The Six Levers to Retirement Income Planning
When transitioning from work to retirement there are six levers you can adjust to create a retirement income and cash flow plan.
When you are about to make the big transition from your working years to your work optional or retirement years, you will need to create a lifetime income from the financial assets you have accumulated to replace the monthly pay cheque you received when working.
To do this, there are six key levers that you can pull or adjust to create your retirement income and cash flow plan.
1. Initial Withdrawal Rate
2. Adaptability of Expenses and Spending
3. Asset Allocation
4. Asset Location
5. Income Withdrawal Location & Sequencing
6. Tax Planning Strategies
(Note: An article by John T. Scruggs called Asset Allocation and Withdrawal Strategies: Three Levers for Management Retirement Outcomes, describes the first three in more detail.)
- What are the six key levers or choices to manage retirement outcomes?
- The key strategies for each.
Real Life Planning: Are you on track?
When we first meet with people making the transition to retirement, they normally have key questions:
- Do we have enough?
- How much can we spend without running out of money?
- Can we reduce our taxes?
- Can we do what we want in retirement?
- Can we retire early?
- Can we leave a larger estate for the next generation?
- Will our family be looked after?
In our planning process we use the first three levers to find out if people are on track to achieve their goals, and if they are on track, then we can fine tune the strategy using the last three levers.
Over time the decision usually becomes a choice between income for the retiree during their lifetime and maximizing the estate value for the next generation.
THE SIX LEVERS
Are You on Track?
- Initial Withdrawal Rate
There have been numerous studies on how much a retiree can withdraw from their portfolio each year so it will last their lifetime.
The lower the initial withdrawal rate, the longer your investment assets will last.
As a simple example, if your investment portfolio was $1 million dollars and you needed $10,000 a year, the initial withdrawal rate would be 1.0% ($10,000/$1,000,000) and most likely you would never run out of money.
As an extreme on the other end, if you required $100,000 a year from your $1,000,000 portfolio, the initial withdrawal rate would be 10% ($100,000/$1000,000) and based on that withdrawal rate you would spend all your capital over time.
Morningstar did a report on Safe Withdrawal Rates for Retirees in Canada Today. For a 65-year-old today, with an 80% chance of the money lasting for 30 years, the “safe withdrawal rates” are as follows based on asset allocation:
Source: Safe Withdrawal Rates for Retirees in Canada Today, Morningstar January 2017.
You can see that the selection of your initial withdrawal rate will have a huge impact on your retirement income strategy.
Strategy: make sure you have a full understanding of what your projected retirement spending may be. From experience, retirees know exactly how much they spend each year in retirement.
- Adaptability of Expenses and Spending
The more you can adjust or adapt your spending in retirement the better. This really means if the investment markets are in a downturn, are you able to adjust your spending until the markets and your portfolio rebound?
As an example, during the financial crisis in 2008 many retirees were able to reduce their spending for a period until their portfolio rebounded (such as delaying a trip or holding onto their car a bit longer).
Michael Kitces wrote an excellent article Segmenting Retirement Expenses Into Core vs Adaptive To Create Retirement Buckets that can help with the planning process.
Strategy: divide your expenses into essential and discretionary, or core vs adaptive. This will help you to make financial decisions over your retirement lifespan when the enviable bear markets occur.
- Asset Allocation
Asset allocation simply means the allocation of your investments between equity and fixed income types of investments.
Typically, over the longer term, the more you have invested in equities, the greater your long-term returns should be.
The main reasons retirees invest in equity investments is that with today’s low-interest rate environment:
- they haven’t saved enough to invest in only fixed income investments to achieve their income goals,
- they require their income to grow with inflation over time (like a raise each year while working),
- they wish to create a larger estate value for the next generation.
Typically to achieve their cashflow requirements, we find most retirees today invest using a globally diversified portfolio with an allocation in the range of:
- Income: 40% to 60%
- Equity: 60% to 40%
Strategy: Review how the different asset allocation strategies affect your:
- ability to achieve your spending goals over time, and
- your estate value over time
By adjusting and reviewing the first three levers we can determine if you are on track to achieve your goals. If you are, we can then fine-tune the strategy and customize it to the retirees’ specific requirements.
Fine Tuning Levers:
- Asset Location
Once an asset allocation decision is made, you then must decide on where to place those investments based on the projected growth and how they are taxed.
The three main types of accounts your investments can be placed in are:
1. RRSPs/RRIFs: the income earned each year is not taxable. When the plan is converted to a RRIF, the payments you withdraw each year are 100% taxable as ordinary income. (You must convert by the end of the year you turn 71.)
2. TFSAs: no tax is paid on the income you earn or when you redeem money.
3. Non-Registered Investments: the income is taxable as earned each year. In Ontario, the tax on each type at the highest marginal tax rate is as follows:
Note: you will have to review based on your specific income and marginal tax rate.
