Net Worth & Spending Net Worth
A unique financial planning characteristic of retirees is net worth is potentially, systematically declining. It is ok if net worth declines in retirement. This is why you grew it in the first place. I’ve met too many retirees who got too used to saving and growing net worth while working that they have a tough time spending it in retirement. If you don’t spend it, it is going to your next of kin.
Retirees typically have a large holding of financial assets. They saved and grew their retirement assets through the working years. It is time to spend it. As a useful approximation, you can spend 5% of the value of financial assets on retirement date per year. This is pre-tax. If your financial assets grow at an average of 3% for the rest of your life (5-year GIC rates are approaching 3% at the start of 2018) your portfolio will exhaust around the 30-year mark. If you average a 4% rate of return, your assets exhaust around the 40-year mark. If you average 5%, your assets will never exhaust. If you average above 5%, your financial assets will grow through retirement. Add CPP and OAS payments, and any private pension you may have, and you have an approximation of pre-tax retirement income. The 5% approximation does not account for inflation so the 5% amount loses purchasing power year after year. CPP and OAS payments rise with inflation providing inflation protection.
If you own a home you have options. You can live in your home or you can convert your home into financial assets and pay rent. Sometimes the old family home is just too big. 5% of the net value (market value less mortgage) approximates your new spending level but add rent expense. Selling a home for net $500,000 generates a sustainable $25,000 annual boost to pre-tax income.
A general theme among retirees who are at least a couple of years into retirement is that they are surprised at the magnitude of decline of their expenses.
Tax and Retirees
A characteristic of a progressive tax system is that when your income falls, your tax bill falls by a greater percentage. After-tax income falls substantially less than the decline in pre-tax income. For example, let’s say you earn $70,000 at work, retire, and retirement income is $40,000. Although income falls by $30,000, your after-tax income falls by $21,519. Income falls by 43%. Your income tax bill falls by 61%. Many budget for a pre-tax decline only to be pleasantly surprised with a smaller than expected after-tax decline.
The rates and tax brackets are the same for retirees as everyone else. But, there are two credits that affect almost all retirees. The Age Credit and the Pension Income Credit. The age credit starts at 65 and affects everyone over 64. The two credits are means tested and disappear when income exceeds certain thresholds depending on the province. You can see a chart of all credits here. If taxable income is $50,000 in Ontario, tax owed is $8,311. The age credit and pension income credit (RIFF income is eligible) would reduce tax owed by $1,302 in 2018. That is a 16% reduction in the tax bill. You can see an example of the age credit in action here. (If you understand the workings of the age credit, you have graduated up from a rudimentary understanding of income tax.)
Income tax in retirement falls because of our progressive tax system and, on top of that, the credits earmarked for retirees; especially those 65 and older lower the tax bill further. New retirees seem surprised at their financial situation. They thought it would be worse.
Inflation and Retirees
You will hear much about the concept of inflation and its effects on the population and especially on retirees. Employees are somewhat sheltered from inflation through salary increases. Retirees are also somewhat sheltered because CPP and OAS payments increase at the rate of inflation. Headline inflation can be misleading. Shelter costs are the heaviest weighted component of CPI at an approximate 26% weight. If home prices and/or rental costs increase drastically, CPI will increase. If you are a homeowner, your net worth is affected to the positive. If you are a renter, you are affected to the negative.
Retirees are skilled at substituting higher priced goods for lower priced goods. If the price of beef goes through the roof, they eat more chicken. Your personal inflation rate may be much different than the headline rate.
Portfolio risk in retirement
Retirees display a greater aversion to risk than those working. This is reasonable. Those working can replenish their portfolios from employment income. Retirees don't have that luxury. However, retirees tend to become overly risk averse. A 65-year-old retiree has a decent chance to live to 90 and beyond. We get better at what we do and this includes health care advances. A portion of a 65-year old’s savings will not be needed for at least 10 years. A smaller portion may not be needed for at least 20 years. Savings needed 10 years out can assume some risk. There has never been a 10-year period where the market is negative in a capitalistic country. We get better at what we do. Some of long-term savings should be invested in growth markets.
GICs and online brokers
Right now, on RBC Direct Investing, an online broker that I use, there are 33 issuers of 1-year GICs. I can choose to invest in any of the 33. At the moment, mid January 2018, General Bank of Canada is offering a 1.91%, Canadian Western Bank is offering 1.87%, Bank of Nova Scotia is offering 1.82%. On the other end of the spectrum, TD Mortgage Corp is offering .75%, and Bank of Montreal Mortgage Corp is offering 1.35%. I can choose any of these or any of the remaining 27 or longer terms through my online broker. If all or a portion of your financial assets are invested in GICs, opening an online brokerage account should be considered even if only for the GIC advantage.
Financial institutions have differing demands for money at different times. If people are lining up for car loans at institution A and not at institution B, institution A has a higher demand for money than B. To attract money to lend out, institution A offers higher rates than B. This can be taken advantage of through an online broker. I choose the GIC from the provider that has a high demand for money. If I deal with one bank only, I am captive to their offerings. I may want a GIC at a time when my bank has a low demand for money. If so, I am stuck with a bad rate when compared to other institutions. Imagine the boost to wealth over a lifetime by purchasing GICs from institutions with only a high demand for money. All online brokers offer multiple GIC providers. Some of the financial institutions offering GICs are not household names. Note that you are protected if the financial institution you purchase the GIC from goes bankrupt. Find out more at here.
Don’t settle for poor GIC rates and don’t necessarily blame your bank. They may have a low demand for money at the time you want to lend them money (purchasing a GIC is lending the financial institution your money).
Dividends from Canadian corporations
Passing Wealth to the Next Generation
If a goal is to pass on wealth to the next generation, this should be planned. I’ve mentioned before that the order of tax attractiveness for the three accounts to pass on wealth is the TFSA, the non-registered account and least attractive is the RRSP/RRIF. The principle residence is on par with the TFSA. See the tax section for details.
Savings earmarked for a generational wealth transfer has its own risk tolerance. Depending on the time difference between now and the date of death (of the surviving spouse), it is reasonable to skew the portfolio towards growth. The longer the time difference the greater the risk tolerance.
What does your will say?
Here is how savings are distributed if you pass away without a will. Is this what you want? If not, see a lawyer. And, the process to wrap up your estate will take substantially longer without a will.