Financial Planning

Be Retired and Grow your Portfolio!


Mark McNulty


September 15, 2015

September 15, 2015

Many of the professionals we work with have reached the ultimate level of financial independence. They have saved enough money to fund their retirement lifestyle from their portfolio, without eating into any capital. In other words, they can live off the income their portfolio generates and their nest egg continues to grow.Take Dr. John and Mary Doe as an example. On December 31, 2010 they had a portfolio with us of $5,012,695. Every year they withdrew just under $150,000 and at the end of 2014 their portfolio was worth $5,896,515. They spent $150,000 annually after-tax in retirement and their portfolio grew.Another family who joined our firm in 2012 started with a portfolio of $5,574,518. They withdrew an average of just over $260,000 annually. Today their portfolio is worth $5,874,806. They enjoyed $260,000 in retirement spending after-tax and still their portfolio grew.

THE MATHMany dentists we meet have a history of what we call “bar napkin planning”. For example, they might say, “If I sell my practice and wind up with $5 million in total savings and earn five per cent on my investments, I should be able to spend $250,000”.Unfortunately, there is problem with that line of thinking. Their computation doesn’t account for:1. Income tax: if you are like most professionals we work with, you have money saved in RRSPs, corporations, etc. When you withdraw this money to fund your lifestyle, it is taxable. As well, the investment income you earn is taxable. In the case above, if you were making five per centon $5 million, then that $250,000 is taxable.2. Inflation: $1,000 today will not be worth $1,000 in10 years.3. Variability of investment returns: while you may assume an average return of five per cent, the reality is this will not happen every year. In 2008 your portfolio might have been down 10 per cent, so then what happens?4. Reality: there is a big difference between talking about how you are going to fund your retirement and doing it. In other words, one day you actually have to retire. Properly managed means you will get a steady paycheque into your bank account from your portfolio the day you retire. This requires much more planning and organization than happens in “bar napkin planning”.

HOW WE DO ITWe take a formal approach to living off the income from the portfolio through a system we call The Portfolio Paycheque. The first step we took in developing this system was to recognize there are too many variables (one through four mentioned above) to guarantee a cash flow for a long period of time, as is required for your retirement. Therefore, this is a calculation that needs to be run every year. We look at all those variables and investigate probable outcomes. We determine cash flows with which there is a high level of certainty and put risk protocols in place to minimize the volatility of cash flows that have a lower level of certainty.For simplicity sake, assume your retirement assets look similar to those found in Column A (in the Chart on the next page). Suppose with these assets you would like to fund a lifestyle of $150,000 after-tax and indexed to inflation without encroaching on capital.

Step 1: Calculate your high certainty incomeCarefully selected stocks and bonds will make periodic payments to reward their investors. Over the short-term, these cash flows can be known with a relatively high degree of certainty. In Column C, we calculate the net yield, or the interest and dividends expected to be earned over the next 12 months after management fees.

Step 2: Calculate high certainty after-tax incomeEach year we would forecast the taxes for a twelve month period to help understand the level of after-tax cash flow we should expect. In the case above, this was roughly 20 per cent. Using 20 per cent average tax, we can calculate high certainty after-tax spending in Column D. In our example above, we plan to have 98 per cent of the after-tax spending required for the next twelve months to come from high certainty income sources. A further $2,896 will need to come from lower certainty income sources.

Step 3: Calculate lower certainty after-tax incomeWe consider capital appreciation of stocks and bonds as lower certainty sources of income. While this growth has historically produced positive returns over the long run, over a twelve month period the track record is less certain.Our estimate of future growth begins with historically observed price growth across broad market categories. We then consider whether this level of growth could be expected to continue in the future given what we know today, and adjust downward if required.In Column G we arrive at our estimated income from net growth after-tax. Taken at face value, this income may appear to be significantly greater than what would be required to fully meet the $2,896 of shortfall from high certainty income. All this growth should not be considered surplus growth however, but rather growth critical to the portfolio. Sufficient income must be re-invested to the portfolio over the long term to help it outpace the effects of inflation (the rate at which goods and services go up in price over time).Over the last ten years, inflation has been 1.7 per cent in Canada. Therefore, we estimate that 1.7 per cent of the portfolio’s value at the beginning of the year must be re-invested by the end of the year to allow the portfolio to maintain its true purchasing power. The growth required is calculated in Column H and, as indicated, would allow for sufficient re-investment to offset inflation. In fact, there would be a projected $13,507 surplus of growth which could be re-invested to increase the percentage of high certainty income from the portfolio as a risk protocol in future years.

Step 4: Do it all againLaws change, geo-political events occur, you may decide to give money to your grandchildren today so you can experience them enjoying it… these changes make it necessary to re-do this process frequently to keep your plan adaptable to your needs and to future events not envisioned yesterday.Growing your portfolio while in retirement is possible, but it requires an often time-consuming focus on organization and repetitive income modelling, elements generally not present in typical investment strategies.