Everyone falls into two broad categories: net saver or net spender. If you’re a net saver, your cash inflows are greater than your cash outflows. If you’re a net spender, your cash outflows are greater than your cash inflows.
Net savers are typically characterized as individuals who are pre-retirement, whereas net spenders are often retirees who no longer earn employment income and fund any shortfall in their day-to-day expenses by using their retirement savings.
Some people are in the admirable position where they have significant net worth and will always be in the position of a net saver as their investment income and growth surpasses their cash flow needs. For most people there is a time in their life where they will become a net spender.
The transition from net saver to net spender can be difficult. After years of saving for retirement it becomes a habit to see your bank and investment account balances increase month after month.
A common question we are asked is whether someone’s retirement savings will be enough. What is “enough” varies from person to person. Having a tailored financial plan can help provide some clarity in this respect and prepare you for the transition from net saver to net spender.
Creating a financial plan
Financial plans require us to gather both personal and financial information. Your financial planner inputs this information and can generate a variety of documents ranging from a simple concept (i.e. a Registered Retirement Income Fund (RRIF) payout duration report) to a comprehensive financial plan.
The information you gather is mostly concrete and is based on actual amounts as of a certain date. As well, you will have to make some projections as to the level of income you would like at retirement. Your financial planner will also establish various assumptions or estimates (inflation rates, life expectancy, investment returns).
The best part of a financial plan is the list of savings required to meet your goal. As an example, a typical financial plan may recommend that a couple each maximize Registered Retirement Savings Plan (RRSP) contributions, maximize their Tax-Free Savings Account (TFSA) and save monthly in a non-registered account. These savings are required whether we are experiencing good times or bad.
Unfortunately, when markets decline, many people stop investing. This often has a bigger long-term impact on your financial situation than for someone who continues to save. By continuing to invest during difficult times people are essentially dollar cost averaging. By dollar cost averaging we mean that some investments are purchased at higher amounts and others are purchased at lower amounts.
Rather than stopping the amount you save, consider saving more. By saving more, at any time, you increase your chances of reaching your goals.
A typical financial plan should have an investment return assumption that is on the low side of expectations and is low on purpose. If retirement goals can be achieved with a low return assumption, then it can help make the decision to retire easier. Approximately every four years we update the financial plan to reflect current balances; however, the return assumption in the plan will continue to be conservative.
When returns are greater than expectations then three things can be discussed. Consideration should be given to shifting the investment portfolio more conservative as the required returns are now lower. Another discussion point would be lowering the required amount of periodic savings. The last item to discuss is the possibility of either retiring younger or having more funds available at retirement.
When returns are lower than expected it is important to assess how this will impact your financial situation. For some people it may involve saving a little more or working a little longer. We would prefer these two options rather than encouraging people to speculate on their investments to make up the short fall.
For younger people, a negative year in the markets has minimal impact to long-term financial plans. The older a person is, the more the stock market may have an impact on your financial situation.
When it comes to investing in retirement, the period can be 30 years or longer. This is a long period in your life and many people require some growth during this period as well.
When interest rates were higher, it was advised to shift to a more conservative asset mix with a higher percentage in fixed income investments, such as corporate bonds, provincial bonds, federal bonds, coupons, GICs, term deposits, debentures, notes, and preferred shares.
Old textbooks used to suggest that your age be your percentage allocation to fixed income. For example, someone at the age of 75 would have 75 per cent of their portfolio allocated to fixed income. Today this simply doesn’t work since many of these interest-bearing investments do not exceed the rate of inflation, and in many cases provide a negative after-tax and inflation adjusted rate of return.
Creating the wedge
A recommended approach is to create a cash reserve, also known as a cash wedge. With the wedge, our clients determine what their monthly cash flow requirements from their portfolio are. We then multiply that by a number between 12 months to 24 months and set aside these funds in cash equivalents or fixed income.
When determining the wedge, we also ask our clients if they have any large expenses anticipated in the next year, such as a new car, home renovations, vacations, etc. By having this wedge set up for our clients who are living off their investments we are never forced to sell an equity at the wrong point in a market cycle.
We will use Mr. Jones as an example of how to set up the wedge. Mr. Jones is 65 years old and has $1,500,000 to invest. He would like to have $6,000 per month transferred from his investment account to his chequing account to fund his day-to-day expenses. Annually this equals $72,000. In the next year Mr. Jones feels he will need a new car, which he estimates after the trade-in will require $30,000.
Mr. Jones’ cash wedge should be in the range of $102,000 to $174,000. The lower end of the range is calculated by his annual cash flow needs of $72,000 for one year, plus his anticipated car purchase of $30,000. The upper end of the range is calculated by his annual cash flow needs of $72,000 a year two years, plus his anticipated car purchase of $30,000. This wedge will ensure that cash is available to Mr. Jones when required.
If you’re approaching the transition from a net saver to a net spender, speak to your Portfolio Manager today about creating a financial plan. After your financial plan is prepared, it is important to update it with details of any significant changes in your life. Significant changes may include family death, marriage, birth of child, inheritance, sale or purchase of a property, significant raise, job loss or health issues.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email firstname.lastname@example.org or visit greenardgroup.com.