Step 1: Make a Plan

 

Start with a plan and collecting the information you’ll need.

• How old are you now?
• When do you want to retire (perhaps select a few years to test early, delayed, and planned retirement scenarios), and how long will you live (or how long a contingency will you plan for)?
• How much money do you make?
• What does your household budget look like? What big expenses do you need to save up for in the near- or medium-term (education, cars, houses, etc.)?
• How much money can you save per year without making any changes to your budget? How much money can you save with some belt-tightening?

The younger you are, the more nebulous your plan may be: there are many possibilities and it’s hard to plan for them all. For the younger investor, perhaps the most important points are to identify how much you can save, and what you might need to save for in the nearer term so you know what money you shouldn’t put in your long-term retirement investments.

Play around with a spreadsheet program and calculator to see what various scenarios are. Here are some helpful rules of thumb and starting assumptions to help with your planning activity.

Investment returns: assume savings accounts/short-term GICs give zero real [38] return (or even negative real return after taxes). Assume [39] a bond fund gives about 1% real return. Assume stocks give about 6% real return in the very long term. Be sure to see what happens if you’re wrong (what if stocks only give 3% real return?) and make contingency plans. You don’t necessarily want to plan just for the worst-case scenario, as it’s no good to live your life trying to save so much for the future that you don’t get to enjoy the present, but at the same time you don’t want to fiddle away your productive years and be left with nothing in your old age.

Life in retirement: it can be tough to estimate how much you’ll need to live on in retirement. One (hopefully) large component of your budget won’t be needed any more: savings. You may also be more frugal in other areas, such as not needing to make a daily commute or to buy quite such expensive clothes as when you’re working. If you have/will have children, by the time you’re in retirement you probably won’t need to budget for their needs. So it may be safe to assume you’ll need less than your current salary to support yourself. On the other hand, if you’re in a profession where you expect to earn much more later in your career, you may then become accustomed to a more lavish lifestyle than you currently live, and might need to plan on more spending than your present budget in retirement (though still less than your final working years). Similarly, if you have dreams of travelling the globe in your sunset years you may need to save more for that now. A decent starting point is to assume that you’ll simply need as much as you’re spending now except for the savings portion (so about 85-90% of your current salary). Also keep in mind that you'll have larger, rarer expenses like purchasing a new car or taking a large trip on top of your regular budget.

You may also not need to fully support yourself on your own investments: you may have a company pension, or payments from programs like CPP and OAS, which allows you to assume a smaller needed nest egg.

Your health may be the biggest unknown, as medical expenses may be quite high in old age – and health-related costs may stretch beyond medicine, including paying someone to do work you may do yourself now, like mowing your lawn or clearing your snow. Health will also impact how long you live: you can start with a conservative assumption that you’ll live to 95 or 100 at this point in your planning. It’s a difficult balance to create a conservative plan, but not to get overly conservative.

 

Footnotes:

38: Recall that real return is what's left after accounting for inflation. So a zero real return might be a 3% nominal return with 3% inflation.

39: There is very little agreement on what makes for a reasonable estimate of future returns. These starting points are based on my own synthesis of various estimates and methods: for fixed income, simply compare the current inflation rate to the yield-to-maturity; for equities, the 6% figure is a compromise between a long-term "Stocks for the Long Run" average figure and the current estimate from the Shiller PE10 approach.