Historically, many investors have placed:
- interest bearing investments into RRSPs and TFSAs since the tax you pay on interest income is at the highest rate.
- capital gains and dividend paying investments into non-registered accounts, as these types of income are tax preferred.
Given the low interest rate environment today, it may not make sense for retirees to place only fixed income investments into RRSPs/TFSAs, and compound those accounts tax-free at today’s low rates.
A strategy many may opt for is to “mirror accounts” where each account has the same asset allocation.
Strategy: Retirees may want to model placing different types of investments (equities/fixed income) in different accounts to see how it affects the overall plan.
- Income Withdrawal Location & Sequencing
One of the most important decisions a retiree must make is when to decide which sources of income to start and which to defer.
The following is a list of the potential cash flow sources that may be available. The sources are divided into reliable income such as government plans, and variable sources of income from your own savings.
Reliable Sources of Income
Canada Pension Plan: earliest start is age 60 and can be delayed until age 70.
Old Age Security: earliest start age is age 65 and can be delayed until age 70.
Company Pension Plans: defined within the plan.
Annuities: normally when purchased.
Guaranteed Income Products: normally will have a minimum age to start.
Variable Sources of Income
RRSPs: You can start income at any age (convert to a RRIF) but must be converted to an income plan (RRIF) or annuity by the end of the year you turn 71 and you then must start the minimum withdrawals the following year.
Locked-in RRSP: Normally you must wait until age 55 to start an income, but it must be converted to an income plan (i.e., LIF) or annuity by the end of the year you turn 71, and you must then start the minimum withdrawals the following year.
Non-Registered Investment Accounts: Income and withdrawals can be started at any time.
HOLDCOs: If you owned a company, you might have an investment account in a holding company (HOLDCO). It can normally be accessed at any time.
Each of the above cashflow sources can have different start dates and a retired couple could easily have to decide on how and when to start the income or cash flow from 6 to 12 sources or more.
The typical drawdown order we compare (in a sequencing order) are:
- Non-Registered Investments, TFSAs, and RRSPs
- Non-Registered Investments, RRSPs, and TFSAs
- RRSPs, Non-Registered Investments, TFSAs
- Blended withdrawals – equal from each source
- Custom withdrawals based on tax bracket management. This often includes partial RRSP conversions and using TFSAs as a long-term and/or estate asset.
Strategy: You will want to model starting the various sources of income at different times as will each have a different effect on the taxes you have to pay and your estate value for the next generation.
You may also wish to review if it makes sense to start or delay CPP payments in your modeling.
- Tax Planning Strategies
In reviewing the options, often it can come down to balancing short- and long-term tax efficiency as follows:
- maximize your current income or cash flow today, or
- maximize your terminal wealth (estate value).
If someone is retiring early, they may wish to minimize current taxation as this may help them make their own assets last longer, and as they age, they may wish to look at estate maximization.
As a rule of thumb, often we see with younger retirees their goal is to maximize their current cash flow and preserve their own assets if possible. So, for an early retiree, a typical drawdown order might be:
- Non-registered investments, RRSPs next, then TFSAs last.
- Depending on the tax rate, partial conversion of RRSPs may be done.
Other tax strategies to review will be:
- tax efficient investment for non-registered investments
- income splitting
- maximize credits and deductions
Strategy: You will want not only to examine the current taxes you are paying but review how your marginal tax rate may change over time, followed by the potential taxes in your estate.
Test Your Strategy – The What If Options
Fortunately, with the current financial planning software you will be able to see how the various levers will affect your:
- After tax cash flow.
- How much you can spend without running out of money.
- Taxes (today and in the future).
- Success rate of the plan.
- Estate value.
To compare one plan to another, one tool we use is Monte Carlo analysis to help with plan review and design. The article by John T. Scruggs recommends that Monte Carlo simulations be run annually for retirees, and that makes a lot of sense with life changes over time.
By adjusting the six levers we can determine:
- If you are on track.
- Can you spend more each year?
- Can you retire early?
- Can you leave a larger estate for the next generation?
- Will your family be looked after?
- Can your taxes be reduced?
The six levers should be reviewed each year to adjust for changes in:
- Your spending requirements
- Family Changes
- Health Changes
- Tax changes
- Spending Shocks
While your initial strategy will help you create your financial road map, ongoing guidance and adjustments will be required to keep you on track.
For more information you can refer to Preserving Wealth: The Next Generation - The definitive guide to protecting, investing, and transferring wealth by Jack Lumsden, MBA, CFP®
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Jack Lumsden, MBA,CFP® Financial Advisor, Assante Financial Management Ltd.
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