For many years, I hoped to retire on the income generated by our fixed income investments. Since 2008, however, the rates paid by these types of investments have drifted down so low I’ve had to re-consider our options. I’ve been trying to decide whether we now intend to retire on income from our dividends and interest payments or whether we intend to live off primarily the capital gains and principal generated by selling part of our holdings: and I need to understand how that will affect what we choose to invest in now before we retire.
Do You Plan on Living Off What Your Capital Earns or on Living Off the Capital Itself?
Yes, I know that if you are planning to live off of the capital itself, you will most likely be living off a blend of the income that capital earns and the capital gains it makes. Your income might be a combination of dividends, interest, capital gains and liquidated principal.
However, the broader question is: do you intend to spend your capital in retirement to live on? Or do you hope to die with that capital intact, leaving it as a legacy to your relatives, friends or deserving others including charities?
What Family Experience Can I Draw On to Evaluate the Options?
This is a question many of my older relatives have faced. In general, since there are no hugely wealthy people in our family tree, their capital has been mostly invested in their homes.
The only practical ways they could access that capital were
- via selling their home and renting or moving in with a relative or friend, or
- by taking out some form of loan (C.H.I.P., HELOC etc.) that had to be re-paid when the home was sold.
We’ve had relatives who did access the home ownership capital and use it and others who kept their home in reserve in case they needed the capital to pay for long-term end-of-life care.
A small minority of my relatives had additional savings. Some of them have not touched the principal of those savings but have used the income that they generate to supplement their pension income. An even smaller minority has gradually spent those savings.
Looking at various family members’ retirements, I’ve tried to see what would work best for us. It’s complex because different people retired into different world situations and financial times. Some had no work pensions. Others had defined benefit pensions. The only common thread is none of them were reckless spenders.
Retirement Spending Plans Can Change With Age
One thing I did notice is that the older people grew, the more reluctant most became to spend. They had all seen friends and relations end up needing expensive end-of-life care. They had seen some whose finances could not stretch to provide the care they would have preferred. Home care, for example, is often the most expensive type of care for most people because almost none of the costs are covered by the government. The quality of nursing home you can afford is also often dependent on how much money you have to buy additional services or to provide care elsewhere while you wait for an opening to become available at a favoured location.
For that reason, many of them would not consider selling their house or getting a loan against the value of their house. They were counting on their houses to provide a small nest egg to pay for care should the need arise.
Others also became reluctant to change homes because the familiarity and proximity to life-long friends provided great comfort.
These observations led my husband and I to the knowledge that if we intend to move to free up some of the value of our current home, we’d better plan on doing it near the beginning of our retirement before we become too risk averse.
Can You Count on Funding a Retirement from Capital Gains?
There are various types of capital gains. The gain comes if you sell something for more than you paid for it. In theory, you could then use the gain for income and re-invest the original principal in something that can earn you a second capital gain. In reality, many people use both the gain and the re-gained principal for income. They just sell less of the investment and leave the balance for the next time they need income.
What Types of Investment Can Generate Capital Gains?
You can realize a profit on
- Stocks and shares in companies
- Real estate
- Investing in tangible goods such as coins, precious metals, jewels, art, antiques, etc.
None of these investments guarantees an investor will realize a capital gain when they sell the investment. All of these investments can actually suffer a loss.
Still, some of these investments offer a measure of reassurance when you look at their historical trends. Stock markets generally move up over the long term. Real estate in major cities in Canada has usually gone up in value, although the forces that created that demand in the 1950s are very different from those at work now. Tangible goods have bounced every which way in value but some like precious metals and raw gems have mostly increased in value over time.
Am I assured that investing in, say, stocks will guarantee me a retirement income? No.
But I can’t think of any other type of investment that will guarantee me an income either.
Well I can think of one: Maybe buying an annuity would. That would shift the need to make a steady income from a chunk of capital from me to the annuity issuer. Given the low rates per $100 000 invested in an annuity right now, though, it doesn’t seem like a great solution.
Can You Count on Funding a Retirement from Investment Income?
There’s two parts to this question:
- Can you stockpile enough investments to earn a sizeable income?
- How reliable is that income?
What Types of Investment Can Generate a Retirement Income?
Traditional means to create investment income include
- Dividends from shares and stocks and privately-held companies
- Dividends from preferred shares
- Interest income from bank accounts, GICs, Term Deposits, T-bills and money market instruments
- Interest income from government and corporate bonds
- Interest income from private loans and mortgages
- Return of capital from various investments
- Distributions of various types from income trusts (There are still some income trusts available including Real Estate Income Trusts (REITs) and food-related trusts such as the Keg, A&W etc.)
How Reliable Is the Retirement Income from These Types of Investments?
Most of these types of investments yield 6% before tax or less on the day you buy them.
Many of these types of investments do not guarantee they will continue to provide the same rate of income.
For example, a 5-year GIC issued today does guarantee your rate of return for the next 5 years; but there is no guarantee that you will be able to negotiate a similar rate of return for the next interval once the certificate matures.
Dividends can also change. Many dividends have a history of slowly growing. They are not guaranteed though and they can be reduced or stopped altogether. And if the issuer goes bankrupt, your principal can disappear along with your income stream.
How Much Do You Need to Have Invested to Earn Enough Income to Retire?
Is it even possible to save and invest enough money to generate an income for retirement?
Say you want $50 000 a year, after tax, in retirement.
Here’s the first cheat: You’re part of a couple. That makes a decent retirement income much, much easier to acquire.
You plan to each receive $25 000 a year after tax. In Ontario that means you’d have to earn about $28 600 a year before tax. (That’s a really rough estimate: you may need less if your income is from dividends in a non-registered account and/or if you have higher deductions for age or disability etc.)
Here’s the second cheat: you include receiving OAS (at age 69) and CPP as part of your retirement income plan. This makes the goal of living off of investment income more plausible.
The maximum OAS payment for someone who has lived in Canada for 40 years since turning 18 is 551.54*12 = $6618 a year. (from the Service Canada website, June 2014)
The average CPP payment 633.46*12=$7601 a year. (from the Service Canada website, June 2014)
Combined that’s $14 219. Each. See why planning for a couple is easier? If you’re not romantically partnered for retirement, you may want to consider whether there is a good friend with whom you’d like to share retirement. Just kidding. Or maybe not?
That means you’d each need to earn an additional 28 600 – 14 219 = 14 381 per year from investments. That’s 28 762 in total.
Say you were earning 6% a year from your investments. As a couple, you’d need $479 367 invested to generate the $28 762.
Of course that’s just for the first year. Then you’ll need to earn more because inflation will start changing the $50 000 income you need. Eeeep.
Still it gives you a ballpark of the minimum you’d need.
If that’s totally unachievable, you may want to skip to planning about how to supplement your income by selling investments and realizing the capital gains and/or living off the principal.
However, saving this much is achievable for us which means I haven’t given up on the income route yet.
A Preference for Funding Retirement from Income Rather than Capital Gains
All this pondering left me back where I started: I would prefer to create our retirement income from dividends, interest and other distributions rather than from realizing capital gains on investments or spending the principal. I imagine that’s what most people would prefer, of course!
So can we do it?
And if we can, how do we get there from here?
That’s what I’ll be exploring more in further articles.
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