The Retirement Pipe Dream

Last modified on June 20th, 2010

When I was about 23 years old, at the encouragement of a family member, I read a book called The Wealthy Barber. The book chronicles the fictitious life of a small town barber and, through a series of stories, tells how he managed to become a millionaire despite having a relatively modest salary.

There are two main take-aways from the book, both of which form the crux of personal finance these days.

The first main idea is to pay yourself first – basically you set aside a fixed portion of your income (often 10%) and dedicate that towards a retirement fund. The second main idea is to take advantage of the benefits of compound interest, allowing money to build to hopefully staggering proportions over time.

Like many financial books, the author uses numbers that are favourable to the desired message of the book instead of being true to economic realities. For example, many financial books assume a marginal tax rate of 43% for RRSP contributions. While many people are indeed in the 43% tax bracket, a larger majority aren’t, so it seems pointless to use examples that only favour the smallest, wealthiest segment of the intended audience when trying to teach financial principles to the general population.

The second problem is that many authors assume a 10% or higher return when doing compounding calculations. On the surface, that seems like a reasonable number, especially considering the S&P 500 has averaged approximately a 12.5% annual return since its inception. But the actual return on investments is usually significantly smaller.

Every mutual fund has an associated fee with it, meant to cover the management of the stocks in the fund, as well as giving commissions to financial advisors who sell the fund. In Canada, the average management expense ratio (MER) is estimated to be around 2.6%. What that means is that if a given mutual fund were to track the market (and that’s a big if – many mutual funds under perform the market indices), and the market had a 12.5% return in a given year, the amount your investments would grow would probably be around 9.9%.

The other variable that many financial books only passively glance upon is inflation, partially because it’s a complicated subject, and partially because it’s inclusion causes the math to break down in many typical scenarios. That’s why many online RRSP calculators ignore the effects of inflation, or have it disabled by default in the calculation.

Inflation in many ways is the theft of wealth by a nation from its people. The first form of inflation was actually performed using metal coins. In order to pay off debts, gold was taken from coins in circulation, and replaced with metals of lesser values such as nickel or bronze. This led to a decrease in purchasing power for each coin, which is similar to what happens when inflation occurs today. Given that most countries do not have the actual means (in terms of resources with intrinsic value) to pay off their interest payments each year, many countries resort to printing more money, which is in a lot of ways the same as taking a percentage of everyone’s savings to make debt payments.

According to the Bank of Canada, the average annual rate of inflation since I was born is around 3.1%. Using my example above, the 9.9% return, when inflation is taken into account, would only amount to around 6.8% – not a bad return, especially in these markets, but far shy of the 10% alluded to in most books. With a 6.8% return, you would have to start investing before the age of 30 and work until the age of 65, but you might have enough for retirement.

Many people think having a decent retirement based on the math above is a pipe dream. One such individual is Tim Ferris, author of The Four Hour Work Week. Tim points out that unless you’re essentially making gobs of money as a young person, the math simply doesn’t work. And if it does work, chances are you spent the best years of your life working 60 hour weeks to make it happen.

Truthfully, it’ll be interesting to see what happens. In my opinion, we’re really the first generation to test the retirement hypothesis. Given the troubled state of real estate, an asset which once provided security for many people’s retirements, many of us will most likely need to finance our retirement on our investments alone. When markets were providing 12.5%, that was a definite possibility. But many people, including John Bogle, believe we’re about to enter into a massive market slump with peak returns of around 9% for the next 10 years or so.

A report in January highlighted the troubled state of real estate in many countries, including Canada. The data in the report is meant to reflect the affordability of housing in many locations in the world, usually measured as multiple of average personal income. Affordable housing is defined as a score of 3.0 or less.

Topping the world’s most unaffordable housing market is Vancouver with a score of 9.3. That means the average home price in Vancouver is about 9.3x the average income. Victoria rings in at 7.3, Abbotsford at 6.6, and Toronto at 5.2 (still in the ‘severely unaffordable’ category).

Given that interest rates are at an historic low, and that housing prices do not seem to reflect the fundamentals, many people are predicting a fairly massive pricing correction in Canada in the next few years. Regardless of whether or not you believe prices will crash or not, interest rates only have one direction to travel in — up.

One thing is for certain, we’re currently in uncharted waters. The near collapse of the financial system in the United States was an unprecedented event, even when compared to the Great Depression. The United State’s debt is currently at about 98% of its GDP, which is obviously worrisome, especially considering that Greece, with a debt of 120% of its GDP, nearly collapsed. So right now I think it’s anyone’s guess what happens over the next few years. I have friends in Vancouver that recently sold their houses and have decided to rent for a while. I have other friends who have pulled all their money out of the markets and put them into cash for the near future. I’ve even seen people on various financial boards switching their investments primarily into gold which, historically, has always provided a hedge against devaluing currencies.

It’s undoubtedly going to be a bit of a rocky ride these next few years, at least that’s what many people seem to be predicting. I don’t have enough of a nest-egg in the markets to be too worried at this point, but if I was nearing retirement and had a sizeable amount of money in the markets or real estate, I’d probably be pretty worried right now.

4 responses to “The Retirement Pipe Dream”

  1. smithdm3 says:

    Mutual funds can often be a rip off as you point out, a better option is to form a balanced portfolio of Exchange Traded Funds (ETFs). These can be had in specific industries, commodities, etc and can represent a great way to diversify while also avoiding high management fees (ETFs maintain a consistent portfolio unlike mutual funds and so do not ordinarily require a lot in the way of management).

    Another thing is that while you describe the bad side of inflation, there can be positives as well. For instance, if you buy your home and are paying down a mortgage as time goes on your housing costs should make up a smaller percentage of your income. The base cost of the house does not increase (assuming you don’t go hog wild into home equity loans, lines of credit, etc.) while your income will track close to inflation.

    In general, the lessons the Wealthy Barber teaches are good ones. Paying yourself first and taking advantage of the power of compounding are two of the best ways to save, as are managing a diverse portfolio within what you believe to be your own risk profile (some say the percentage you have in fixed income should be roughly equal to your age for instance).

    Anyway, just more food for thought… certainly makes the ordinary joe rather jealous of the gold-plated pensions associated with civil servant roles, especially here in Ottawa. 🙂

  2. Duane Storey says:

    I think ETFs are good vehicles, but given that they have per-transaction costs, aren’t really applicable (IMO) unless you’re investing large amounts of money and not buying/selling them very often. Strangely enough, many people buy ETFs that represent index funds, and then go about buying and selling them as the markets go up and down (in effect, trying to chase the market), which is precisely what index funds weren’t intended to be used for. In that scenario (and many scenarios involving ETF traders), those investors are actually doing worse than their mutual fund equivalents.

    The fixed income portion of your portfolio is actually something I was going to address in my post, but didn’t want to confuse the issue even further. My point was going to be that if you do what you suggest (and most financial advisors suggest, which is to allocate a fixed income at a percentage roughly equal to your age), the expected return is even lower (for example, if 30% of my portfolio is fixed-income at 4% and 70% is at 6.8%, my weighted annual return is only about 6%, which is even further away from the 10% depicted in books). The upside is obviously reduced risk, but the downside is a diminishment of the potential annual return.

  3. All our retirement savings will be worthless once the inevitable skeleton robot uprising comes. Time to start building your bunker.

  4. Beth says:

    I wonder if the Home Buyers Plan will allow me to withdraw money from my RRSPs to fund my anti-skeleton robot bunker?

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