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Three simple (but vexing) questions that sum up retirement planning

Spaniards have a wonderful word for retirement. They call it jubilación.

Canadians also have some choice words for retirement. We call it stressful and confusing – at least when we're still in the planning stages.

When I edited a personal finance magazine, I was amazed by the constant e-mails we received from people in their late 50s with paid-off homes and portfolios well in excess of $1-million. Their question was always the same: Could they possibly afford to retire?

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If even affluent Canadians feel uneasy about whether they have enough set aside for their golden years, it's a safe bet that many middle-class Canadians are viewing the topic with quiet dread.

The reality is not nearly so frightening as many people think – but to get a handle on your own planning it's important to understand why even people with seven-figure portfolios can feel like retirement paupers.

It all comes down to the inherent uncertainty of retirement planning, which can be summed up in three key questions.

How much do I need?
Pension planners have historically assumed that retirees needed to replace roughly 70 per cent of their preretirement income to enjoy substantially the same lifestyle they did while working.

But the notion of the 70 per cent replacement ratio is coming under increasing attack. Malcolm Hamilton of the C.D. Howe Institute argues that most middle-class earners will be fine in retirement if they replace 50 per cent to 60 per cent of their working incomes.

Mr. Hamilton says many of the expenses we face during our working lives – including mortgage payments, child care expenses and RRSP contributions – disappear in retirement. On top of that, retirees usually pay less in tax since their incomes are lower.

What returns can I expect?
History suggests that $100,000 invested in a portfolio of stocks and bonds will produce an after-inflation return of $4,000 a year – a 4 per cent real rate of return.

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But that figure, too, is coming under increasing scrutiny. Economist Keith Horner, in a 2009 study, points out that economic growth in the developed world is likely to slow in the coming decades as labour forces shrink. He suggests a 2.5 per cent rate of return, after inflation, may be a realistic estimate of what to expect in the years ahead.

What will government provide?
Some financial planners encourage clients to plan on the assumption that Canada Pension Plan and Old Age Security will not be around when they retire. Doing your planning on that basis will safeguard you from any unpleasant surprises – but it could also lead you to save far too much.

CPP is funded out of deductions from your salary and actuaries say it is on course to pay out everything it has promised. OAS is a trickier matter – it is funded out of general tax revenues so it depends upon government's resolve. That being said, it's difficult to imagine OAS being trashed by any politician – at least, any politician who wants to be re-elected.

The rules surrounding both payouts are complicated, but assuming that the system remains much as it is now, a married middle-class couple who have worked in Canada for most of their lives and retire at 65 can reasonably expect to receive a combined total of $25,000 or so a year.

Putting it all together

It's no wonder so many people are petrified by retirement when you look at the vast gap between possible projections.

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Consider a working couple with a combined $100,000-a-year income who assume they need to replace 70 per cent of their paycheques in retirement. If they figure on a 2.5 per cent return on their portfolio but no government stipends, they need roughly $2.8-million.

In stark contrast, the same couple could conclude they need to replace only 50 per cent of their working incomes. Factor in a 4 per cent return from investments, as well as payouts from CPP and OAS, and they need only about $600,000 – or about $2.2-million less than in the first case.

Which set of assumptions is better? I tend to side with the second, but the important point is that you need to understand the logic underlying your own plan and the potential threats to it. To achieve jubilación, think of retirement as an exercise in risk management – a topic we'll explore more next week.

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