How Much Do I Have to Save for Retirement?

(Ben and Nick Rowe correctly pointed out that I goofed in the calculations in the earlier version of this post, which I have deleted and replaced.)

How much money do I need for a secure retirement?

That is the question many baby boomers are asking themselves.

The short answer is, a lot, at least so long as we have to depend upon private investment vehicles.

Some fortunate workers belong to employer sponsored defined benefit pension plans which offer a secure, definite, adequate, inflation indexed monthly pension for life.

However, good private pension arrangements are eroding fast. Just four in ten workers still belong to a workplace pension plan, and one in four of them belong to defined contribution plans which provide a variable lump sum rather than a defined pension benefit. Defined benefit plans do pay a pension for life, but most do not offer full indexation to inflation. Six in ten workers have no workplace pension at all, but are forced to rely on RRSPs and other forms of individual savings.

In short, the great majority of retirees face two key risks. Their savings at retirement – usually held in RRSPs and sometimes in other investments – may not last as long as they live, and they may be eroded by inflation. Of course, the even bigger risk is that their savings may simply not be enough to start with. (The median value of an RRSP at age 60 is only about $60,000.)

Public pensions – Old Age Security and the Canada/Quebec Pension Plan – are good basic building blocks for a secure retirement. But they replace only a very modest share of income, with the exception of very low income workers who qualify for the income-tested Guaranteed Income Supplement to Old Age Security.

Old Age Security and the Canada Pension Plan in combination theoretically replace up to 40% of the pre retirement earnings of an average worker, but that percentage is much lower for those with above average incomes.

The CPP replaces 25% of career average earnings, up to a maximum of 25% of the average, or about $11,000 per year. That leaves a big hole to fill for many people.

However, the CPP has some great features which are hard to find in the world of private pensions. It follows workers from job to job, so benefits are earned for every year spent in the job market. The premium costs are shared equally between employers and workers, and returns on CPP investments are higher than returns to individual savings and to small pension plans due to economies of scale and low management expenses.

Benefits are rock solid, backed not just by the CPP Investment Board but effectively by governments. CPP provides a defined benefit which is paid for your entire life, and it also offers a benefit to surviving spouses and children. On top of all that, the CPP is fully indexed to inflation.

These features are very hard to match in the world of private pensions for those not covered by very good defined benefit plans, and indeed are all but unavailable.

Consider what would have to be saved by an individual to simply match the maximum fully indexed CPP benefit of about $11,000 per year from RRSPs, lump sums accumulated in defined contribution plans and other retirement savings.

The financial pages of our newspapers are full of advice from people who make a living extracting fees and commissions from our retirement savings. (Fees on equity mutual funds average about 2.5%) . At age 71, RRSPs have to be converted into RRIFS which have to be drawn down, or used to purchase an annuity. Annuities are expensive, so the norm is to invest RRIFs and other savings into a mix of mutual funds and GICs. Retirees are basically left to hope that investment returns (minus those fees) provide them with a sufficient income for life, with enough left over to pay for a funeral and to leave something for the kids.

The fail safe option for those tired of failed promises of high returns is to purchase an annuity, guaranteeing a monthly payment for life or for a defined period of say 25 or 30 years. The Cadillac version would be to match what you get from the CPP, payments for life, indexed to inflation.

It turns out that such a product is hard to find, and very expensive, especially now. Insurance companies selling annuities consider anyone who wants to buy one to be a bad risk, in that they clearly have some reason to think that they are going to live for a long time. Women will find that they have to pay much more than men, since they live longer. Men at age 65 can expect, on average, to live to age 83, while women can expect to live to age 86.

Further, sellers of annuities base the cost on a much less rosy view of real investment returns than those offered to retail clients by financial advisers. Like defined benefit plans, they estimate how much has to be set aside to pay the promised benefit using the rate of interest on long-term bonds. Today that rate of interest is very low, under 3.5% on ten year Government of Canada bonds, and just 1.3% on top of inflation for a long term Government of Canada real return bond which would be needed to backstop an indexed annuity with complete certainty.

If you run the numbers, you find that it would take about $250,000 invested at a 2% real rate of return to pay for the rough equivalent of the CPP – a fully inflation indexed benefit of $11,000 paid out for 30 years. Of course, that does not match the CPP since there is no survivor benefit and you could live past age 95. Also it would appear to be very hard to buy an annuity which is fully indexed to inflation, as opposed to promising a set amount plus 2-3% for inflation protection.

(Full disclosure here: a good part of a non registered annuity is considered to be re-payment of principal so there is a tax advantage compared to pension income. But that would be of most interest to those with very high incomes.)

Even in more normal times, I am told the rough rule of thumb for calculating how much you need to set aside to guarantee an annual payment for life, indexed to inflation, is to multiply the desired payment from age 65 by 20. So it would take some $220,000 to pay the equivalent of the maximum CPP benefit.

The key point here is that it costs a lot of money in the market to match the CPP. That is why the CLC proposal to double the CPP benefit from 25% to 50% of average earnings is preferable to the ersatz idea of “pooled” pension plans which will provide an uncertain lump sum at retirement, at much higher cost than the CPP. (The research I have seen suggests that the CPP costs about one third less than the private sector to produce an equivalent retirement benefit dues to economies of scale, low investment management expenses and much greater pooling of longevity risk, but that is a topic for another post.)