Chapter 2

The Thompsons Are Ready to Retire

Meet the Thompsons

Consider the case of Nick and Susan Thompson. Nick is 65 years old and Susan is 62. Their combined earnings peaked in their final year of work at $120,000, which is just a little above the median for a Canadian household with two breadwinners.

The Thompsons are psychologically ready for retirement as they look forward to being free of the daily grind of the working world. On the other hand, they are a little anxious. Once they cut off their stream of employment income, there is no turning back. They have to hope they can turn their life savings into steady income that meets their needs and lasts the rest of their lives.

The Thompsons are what I will call mainstream retirees, the type of people that most readily come to mind when you think of retired people. Mainstream retirees held down a job for most of their working lives, bought a home at some point and paid off the mortgage, raised children and paid their taxes. As Anthony Quinn’s titular character declared in Zorba the Greek, “Wife, children, house, everything. The full catastrophe.”

Almost anyone with a solid employment history and a reasonably good record of saving could be a mainstream retiree: professionals, executives, and successful entrepreneurs, for example. They could also be middle-managers and anyone else who held down a steady job for much of their careers. It is not so much their earnings level that characterizes mainstream retirees as their attitude toward retirement. In particular, they:

• assume personal responsibility for saving enough to finance their own retirement,
• aspire to maintain the same lifestyle that they enjoyed when they were working,
• kept their debt under control, especially in their later working years, and
• won’t take too much risk with their investments.

When it comes to planning a bequest (i.e., what they will leave behind for others), they don’t have a specific number in mind and, in any event, they won’t put that in the way of their decumulation strategy. If they thought about it, they would feel that their loved ones should be happy to inherit the residual value of their estate, which will probably include some financial assets as well as the equity in their home.

On the eve of retirement, the Thompsons have amassed $600,000 in RRSPs. Not bad for a middle-income, two-earner couple and maybe a little above normal for anyone with similar earnings who has been saving regularly for 30 years. Converting this $600,000 into income will form the core of their retirement security. The big question is: how do they do this intelligently?

Saving for retirement isn’t always easy and at times you might have wondered if the sacrifice was worth it. Think of the things you had to forgo to make that saving happen, like better vacations, nicer cars, and fancier restaurants.

If your saving days are over, you might think that finally being able to spend your accumulated wealth is the easy part, kind of like scratching a long-endured itch. Unfortunately, that is not the case. Drawing down savings is something very few retirees do well, even when they have the best of intentions.

They Try to Do Everything Right

Even before they mapped out a decumulation strategy, the Thompsons wisely got rid of any debt. They had already paid off the mortgage on their home, as have most people in their 60s. They also made sure to pay off their credit card balance each month and resisted the temptation to take out a home equity line of credit.

If you cannot pay off all your debt by retirement age, I see it as a sign of trouble. It suggests you have been living beyond your means, which will make it just that much harder to rein in your spending after retirement.

Another reason debt is incompatible with retirement is that some of your invested assets will be in bonds or other fixed income assets. These investments will almost certainly be earning less interest than what you would be paying on any debt you owe.

The one argument for not paying off your mortgage before you retire is that you left it too late and the only way you can pay it off now is to withdraw a large sum from your RRSP. I don’t recommend doing this since you will almost certainly end up paying more tax than if you made smaller, regular withdrawals over a few years. We will assume that Nick and Susan do not have this problem since they made sure the last mortgage payment happened before they retired.

Their next step is to visit an advisor at their local bank branch. There, they learn that if they want to turn their $600,000 in RRSP assets into regular income, the money should be transferred into a RRIF first. Hence, they set up a RRIF account. (If their savings had accumulated in a registered pension plan instead of an RRSP, the monies would be transferred to a LIF.)

RRIF (pronounced “riff”) stands for Registered Retirement Income Fund. This is the vehicle to which RRSP monies are transferred in order to draw a regular, periodic income. The rollover from an RRSP into a RRIF is tax-free. It usually happens at the point of retirement but must take place no later than the end of the year in which one turns age 71. Withdrawals are subject to income tax. See Appendix B for more details. If savings had accumulated in a pension plan instead, the monies would be transferred to a LIF instead.

