In The Wealthy Barber, which was one of the best-selling books on money in Canadian history, author David Chilton argues that the average Canadian can set themselves up for a comfortable retirement by doing one simple thing. All you have to do is set aside 10% of your income, invest it wisely using a mutual fund, and you’re in business.
Critics of the book point out it was first published in 1989, which was an era of much higher interest rates, and often uses aggressive return assumptions of 10-12% per year to “prove” setting aside just a small percentage of one’s income can work. And Chilton himself acknowledges that the advice to buy mutual funds is outdated, telling Canadian investors in 2015 to find exchange traded funds instead.
Are the critics right, especially considering the low interest world which we deal with today? Or is Chilton right? Let’s have a closer look.
The power of compounding
We all know that starting to invest earlier in life is a big part of making sure you’ve got enough cash for retirement. So let’s run the numbers on two imaginary investors.
Say they both make $50,000 per year, which is about average these days. One puts aside $5,000 per year starting at age 25, while the other horses around and doesn’t get serious about saving until age 40. We’ll assume each investor can earn a consistent 8% return over time and stops contributing at age 65.
The first investor does quite well for himself, turning his periodic investment into a nest egg worth more than $1.5 million. The second investor still does pretty well, but only accumulates $429,000.
Now we have to make an assumption about their retirement. If each retires at age 65, it’s prudent to assume they’ll still be kicking around at age 90, just to be safe. Each wants to keep the same lifestyle, so we’ll assume they withdraw $45,000 per year, since they don’t have to save for retirement any longer.
There’s just one wrinkle we’re missing, and that’s inflation. Over 40 years, inflation of just 2% will approximately halve the spending power of $50,000 per year. I’m not sure that it’s fair to include it though, since we haven’t given our imaginary borrowers a raise over their working lifetimes. So we’ll be a little conservative and assume they both want to live on $60,000 per year.
The conclusion is obvious. Our second investor only accumulated $429,000, which means he’ll have to withdraw 14% of his nest egg each year. It’s not going to last any longer than a decade at most.
Even our first investor might be in for a rough time. $60,000 per year is 4% of his $1.5 million retirement fund. If it continues to grow at a modest pace, he’ll be fine. But if it doesn’t, he’s running into danger of running out of money too.
The problem with projections
The investment business would take my hypothetical situation and use it to guilt people into buying more investments. Hey, it’s what they do.
But the future isn’t quite as dire as I’ve painted it out to be. Firstly, both of our fictitious savers would be eligible for Canada Pension Plan and Old Age Security payments, adding at least $1000 per month to their income. And if both were married, they can count on their spouse to get at least OAS.
Plus, there’s no reason to assume that much spending. Most retirees have their house paid for and their kids have left the nest, hopefully becoming financially independent. And like I previously mentioned, they no longer have to save for retirement.
In reality, I can picture a scenario where a retiree only needs $30,000 or $35,000 per year to live comfortably, with between $10,000 and $20,000 of that coming from the government. Suddenly, our two investors only need to generate $15,000 or $25,000 per year from their portfolios. In that situation, even the borrower with a $439,000 nest egg is still in pretty good shape, while the guy sitting on $1.5 million will never run out of money.
I’m not saying you don’t need to save for retirement, because of course you do. Just remember that likely your spending won’t be as high as it is now, and you’ll have help from the government. With those two things in your favor, saving 10% should be all it takes to ensure you’re not eating cat food during your golden years, provided you start at a relatively early age.