I have a very complex spreadsheet model (I’m an economist) that projects out our
- desired spending,
- expected income,
- withdrawals from different accounts,
- the taxation of these, and
- adjustments for inflation.
The key metric is how much is left when we are 95 – this represents a safety margin as it seems unlikely that we would both live to 95.
- Desired spending
I’ll outline in the next post how I determine how much I think we will need to maintain our desired level of spending.
- Expected income
I treat each of our different investment pools separately:
- Registered Retirement Savings Plans (RRSPs) [like U.S. Traditional IRAs]
- Tax-Free Savings Accounts (TFSAs) [like U.S. Roth IRAs]
- taxable investment account
- Guaranteed Investment Certificates (GICs) [like U.S. CDs] and high-interest savings account.
- Withdrawals from different accounts
For each pool I start the decumulation plan with the current value of the pool, and assume income based on the current yield of that pool. I am using my current dividend and interest yields, but given that yields are very high right now, I have adjusted them downward in the RRSP and TFSA accounts where I expect that we will continue to accumulate over the coming years.
I assume that we use all of the income from the taxable account for each year in that year. Then I add in any income from my defined benefit pension plan (starting at 65), Canada Pension Plan (from 65) and Old Age Security (from 66). [CPP and OAS would be “Social Security” in the U.S. CPP is a contributory plan, while OAS is paid to all but the highest income seniors.]
I then withdraw from the RRSP and TFSA accounts in order to top that up to the desired pre-tax income.
I have built in a tax calculator based on current tax parameters to determine the after-tax income, including the OAS clawback on high-income people, which we generally stay under.
I then somewhat iteratively adjust the RRSP/TFSA withdrawals to equate the after-tax income to the desired after-tax income.
Each year the income from an account increases if my withdrawal has been less than that year’s income, or is reduced as I draw down the capital in the account.
I assume no future capital gains (since capital gains are wildly unpredictable), which builds in an extra degree of prudence. Over time, the stock market has always gone up, if you wait long enough. This could mean higher taxes when withdrawing from the taxable account, but then I’ll have more money to pay taxes, so it should be okay.
I will have a cash cushion of Guaranteed Investment Certificates and a pool in a high interest savings account so that I don’t have to sell off my dividend stocks or REITs during a downturn. If I use these up during a downturn, I will replenish them when share prices recover by selling off at a higher value.
The tax calculator reflects the different tax brackets, the tax treatment of different types of dividends, capital gains and other investment and pension income. For taxable investments, I am assuming a capital gain of 25% of the amount withdrawn, which is probably an over-estimate – our portfolio is relatively young because I have been investing directly for only a few years, and I trade more than I should.
I have set inflation at 2% because the Bank of Canada targets consumer price index (CPI) inflation of between 1% and 3% per year, and has been in that range consistently for the last 20 years. Over that period, average CPI inflation was 1.9%.
Some people look back further and cite the high inflation of the 1970s and early 1980s as justification for assuming higher inflation. I don’t think that this is a good basis for forecasting. There was a sea change in monetary policy in the 1980s – Maggie Thatcher’s “monetarism in the lab”, Alan Greenspan in the U.S., and similar policies in Canada. The Bank of Canada now aims for price stability instead of using expansionist monetary policy to stimulate the economy. Since the latter was shown to cause inflation instead of long-term expansion, I cannot see us going back there.
This approach is more sophisticated that the simplistic “4% rule” that is often cited as it deals with our portfolio and our rates of return and our tax rates in the 21st century, rather than using a figure developed in studies using typical portfolios of U.S. stock and bond markets over a hundred year period.
I will write a separate post on the so-called 4% rule.
Thank you for reading. Comments are welcome.