The 4-per-cent rule involves drawing down income equal to 4 per cent of your savings in the first year of retirement and then increasing that withdrawal by inflation in future years.
This rule is well-known but fraught with problems. First, it only applies to a narrow group of retirees: those who retire around age 65 with a 50-50 asset mix of equities and bonds.
Second, it doesn’t integrate well with other sources of income. So, if that other income is “bumpy” – different amounts in different years – total income under the 4-per-cent rule will also be bumpy.
Its biggest shortcoming, though, is that it doesn’t adapt to changing circumstances, such as higher or lower investment returns than expected.
Consider Mary-Helen, a 62-year-old retiree with husband, Joe, the same age. The couple have $800,000 in RRSPs and $200,000 in TFSAs. Mary-Helen is a runner who expects to live a long life so she wants her money to last at least until age 93.
If the couple’s average investment return net of fees is just 3 per cent, however, the chart shows they will run out of money by the time they are 90. (They still have some income, thanks to their pensions from the Canada Pension Plan and Old Age Security.)
If they instead achieved net investment returns of 6 per cent a year for 10 years, then dropped to 3 per cent, their money would not run out. Whether they earn a 3 per cent or a 6-per-cent return, however, their income under the 4-per-cent rule is the same up until 90, which I see as a shortcoming of this rule.
By using an algorithm, the couple can estimate their retirement income with more confidence.
A previous column of mine generated some questions about the algorithm used to determine how not to run out of money in retirement. Here is a deeper explanation.
By algorithm, I mean an online calculation tool that determines how much income you can draw under a given set of assumptions for investment returns, inflation and longevity.
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A sophisticated algorithm will also take into account CPP and OAS pensions and the impact of starting those pensions earlier or later.
If the algorithm assumed a 3-per-cent return in all future years and future income is never recalibrated, the result would be the purple line in the chart. A much better result can be obtained by rerunning the algorithm every year (the blue line) to reflect actual experience (such as higher or lower returns).
The algorithm approach allows for higher income – in most years – than the 4-per-cent rule because it can be used to find the optimal age to start CPP pension. Not every algorithm does this.
In the case of Mary-Helen and Joe, the best age to start CPP turned out to be 70, even though waiting beyond age 62 diluted their CPP pensions a little.
To be clear, you might assume a 3-per-cent investment return in the algorithm not because you think it is most likely but because you want to be safe. If you earn more, this will eventually work its way into the calculations when you rerun the algorithm in future years.
Some examples of sophisticated algorithms include the Government of Canada Retirement Income Calculator, the Retirement Planning Calculator (Canadian), the Moneyready app and, of course, the Personal Enhanced Retirement Calculator. In addition, most banks and insurance companies, and many investment managers, offer free online calculators.
Frederick Vettese is former chief actuary of Morneau Shepell and author of the PERC retirement calculator (perc-pro.ca)
Editor’s note: A previous version of this article made incorrect references to the colours in the chart. Previous references to the black and green lines in the chart have been updated to correctly refer to the purple and blue lines.
