There are a lot of differing opinions about how to construct a long term investment plan – some go for a fixed total amount (indeed this option is the backbone of advice from financial institutions who have a clear interest in gaining large deposits), others want sufficient income for financial independence that will not reduce their capital.
Wealth-Based Investing
One million dollars was always the target for a retirement account and today it probably is considerably more. This option allows for a 4% withdrawal rate on the total financial assets each year.
This means you need to save roughly 25 times your expected annual expenses. Thus $1M allows you to withdraw $40,000 per year and $2.2M will give you $100,000 per year. Disadvantages of this plan are:
- You need to start early in life, or contribute a great deal more of your income in later years to amass the target amount by your retirement age. For example: Assuming an annual return of 8%, 21 year old Dayle can contribute $167 per month for 44 years, but 40 year old Jamie needs to deposit $815 monthly for 25 years for the same grand total. Interestingly, if the rate of return drops to 5%, Dayle’s deposit climbs to $525 and Jaime must come up with $1,660.
- It’s difficult to accurately predict variables such as investment returns, rate of inflation, tax rate, unforeseen future expenses, and health and longevity, especially the further away you are from retirement.
- A severe market downturn can drastically erode capital in your stock or mutual fund portfolio just when you need it. As a precaution, many people close to retirement convert to a fixed income portfolio but will then lose the greater growth potential of equities.
- If the funds are held in a RRSP or RRIF the total amount withdrawn is taxed at your highest tax rate, as is interest from fixed income sources.
Income-Based Investing
On retirement, employment income must be replaced. Unless you are fortunate enough to receive royalties from a creative endeavor, this usually means supplementing income from a defined benefit plan or defined contribution plan with investment income.
A rule of thumb is to receive 60% to 80% of pre-retirement income. Disadvantages of this method are:
- You still have to amass a fair amount in order to have sufficient capital to earn the interest or dividend amount you require.
- Good quality blue chip companies regularly increase their dividend payments, but there could be occasions where dividends are reduced or eliminated altogether.
- Unexpected medical bills or other expenses can force you to dip in to your principal amount if you haven’t calculated sufficient monthly income to cover them.
Personally, I’m working at generating enough monthly income to fund my retirement years. I suspect that most people will do some combination of the two methods.
Related: The Best Time To Start Saving Is Now
Consult with your financial professional to determine your personal calculations (for DIY investors there are a lot of resources available). The goal for everyone is to have the financial resources to live an active, healthy life doing what they love best.
