I often like to play out different scenarios with my finances. It’s sort of the equivalent to day dreaming for me, where I can choose a different life and try to imagine the details how it would feel. One day I’m living the material high-life by spending all my hard earned money, the next I’m clipping coupons and sleeping in until 10am every morning. Realistically the right balance is in-between these two scenarios, but another scenario I play out is retirement in ten years at which point I would be 40.
Retirement means something different to each person. Some people enjoy going cold turkey in regards to their careers, while others start side careers where they pursue different passions. For the purpose of this conversation we’ll define retirement as a state in which you are not required to actively work to support yourself. This is also known as financial independence.
Retirement: A Bottom-Up Approach
A lot of people toss and turn at night wondering the amount of savings they need to retire. I often hear the million dollar figure arbitrarily tossed out there. The truth is for some this may not be enough, not by a long shot. The amount you will need to retire is directly related to your lifestyle and the cost of living during retirement.
Determining your cost of living during retirement requires quite a few decisions and assumptions. Do you want to travel? What big one-time expenses will you have? Will you have your mortgage paid off? Do you want to downsize your house? Could you cut your current spending budget? How much will you pay for health insurance? Ideally you will have paid off your mortgage before you retire, which will reduce the amount of income you need each year to get by.
A safe rule of thumb for retirement savings is to determine your annual cost of living and multiply it by 25. For example, if your living expenses each year were $50,000 you would need $1,250,000 of investments to safely live out the rest of you years in retirement. The lower your cost of living in retirement the less you will need to save. Lowering your cost of living will also have tax advantages as lower income levels will result in a lower marginal tax rate.
Frugality: Less is more
I really don’t like the word frugal for some reason (you’ll learn there are a lot of words I arbitrarily dislike…like the word “moist”), but I love the concept.
Frugality is not the same as cheap, although the two words are sometimes used interchangeably. Frugal is making efficient use out of what you have to obtain good value while cheap often cuts corners by sacrificing value for cost. For example a frugal person that wanted comfortable shoes would research the best type of shoes and look for a sale on the shoes, while a cheap person would wear discarded shoe boxes on their feet.
I’ve really started to buy into this whole concept of frugality and how it really can explosively change your life. By being frugal it allows you to save more money to generate wealth. It also lowers your future cost of living which requires a lower amount of wealth.
Compare a frugal doctor (high income earner) with a high consuming lawyer (also a high income earner). The lawyer buys a big house, cottage, boat, expensive cars and often doesn’t shop around for a good deal because he makes lots of money. The doctor on the other hand has a medium sized house, rents a cottage for a few weeks in the summer, drives a used car luxury car and never shops without researching prices and deals. If the doctor and lawyer make the same amount the doctor should be able to save more each year. The lawyer will have a difficult time retiring because he requires more income to support his properties and spending habits. Having a higher income will also result in higher taxes which also increases his cost of living.
I’ll touch on frugality consistently throughout my posts, while still attempting to minimize the use of the word!
The Nest Egg
Once you’ve determine your cost of living you can start to work towards saving for your retirement. Let’s assume I have a projected annual cost of living of $30,000. For those who are lucky enough to have employer defined benefit pensions some or all of this cost could be offset by annual pension income, but an increasing vast majority of people do not have this luxury. For this example I will assume there is no pension income. That means I will require $750,000 ($30,000 x 25 rule of thumb) to safely retire in ten years. Assuming a 5% rate of return on our savings we would be required to save $58,200 each year to safely retire in 10 years:
|Year||Savings Contribution||Year End Balance|
By utilizing the TFSA and RSP accounts I should be able to avoid most of the tax associated with any investment income during the 10 years. The overall appreciation in value of $168,334 assumes a 5% rate of return, which is reasonable but not a given.
My retirement withdrawals for the $30,000 cost of living would be as follows:
|Retirement Year||Living Withdrawal||Year End Balance|
Notice how the yearend balance actual grows due to the 5% rate of return on the investment balance despite the living withdrawals. I’ve also factored in 2% inflation on the cost of living.
Saving $58,200 per year may be impossible for most based on their income levels and current cost of living. However, this scenario above uses a very aggressive timeframe of 10 years to retirement. Stretching out this savings period will allow for more time to save and put less pressure on your budget.
While retirement may be more than 10 years away for most it’s never too early to start working towards making those golden years reality.by