This is the most difficult question to answer in any discussion of financial independence. Everyone is looking for the one number to tell them exactly how much money they need in order to be able to stop working. Thinking that there is one number is a fallacy.
First of all, everyone has different needs and wants. That should be obvious. There are lots of people out there, especially among the “extreme early retirement” community who say that they can get along just find on the change they find under the cushions in the chesterfield. Others will tell you that you can never have enough, so you’re better off just keeping working.
Charles Dickens’ Micawber Principle is most instructive here:
“Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.” – (David Copperfield, Chapter 12)
There are four tests that I have used to evaluate our financial readiness for life after work. Three of them are not new, but I will repeat them here for completeness, and to provide my comments on each of them.
No single test is going to give you an unambiguously definitive answer. Even all four tests together may not tell you what you need to know, but it is better to look at all of the results to make your decision. (If any reader – if anyone is reading – knows of another test, please share it in the comments below.)
Test 2 is the only new thing here – at least I haven’t seen anyone else calculate this starting with the tax return, so you may want to skip to that if the rest is old hat to you.
Test 1: the 70% of income rule
A standard rule-of-thumb in the financial planning industry is that you will need in retirement income equal to 70% of you pre-retirement before-tax income. A rule-of-thumb is a pretty blunt instrument. It should only be the start of the discussion, not the end point.
This rule of thumb I don’t find to be very useful. Let’s consider this example: if Spendthrift Sandeep earns $60,000 a year, pays $10,000 in tax, and spends the rest, he’s consuming $50,000 a year. 70% of $60,000 is $42,000, which means he will have to reduce his standard of living in retirement. If his neighbour Frugal Frieda is earning $60,000, paying $10,000 in tax, and saving $20,000 a year, she is consuming only $30,000 a year, so 70% of her pre-retirement income means her retirement at $42,000 will be a big party by comparison.
Having had a high savings rate through my working life, my pre-retirement income has little bearing on what I need to spend to be happy. But also, my plans for life after-work have little relation to my life during work. If Spouse and I are to travel the world, we will be spending much more on travel than we did during our working lives. We have travelled a fair bit, but there were some staycations in there – some years where we spent our time off renovating our home, for example.
Furthermore, there is hardly unanimity around the 70% figure. You will find financial writers who will provide very good reasons for why 50% or 60% should be enough. Others, mostly in the financial planning industry, will tell you that you will need 80% or even more in order to have what you need to be happy. A cynic would say that the financial sector makes money when you save more. A more charitable explanation would be that no financial adviser wants to be responsible for having one of their clients retire too early and be disappointed with their retirement lifestyle.
Test 2: your current spending
Following on the criticism of the 70% rule, it makes more sense to look at how much you are spending now so you can get an idea of how much you need to spend in retirement to maintain your current standard of living.
If you have an annual budget and you know how much you spend, then I would say to you: congratulations, and you should get a life.
That’s not really fair – everyone has their own particular obsessions, and I’m in no place to criticize someone else’s.
Since I didn’t know how much we were spending as a couple, and didn’t want to take the traditional approach of tracking my own spending, let own asking Spouse to report to me what he was spending (that would not have gone well), I decided to find an alternative method.
Your Canadian tax return has a lot of the information that you need to calculate your current spending and adjust it for life after work so you can determine how much after-tax income you need to maintain your current spending.
Your current spending can be calculated as follows:
Start with your income – I use Line 101 from the T1 form (employment income) – the only other income I have is investment income, and that is all being reinvested, so it does not form part of my spending. You may have other types of income, so check through Lines 102 to 147 to see what makes sense to include.
- remove pension (T1 line 207) and RRSP (T1 line 208) contributions which you won’t be making any more,
- remove professional fees and union dues (T1 line 212)
- deduct taxes payable (since we are calculating how much you have left over to spend) (T1 line 435)
- remove CPP contributions (Schedule 1 line 9) and EI premiums (Schedule 1 line 11) that you won’t be making any more.
There may be other lines that you would deduct depending on your personal circumstances, so you should go through you return carefully when doing this.
Now off your tax return, there are other things you are putting your money into that you won’t be doing after work:
- Any increases in taxable investments
- Your TFSA contributions (well, you should continue these after work if you have taxable investments to transfer into your TFSA, but this isn’t coming out of the income you need to support your spending)
- Other uses (funding your kids’ education, mortgage payments, etc.?)
Now you have a good idea of how much you are spending in a year without going through a stack of credit card and bank statements.
