The Impact of Retirement Planning Assumptions
Creating a plan for retirement income that lasts as long as you do is a challenge. Several important factors which affect your future income need to be estimated. While no one knows the future, we can make educated guesses based on past trends and your current situation.
What makes this particularly difficult is that some of these assumptions will affect retirees differently, depending on their financial situation. Because of this, it's important to consider various scenarios and their potential impacts on your income. By planning for a range of possibilities, you can create a more resilient retirement income strategy.
How Assumptions Affect Your Retirement Plan
Many financial assumptions go into a retirement plan. Being aware of how sensitive your plan is to each is critical to avoid being caught off-caught. Here are some common assumptions used in a financial plan and how they could impact you:
Retirement Age
The age you retire can have several implications for your retirement income. By working longer, you'll have more time to save and you'll spend fewer years in retirement, which means you'll need less total savings. When you retire can also affect the size of your Canada Pension Plan benefits. While working longer can seem like an easy solution to improving retirement income, not everyone will be able to. Many workers are forced to retire before they would like, due to illness, disability or family obligations.
Life Expectancy
We all know people who have died at a tragically young age, but many of us will live longer than we expect. This makes life expectancy one of the most challenging retirement assumptions. How long we live in retirement will determine how many years of income we need to plan for. This is crucial if your plan includes a high level of income from investments. On the other hand, those with more pension income are less affected by the life expectancy assumption.
Inflation Rate
The prices of most things go up each year. The increase in the cost of living means that you'll need more dollars in the future to get the same stuff you normally buy today. This change over time can be hard to estimate. Some will be fortunate to have a higher level of income from sources that are fully, or partially, indexed to inflation. These include some workplace pensions, Canada Pension Plan (CPP) and Old Age Security (OAS).
Investment Return
For those who will rely heavily on investments for cash flow in retirement, this is critical to correctly estimate. Many people have unrealistically high return expectations. Current estimates for future investment returns are lower than what they have historically been over the past 30 years.
Retirement Expenses
How will your expenses change in retirement? Understanding your spending needs becomes especially important after you retire and no longer earn an income. Using a rule of thumb of needing a certain percentage of your working income in retirement has too many exceptions to be relied upon. To spend your savings confidently in retirement, you'll need to know your real needs.
Pensions and Government Benefits
What income sources will you have in retirement and will they keep up with inflation? If your pension has an annual cost-of-living increase, it is important to include that in your financial plan.
Tax Rates
Taxes are a confusing topic for many and estimating future taxes is even more difficult. Retirees and seniors are eligible for tax credits which can substantially reduce taxes paid. Some retirees will benefit a great deal from these savings, while others will only get a slight boost.
Risk profile
This is your ability or willingness to endure losses in your investments for potential future gains. This will influence the type and amount of riskier assets like stocks in your portfolio. Retirees often choose to reduce investment risk with age.
Case study: The Friesen's retirement journey
Laura and Robert Friesen are both 55 years old and would like to retire in five years. They have a total annual income of $190,000 and have been saving for their retirement over the last 25 years.
When they started their journey, the Friesens made the following assumptions:
Rate of return on investments: 6%
Inflation rate: 2%
Life expectancy: 85 years
Retirement expenses: 70% of their current income
Other income sources: Canada Pension Plan, Old Age Security, and a modest pension from Laura's employer
Now, at the age of 55, the Friesens decided to reassess their retirement plan and find several changes:
Their investments' rate of return was lower than they hoped, averaging around 5% per year.
Inflation was a bit higher than their estimate, averaging about 2.5%.
After considering advances in healthcare and their family health history, they now believe they might live until 90.
They've realized their retirement expenses might be higher than they initially thought due to increased travel aspirations and rising healthcare costs.
They're considering moving to another province to assist Laura's aging parents, but the province has significantly higher tax rates.
These shifts significantly influenced the Friesens' retirement plan. Their anticipated retirement income was lower than expected, and their projected expenses had unexpectedly increased. Their aim of retiring at 60 now seemed more challenging.
Upon consulting with a financial advisor, they adjusted their plan. They reduced their expected rate of return to a more conservative 3.5%, adjusted their expected inflation rate to 2.5%, increased their life expectancy to 95 years, and raised their projected retirement expenses to 80% of their pre-retirement income. They also explored other potential income sources to supplement their retirement, such as part-time work or downsizing their home.
With these adjustments, the Friesens felt more secure about their retirement plan. They acknowledged that they might need to work a few years longer than planned, but that would ensure a more comfortable and worry-free retirement.
Best practices for financial planning assumptions
Begin with professional financial planning guidelines: Each year, FP Canada updates their guidelines for financial assumptions for planners to use for their projections. This is the recommended starting point for thinking about future investment returns and life expectancy.
Consider a range of scenarios: It’s also important to consider a range of scenarios when making a retirement plan. Doing so will give you a sense of the range of possible financial outcomes. If you find that your plan is too sensitive to certain variables, you may need to revise your plan to make it more robust.
Seek professional advice: Finally, get professional advice if you feel you may need it. The complexities of retirement planning can be daunting, and having an expert on your side can be invaluable. A financial advisor can help you understand the risks associated with each assumption, and come up with a plan that takes these risks into account.
Updating your retirement plan
The assumptions you start with shouldn't be set in stone. They need to be regularly reviewed and adjusted as circumstances change. Regularly updating your plan's assumptions will allow your retirement to stay on course.
