How much to target for retirement (baby step 4)

[geode]

Our family has progressed on our own, and just realized that we've followed DR's advice fairly closely without knowing it. Having now discovered the Baby Steps, we're trying to align our own financial journey with those steps.

As of right now, we've got about 4 months of expenses in an emergency fund, all debt is gone except for the mortgage, and we're working on baby step 5 putting about $5000 per year into our kids' college funds (enough to get the bonus government grant money of $1000/year for two kids here in Canada), and we are working on baby step 6 by putting a little bit extra (about $50 biweekly) toward our mortgage.

Both my wife and I have excellent pension plans through work, and since we're in Canada, we're also part of the Canada Pension Plan (similar to social security in the USA, but it's totally separate from government revenues and it's highly probable that we will actually receive a CPP pension when we retire).

Here's my question: Via CPP and the pensions through our employers, we're paying about 11% of our gross pay toward retirement "savings". What amount should we contribute to our retirement accounts above-and-beyond the money that's being deducted from our paycheques? I see a few options:

1) Ignore the pension and CPP, and contribute 15% of our gross income.

2) Deduct the CPP and pension contributions from our gross income, and save 15% of the remainder in retirement accounts.

3) Consider the CPP/pension contributions to be part of the 15%, and only save 4% of our gross income toward retirement.

Any thoughts or suggestions you might have would be more than welcome!

[Greebo]

I don't know the ins and outs of the Canadian Pension Plan - but in my opinion, I would not factor any Government run program as part of retirement savings.

So I would ignore the CPP, but consider the pension to be part of the 15%.

However, bear in mind that the idea of retirement savings is to have enough money to live on with no other sources of income for the rest of your life. Assume first that your house will be paid off (as early payoff is part of the plan), then figure your monthly expenses PLUS how much money you want to use for having fun in retirement. Increase that amount by 4% for every year till retirement. Multiply by 12. That's the living expenses per year you need at retirement age.

You want your investments to return enough money that they grow by 4% on top of paying you out the living expenses you need. Dave uses a 12% rate of return (GOOD mutual funds - and they are out there!) living on 8 and keeping 4 as growth. So you need enough in retirement where the rate of return minus your annual expenses is >= 4%. (Which is why a bank savings account won't cut it...)

The formula is:
FV = PV * ((1+i) to the nth)
FV = future value
PV = present value
i = interest rate
n = number of years

In English - lets say you have 20 years till retirement. Inflation is 4% on average. It costs you $2,000 a month to live, not including your house payment.
PV = $2,000
i = 0.04
n = 20
FV = 2000 * ((1+.04) ^ 20)
1.04^20 = 2.1911
2000*2.1911 = 4382

So it will cost you $4,382 per month to live or $52,586 per year in year one of retirement. On a 12% rate of return, that 52,586 must represent 8% of your total growth (the other 4% going back into growth).

52,586/8*12 = $78,879 total ROI.

To figure out what your retirement amount is, then, divide the 52k by 8 and multiply by 100:

52586 / 8 * 100 = $657,325

So at retirement, with a 12% rate of return, you need $657,325 in retirement to live on 8% of its growth and reinvest 4%.
On yr 1 of retirement, the 4% reinvested will be $26,293, so on year 2 you will pull 8% of $683,618.

NOW - if your rate of return is less than 12%, you need more. For example if your investments are in bonds that return 6% (yuck), then you need 52586 to represent TWO percent of your return (6% - 4% for inflation).

In that case you need two point six MILLION in retirement to live on 52k a year.

Once you know what you need in retirement, divide THAT by the number of years to retirement, and thats how much you need to save per year.

At 12% using my example of 20 years to go, that's 33k per year. If you make 100k, that's 33%, not 15%.

So include the pension as part of the % - but remember - 15% is the minimum, not the maximum.

[geode]

Hi Greebo,

Thanks very much for the math - I've run the numbers, and come to some surprising conclusions.

I've taken a look at our expenses, and deducted things that won't exist in retirement (mortgage, child care expenses etc). A number of items will be lower without children in the house (utilities, food etc) but I haven't factored for that - I figure that any reduction in those costs will be offset by increases to travel and other new expenses in retirement. All told, it looks like our family is spending about $36000 a year to maintain our lifestyle, excluding mortgage payments.

When I retire at age 58, my pension will provide 70% of the average of my salary for my five highest-earning years. Assuming that it's 70% of my current salary, it'll almost entirely cover our expenses. And since the pension is fully indexed to inflation, I shouldn't need to worry about increases in expenses over the years. Add in my wife's pension (she's eligible at age 60) and our two pensions will allow us to maintain our current lifestyle, and even increase our spending by around 20% without a problem! And that's not even accounting for the Canada Pension Plan or Old Age Security!

Strangely, I've come to the conclusion that my retirement savings could be zero and we'd end up just fine. I still think I'll be socking some money away, though - it's always nice to have an extra cushion, especially if it allows us to retire earlier if we choose to do so.

[forHISglory]

Hi Geode!
You are right about expenses not being what they are now. I retired a year ago at age 58. The money I spent on transportation is a huge factor right now. I drove about 80 miles a day, so imagine what my gasoline bill would be now with that! I am no longer contributing to my retirement fund (although I still save, but it's not a fixed expense anymore). So those are some of the areas in which I am saving.

On the other hand, I now have to pay all my of my health insurance premiums. That's a big bite!

I thought that perhaps our utilities would go up since I am at home now, and I thought that my food costs might go down. Wrong on both accounts. Utilities and food (factoring in the rampant food inflation now) have remained constant.

I congratulate you on working through this now and on your frugal attitude. Way to go!

[Greebo]

I agree fully with putting extra away.

After all - if all you have at retirement is enough to live on for your expenses, when do you have any fun?

Glad to hear you're in such good shape though!!!

Oh - one other thing - will your pension go to DW upon your demise?

If not - budget for life insurance.

[geode]

@Greebo: Yes, both of our pensions have survivor's benefits, which kick in whether we die before or after retirement. We have life insurance right now, and will have it in place until the kids are grown, and our goal is to be effectively self-insured (i.e. no debts, big wad in the bank, and enough pension benefits to cover everything) so that we don't need to worry about life insurance after about age 45-50 or so.

It's quite reassuring to know that money we're saving for retirement (outside of our pension plans, that is) is essentially "bonus" cash - it'll give us the flexibility to travel, retire early, or whatever. Better to have extra than not enough.