retiree, they’ll tell you that youth is wasted on the young. Think about it!
That said, I mostly maximize my RSP annually because it gives me an immediate tax break and it also gives me a rainy day fund if I get hurt while I’m old and it prevents me from working. Otherwise, my non-RSP savings are what I hope to use to build some small retail business in the future. The government’s destruction of income trusts has given me a bit of a setback, but at least I’m still relatively young. Still, I certainly won’t forget this! *shaking fist at our government*
16 Chris // Dec 5, 2006 at 7:59 pm
Wow, thanks all for your kind words. Investing is not about quick riches but a personal path to financial freedom. This blog and many other sites serve a great purpose of spending knowledge to others for ideas and suggestions. I am very grateful to CC for his relentless effort to post information on a daily basis.
This early retirement subject seems to quite popular! I was once bent on retiring at 50 but I realized is not that I hate working but I don’t like what I do currently. So that is what I aim to fix. It will be much easier to work doing something you enjoy than to replace the after tax income of the job I hate.
I agree with Oxcc’s statement, “it is easier to grow your portfolio’s income than it is to grow your portfolio’s value” Portfolios rise and fall with investor’s expectations but dividend income is steady in general.
Buying good dividend paying companies on the cheap is difficult but they do go on sale. Look at US big pharma.
17 Ernst // Dec 5, 2006 at 11:44 pm
Phil S: very unusual comment for personal finance blog but thank you for the words of wisdom! “Because on your death bed, you’ll regret not having lived your life to its fullest.” Couldn’t agree with you more. IMHO, there is a flavor of something deeply pessimistic in those “early retirement” calculations.
18 JB // Dec 6, 2006 at 10:44 am
Phil S - My wife often reminds me not to “live too much in the future” . . I recently heard a phrase that’s stuck with me .. “in life we must balance the paradox of living for the day and planning for the future” . . if I’m not mistaken CC had a posting a while back on how some financial analysts evaluated happiness . . “money’s not everything” may seem at odds in a financial blog, but finding the right balance as described above does ring true for me.
19 Phil S // Dec 6, 2006 at 3:12 pm
Thank you all for all your comments. Sometimes we get lost in the numbers and have to be reminded of what’s really important in life. Kind of like not seeing the forest through all the trees. Anyways, with all of the talk about financial projections and how early people can retire, I just thought I’d remind everybody the reason behind why we’re working, saving and investing. To live your life!
20 Retirement Calculations - Assumptions // Oct 17, 2007 at 11:56 pm
[...] it appears I inspired the Canadian Capitalist to dig out his pencil and do some calculations on his early retirement. He came up needing $1.36 million to leave the working world at age 55. Which to me proves [...]
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