January 01, 2019Education
Let's Do The Math
Many people have the wrong idea about investing because they do not understand how the capital markets work. This is not surprising because the basis of our economy – free market capitalism – is not generally taught in our education system. So a lot of people grow up believing that investing is similar to playing the lottery or going to a casino.
But the capital markets are actually pretty simple. If you save some of your income and invest it, that becomes capital. The capital markets act as an intermediary to get this money out to businesses who invest it, thereby creating jobs and growing the economy. That growth enables these businesses to generate a return on your investment so your money grows to fund your eventual retirement. (This happens whether you invest directly yourself or have it done on your behalf by an investment fund or a company pension plan.)
Most people don't think much about funding their retirement until they are nearing the end of their working life. And those who think investing is a risky exercise akin to gambling may not invest in the capital markets at all. But it becomes clear when you do that math that, unless you are able to inherit several million dollars, investing to fund your retirement is essential.
Nobody likes to do math so I am going to do it for you with a very simple illustration. Let's assume we have a single, hard-working bachelor - Jake - who gets a good job at age 20 and makes $100,000 a year. He plans to retire at age 65 and does not have a company pension plan. Over 45 years working he plans to salt away $10,000 each and every year. But Jake does not trust the capital markets so he stashes his money in a secret lock box.
Upon retirement, Jake will have $450,000. Various experts say he should be able to maintain his standard of living with only 70% of his working income, which would be $70,000 in this example. So Jake would have enough for 6 years in retirement, plus a bit more when you include CPP. That might work if he plans on dying at age 72, not leaving any estate. But there is something missing in this simple analysis…
Most central banks target an inflation rate of 2%. In past decades like the 1970s, inflation was a lot higher than that! But if we assume only 2% annual inflation, Jake will need $170,000 a year to live by the time he retires - not $70,000. (Of course, we would expect Jake's salary to go up with inflation too, but this analysis assumes that he puts away only $10,000 each year, no matter what.) At $170,000 spending each year in retirement, Jake maybe has a bit more than 3 years covered, which works only if he plans to live to age 68. Not a very good scenario with lifespans these days reaching into the 80s.
You can see right away that Jake has to invest his savings if he wants to ensure a reasonable retirement. That is where the capital markets come in. If we assume that Jake can earn 6% after fees, compounded within a tax shelter like an RRSP, he would end up with $2,250,000 at age 65 instead of $450,000 in a lock box. If we project his future investment returns at the same 6% rate and continue to inflate Jake's living expenses of $170,000 at 2% going forward, He will not run out of money until age 83. That seems a lot more reasonable than age 68. Investing buys him another 15 years of retirement.
Of course, this is a very simple example. It does not anticipate a family with potentially two incomes offset by the expenses of raising children, including eventual post-secondary education. Also, it is difficult for most people to save much in the first decade or so of working if they are raising a family. On the other hand, many can afford to increase their savings in later years after kids are grown. Plus most couples will have purchased a home and maybe a vacation property, resulting in significant real estate gains by the time they retire. Some will enjoy a company pension while others might be fortunate to inherit material assets. Taxes are another important variable that can affect eventual retirement and estate outcomes.
All of these factors are why we prepare a detailed financial plan for each of our clients. There are a lot of factors that can change over time, which means retirement planning works better the sooner you start. If you would like an assessment of your retirement prospects, please give us a call to arrange an appointment.
This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World
Markets Inc. 2020