I’ve read all of the articles that say your spending goes down in retirement because you spend less on commuting, dry cleaning, office lunches, but since my commuting costs are nil (aside from new shoes), I spend little on dry cleaning, and I take my lunch fairly often, I’m not convinced of that. On the other hand, when I have the time to travel, I want to do as much of that as I can, so my spending could go up. That bring us to Test 4, but first, there is another test that I have explored.
Test 3: what the neighbours are spending
David Aston, writing in Moneysense magazine in 2013 http://www.moneysense.ca/retire/how-much-money-will-you-need-to-retire/, used these numbers to describe the before-tax income required to retire in different styles. Aston assumes no debt in retirement, and for all categories except Bare Necessities, a paid-for home.
for couples | single people
Bare necessities: $25,000 | $18,000
Basic middle class: $40,000 | $28,000
Average middle class: $55,000 | $39,000
Upper middle class: $70,000 | $50,000
Deluxe: $100,000 | $75,000
Aston explains what he means by his categories:
“Everyone spends their money differently, but to give you an idea, think of a “basic middle class” couple as being able to afford a used car that they keep for eight years or more. Vacations are mostly driving holidays, with occasional jaunts outside Canada. “Average middle class” couples can buy a new car and trade it in more often, and enjoy foreign holidays with average accommodations. “Upper middle class” couples can buy a new car every five years, or have two cars that they replace every eight years or so. They can also enjoy higher-end international travel.”
It is not clear how Aston developed these amounts, but judging from an earlier article he wrote, they seem to be based on the average and median income from Statistics Canada’s Survey of Household Spending. I am not questioning Aston’s numbers – I think they add a lot to the discussion – I’d just like to see more explanation of his methodology.
Another piece of information that was really useful to me was talking to a retired couple of friends who were really open about their spending, and told us their after-tax monthly budget ($7500). Getting a real number from someone broadly in our income group really helped because it made me realize how irrelevant what the neighbours are spending is to us. While this couple have a nicer home and travel quite a bit, their style of travelling and spending patterns are very different from ours. They eat out a lot, but don’t drink. They have hobbies that are different from ours. They go to a warm place in the winter and stay there, rather than moving around. How relevant is their spending to what we expect to spend? It is only relevant as a broad indicator.
This was really useful, though, because it pushed me into doing what I had been putting off for a very long time: drafting a budget for life after work.
Test 4: Drawing up a budget
Drawing up a budget for your spending after work is the most tedious, time-consuming, useful exercise of any of these. I resisted doing this for a long time, but I was really glad that I did it because this gave me much more confidence that we will be able to stop working this year.
- I started with as many of our known fixed expenses and I could dig up and put them into a spreadsheet – this is really about housing costs.
- I made estimates for as many unknown costs as I could think of, e.g., for running the car that we will acquire when we finish work.
- Buying a car every six years.
- I put in provisions for other household expenses, and a budget for fun for the months that we are at home.
- I set a budget for travel expenses – some money for airfare for two big trips a year, and then a daily budget. I have tested this daily budget on recent trips, and it seems to stand up well. Of course, travel in Europe is more expensive than travel in Mexico or southern Asia, but I assume that we will mix up trips between cheap and expensive places.
- I set aside an amount for unknown extras.
A key thing here is to be explicitly conservative, but not conservative throughout. By this I mean that I have not rounded up all of the amounts, and hidden away contingencies in each part of the budget, but rather I make one large contingency reserve. It is unlikely that every element of your budget is going to be more expensive than you were predicting, but some parts will be. If you gross-up each of your budget items by 30% “just in case”, you will find you will likely never be able to quit working. Setting aside an explicit 10-15% contingency amount should provide adequate but not excessive coverage.
The total spending amount is projected out through the plan with 2% inflation per year. Over the last 20 years, Canada has averaged 1.82% increase per year in the consumer price index, and the Bank of Canada has an official target range of 1-3% per year, so 2% is a pretty good number. I know that some people look back at the 1970s and years of 10% inflation, but there was a fundamental shift in monetary policy in the 1980s when economists realized that printing money could not provide ongoing economic stimulus to an economy. This resulted in the 1-3% target range. This is pretty consistent amongst developed economies.
I’ve budgeted for six months a year of travel (woo hoo!), and adjusted that down to five months at age 70, when I figure we’ll be more focussed on going somewhere warm during the winter and staying there, and less on gallivanting.
Thank you for reading. Comments are welcome.