Whether you’re just starting out in the workforce or have been working for decades, it’s wise to think about your eventual retirement. You don’t have to obsess over it, but smart retirement planning can allow you to enjoy that time of your life to the fullest extent possible.
Solid retirement planning means putting aside money today for when you need to draw on your savings. And it’s not enough to just save money: You need to invest it smartly for both capital growth and income generation. The younger you are, the more risks you can take. This usually involves having a higher equity weighting in your portfolio. As you get closer to retirement, most experts will tell you to reduce your equity concentration and focus more on keeping what you already have.
While some aspects of retirement planning have stayed the same over the years, one variable has seen a dramatic change in the past decade: Interest rates. It used to be that savers could put money into fixed-income products and enjoy very good returns. Case in point: consider interest rates on GICs in 2006. Retirees and those planning for retirement could get returns of 3.50% on one-year GICs, and close to 4% on a similar five-year offering. Even with the best GIC rates, the best you can get is 2.05% on a one-year GIC and 2.75% on a five-year GIC. And those really aren’t ordinary as many financial institutions’ one-year GICs have rates of 1% or less.
Of course, the magic of compounding is less and less magical as rates decline. You may have heard of something in finance called the rule of 72. What this formula does is quickly calculate how long it’ll take your money to double given a particular interest rate.
For instance, let’s say you’re earning 2% on a GIC. Dividing 72 by two equals 36, so it will take roughly 36 years to double your money. But at an interest rate of 4%, it will only take 18 years.
In effect, today’s low rates have done at least two things for people thinking about retirement: It’s become harder to accumulate savings while working and it’s also become more difficult to earn interest on investments once someone is retired.
So how much do you need to save for retirement?
“As a general rule, you only need to replace only 50% to 70% of your working income when you retire, because a lot of your expenses are gone: You’ve paid off your mortgage; the children are educated; you no longer have other expenses. In Canada, the bare-bones version of financial independence is not that hard to pull off—for a couple, their Canada Pension [Plan] and OAS will probably bring in $30,000 per year. Then there’s middle-class retirement, which is, say, $60,000 or so a year. Part of that is the government pensions, but the rest will have to come from passive income generated by retirement savings. To generate that much income you’ll need $500,000 to $1 million in today’s market with interest rates as low as they are. But if you want the Cadillac retirement, if you want to eat out in fancy restaurants a lot and you want to travel a lot as a lot of us do, then you want $100,000-plus per year. And to do that, you’ll need $2 million. So basically that’s it. If you can live on nothing and you’re used to living on nothing, you can actually not save a penny. If you want to live in the style to which many of us want to be accustomed, you need a million or two.”
Are low rates here to stay?
Ever since the global financial crisis, interest rates in developed countries have been very low (and in some cases, even negative). It’s natural that a person thinking of their retirement might wonder whether this state of affairs will ever change, or if we’re stuck with low rates for years to come.
No one has a crystal ball. On the one hand, if inflation starts accelerating, rates could then move higher. But if growth and inflation remain sluggish, low rates could be with us for many years to come.
If you have your retirement in mind, whether you’re young or not so young, it’s best to hope for higher rates but plan for continued low ones. If you employ something like a GIC ladder, you can then take advantage of a rise in interest rates if they do finally start moving up.
- Government Bonds vs. GICs: What’s Better?
- How GICs Can be Part of a Diversified Investment Portfolio
- How to Build a GIC Ladder
Flickr: KMR Photography