Retirement income modelling

Getting an accurate picture of a client’s retirement prospects requires advisors to drive their planning software harder than they might be accustomed to. Indeed, a February 8, 2010 article by Stephen Lamb on Advisor.ca was right on the money.

In it, Lamb noted: “Retirement funding is a complex machine, with several moving parts . . . A recent RBC survey found 54% of Canadians expect their pension will be the largest source of income, but when asked what kind of pension they have, 19% do not know.”

One of the main causes for this is our industry. We are geared to sell product and do it compliantly, but few planners actually take the time to create a true income model. A retirement income model will pick a retirement date, show the changes in income accurately as the client transitions from working to retirement, and then overlay the lifestyle needs. If the income is able to support the lifestyle needs when compared with the person’s life expectancy, we’re golden.

But it’s harder than it sounds, and here’s why.

Let’s start with the income side. To do proper income modelling an advisor needs to know the pension amount (often it will vary with the option chosen), get the proper indexing assumption, bridge benefit (CPP reduction factor), CPP entitlement, OAS entitlement.

Once an advisor has all this, he or she can make some assumptions around investment returns, RRSP withdrawal, and then calculate the tax consequences of incomes and investment choices. You then need software that will model all this properly and produce a full T1 jacket for every year to get the tax assumption close enough to work with.

This can be difficult, but with some know-how and good software the advisor will be able to arrive at a workable financial plan.

Now, let’s move to the spending side.

A retirement plan should be defined as what the client will be doing when he or she quits work. Knowing what the client intends to do is the first step toward establishing a cash flow requirement. The Retirement Income Model is the document that combines the retirement and financial plans, in other words, it illustrates the client income need as well as income streams after tax. This modelling process relies on getting clients to think and behave in a completely different way than they did when they were working.

During their working years, they were privy to a renewable resource called a paycheque. They spent some of it, saved the rest, and hoped they’d be okay. Money was allocated as it came in, with only a few fixed expenses accounted for ahead of time.

In retirement, by contrast, they’re being asked to think like actuaries—in other words, they must decide how much they will spend up front. And they have to factor that spending for a period of years, as opposed to weeks or months when they were working. So, how much will a client spend every month for the rest of his or her life?

This is the fundamental question that must be answered if any future planning is to be meaningful. Approach this the same way a pension plan would and recognize the importance of good actuarial work in understanding exactly how much money is coming out next year so that money managers can organize cash flows.

When advisors ask the simple, probing questions of clients about what they need to retire, the common answer from most is, “What I can afford.”

When will you retire? “When I can afford to retire, but I can’t afford to live now, let alone when I quit work.” Where will you live? “Where I can afford to live.” Will you travel? “If I can afford to.”

And so on.

If the financial services industry continues to confuse this issue by not clearly defining and differentiating the Retirement Plan (spending) and Financial Plan (incomes) we—as an industry—are not helping.

By completely separating these terms, the advisor can engage a process to walk the client into a position of strength going into retirement.

For clients’ personal pension plan, this question about how much they need is critical. But clients will rarely have a true picture of what it will cost them, or if they do have an idea, it’s often wrong.

The reason for this is most spending on lifestyle needs is not the straight line of utility bills. Many bigger spending decisions such as travel, gifts and house repairs are spur-of- the-moment, or unpredictable, expenses. Life happens. And as a result, clients don’t behave, let alone think, like actuaries.

The clients want me to tell them how much they will have. To get to that, I need to know (much like an actuary) how much they will need.

To help clients establish what they’ll need, find out what it costs them to live right now. This is harder than it sounds.

Here is a simple example of how an interview might go with a couple you’re working with:

Advisor: “What is your income?”

Client: “$150,000, gross.”

Advisor: “That means approximately $35,000 in tax, which leaves $115,000 spendable. So, what are your lifestyle expenses?”

Client: “$75,000 per year.”

Advisor: “That leaves $40,000. Did you save $40,000 last year?”

If the answer is yes, you’ve just established lifestyle needs. If the answer is no, you’re stuck, because there is no way to reconcile the difference in after-tax income and spending. It’s right here that a lot of financial planners get frustrated and fail to continue with this critical process.

The temptation for many advisors is to shy away from this hard work on the soft issues. Yet this is exactly the issue that needs to be dealt with for proper retirement income modelling. This is also where the magic of a good process can go to work. Getting the answers to these questions, in combination with a good Retirement Income Model, works magic with clients.

If there really is $40,000 unaccounted for in the plan, then assume it’s all saved and tell the software to save it all. This can encourage the client to save tens of thousands of dollars per year.

The charts above show three different retirement income models generated from the CCH FP Solutions. These plans are for the same client, but look at different meetings spread over the years from 2003 to 2010.

They show that over time clients were able to get themselves into a position of strength. The bars represent after-tax income; the thin green line is lifestyle needs. The thick green line is total need, which includes saving.

The initial plan from 2003 with these clients indicated they ran out of money at age 65. As a CFP or an IA, I cannot fix this. If they get 8% instead of 6%, they still run out of money.

To correct the problem, clients must be motivated to behave differently. If they don’t they’ll be moving in with their siblings when they turn 67. It’s the advisor’s job to lay this on the line, and in most cases it’s motivation enough.

And there are many levers they can pull. They can work longer, spend less and save more.

This is very powerful for the client and all I did was accurately model their income situation in retirement, overlay lifestyle needs, and articulate their vulnerability. The client did the rest.

In his story, Lamb is right: people do not know what their income will be. More importantly, most have never seen or heard of a Retirement Income Model.

If you remove this area of doubt around income streams and help with the expenditure side, you’ll have gained the clients’ trust.

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John Armstrong, CFP, is founder of The Retirement 101® Program.

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