Retirement planning is easier in small chunks

Retirement planning is like running a marathon. Just break it down into a few manageable portions.

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Thousands of Canadians crossed a milestone off their bucket lists on May 6, the day of the Bank of Montreal Vancouver Marathon. If you want to interrogate a slew of goal-setting maestros, there’s no better place. Take a masseuse down to the finish line, promise massages (on your dime) and you’ll soon have a weary line of runners to question about setting marathon markers.

But ask these same people how much money they’ll need for their retirement and most will give you a gaunt stare. And that’s a shame, because running a marathon and planning for financial independence require the same skill set. You set the target, break it into achievable chunks, then strive to go the distance.

It starts with a game plan to eliminate credit card debt, car loans and your home’s mortgage before you quit work. Then you have to determine how much you could live on if you were retired today. Let’s say $40,000 sounds like a reasonable amount. If so, you’ll need to estimate inflation’s bite. For example, if you’re retiring in 20 years, and inflation averages 3%, you’d require $72,200 in 2032, for $40,000 of 2012 buying power.

Some of the required $72,200 could come from Old Age Security (OAS), with full benefits going to Canadians at age 67 (the age is currently 65, but will be gradually raised to 67, starting in 2023), regardless of work history. The average Canadian retiree earned $508 per month in the final quarter of 2011, amounting to $6,100 per year. If inflation runs 3% and Old Age Security payments keep pace, a retiree might be looking at annual payments of roughly $11,000 in 2032—but you’re still $61,200 short of your $72,200 annual income target.

Canada Pension Plan income could add to the kitty. Payments were $512 per month for the average retiree in 2011. Allocating a 3% annual increase to cover inflation could provide $11,100 per year, putting our financial freedom runner just $50,100 short of her goal. It’s feasible that couples could end up just $30,000 short, after combining CPP and OAS payments.

If your employer doesn’t offer a defined benefit program, you’ll likely need your investments to make up the $30,000 annual shortfall. Plan to withdraw 4% from your future portfolio. Studies show that you shouldn’t run out of money at this rate, and you’ll be able to increase your withdrawals to cover inflation.

If you’ll require $30,000 annually from your investments, you’ll need a portfolio that’s 25 times that amount, or $750,000 (4% of $750,000 is $30,000). Over the past 20 years, the Canadian stock and bond markets have exceeded an average of 8% per year.

Thus a 47-year-old with $100,000 today would need to invest roughly $480 per month to attain $750,000 by the time he’s 67. If the markets make just 6% per year, instead of 8%, he’ll need to invest nearly twice as much: $920 per month. T

he 2% difference between making 6% and making 8% can have huge repercussions. You can’t control the future returns of the markets, but you can plan to control your investment costs. The average Canadian pays more than 2% in annual investment costs. If the stock and bond markets make just 6% annually over the next 10 years, the average Canadian will pay one-third of his annual gains toward investment fees. Instead of making banks and mutual fund companies rich, you may want to check out Dan Bortolotti’s The MoneySense Guide to the Perfect Portfolio, or, if you’ll excuse the plug, my own Millionaire Teacher. In each case, you’ll learn how to build low-cost, diversified portfolios of index funds.

We’ll never know exactly what to expect from future government benefits, nor can we forecast (with precision) stock market returns or the inflation rate. But, especially if times get tougher, reaching financial independence is going to require a lot more planning. As with marathoners who don’t plan, the odds of failure are going to be significantly higher for people opting to wing it.

Andrew Hallam is the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School.