LIF (pronounced “liff”) stands for Life Income Fund. It is much like a RRIF, but with a few extra restrictions. See Appendix B for more.

They also talk to family, friends, and other people who seem to be knowledgeable about investments. Their aim is to identify the most prudent and commonly accepted strategy for drawing down their savings.

After much research, here is a summary of what Nick and Susan decide to do:

• invest their RRIF assets in well-known mutual funds;
• draw an income equal to 4 percent of their RRIF assets in the first year of retirement;
• increase that drawdown in future years at the same rate as inflation;
• avoid annuities, which everyone agrees are nerdy at the best of times and especially unattractive in the current low-interest environment; and
• start their CPP and OAS pensions immediately upon retirement — in this case, at age 65 for Nick and at age 62 for Susan — to extract the greatest value from government pension sources just in case either of them dies early.

An (immediate life) annuity is a contract in which you give an insurance company a lump sum (like $100,000), which is called a single premium. In return, they pay you a fixed monthly or semi-annual amount for the rest of your life.

CPP means the Canada Pension Plan (or its Quebec counterpart, the QPP) and OAS means Old Age Security pension.

Let’s get one thing out of the way before going any further. I could keep on using the term “drawdown,” but I prefer the term decumulation instead. It suggests a certain symmetry because it is the opposite of “accumulation,” which is what you were doing all those years you were saving for retirement.

Decumulation is the process of drawing down one’s financial assets after retirement with the primary goal of producing a regular income, usually for the rest of one’s life.

The decumulation strategy described above is known as the 4-percent rule. Notice you do not draw down 4 percent of assets every year under this rule, just in the first year. In future years, the amount withdrawn increases with inflation.

The mutual funds that the Thompsons choose, by the way, are from a big-name investment company with a reasonably good track record. They put 50 percent in equity funds and the other 50 percent in a fixed income (bond) fund. The annual fee is 180 basis points, which is by no means low, nor is it especially high in the world of actively managed retail mutual funds. Because the fees are quietly deducted from their portfolio, paying them is relatively painless.

Consider equities to be another word for stocks. Owning the stock of a given company essentially gives you a share in the ownership of that company. When you put your money into an equity fund, you essentially hold shares in many different companies. Such diversification lessens your risk, but you will still experience gains or losses over any given period.

A basis point is 1/100th of one percentage point, so 100 basis points equals one percent. If the annual investment management fee on a $100,000 investment is 200 basis points, you pay $2,000 a year.

When the Thompsons describe their decumulation strategy to their friends, everyone nods in approval. Every aspect of the strategy adheres to best practices. It would seem that long-term financial security is all but assured.

Assuming the Thompsons achieve median investment returns in every future year, Figure 2.1 shows what they could expect in terms of future income from all sources, assuming they encounter no nasty financial surprises.

Figure 2.1. What the Thompsons are hoping for

The Thompsons hoped for median returns. Note the income gap in the first three years before Susan starts to receive OAS.

Even this rather rosy scenario is less than perfect since the couple’s income is lower in the first three years than it is in later years. This is because the 4-percent rule implicitly assumes that all other sources of income are going to be smooth and steady for life; i.e., no jumps or dips ever. This is not true for the Thompsons, since Susan’s OAS pension doesn’t start for three years yet. And it certainly isn’t true in general, since it is very common for retirees to have other sources of income that are not smooth or permanent. Consider for example:

• rent from an investment property that they will eventually sell,
• part-time employment for a few years after they retire from their regular job, and
• a possible inheritance down the road.

In the case of the Thompsons, drawing less income until Susan starts to receive her OAS pension produces an outcome that is precisely the opposite of what they really want: to splurge a little in their early retirement years to celebrate their new freedom. If there is ever a time to spend more money, it is while one still has the energy and enthusiasm to try new things. We will be fixing this problem in Chapter 5.

In spite of these qualms, the Thompsons would be pretty happy if Figure 2.1 truly represented their financial future. Unfortunately for the Thompsons, what actually happens is nothing short of disaster. This is described in the next chapter.

Takeaway

1. A conventional decumulation strategy sounds like a prudent course to follow, but it can lead to disaster.