Early retirement has become a trend in recent years. The emergence of the FIRE (Financial Independence, Retire Early) movement is a testament to it. FIRE proponents believe that through aggressive budgeting, saving and investing, people can have financial freedom decades before the usual retirement age.
However, there are two questions for people who want to retire early: How do they do it? Do they really want to do it? A financial advisor’s role is to help them answer these questions.
In terms of the “how,” you can help them through the following steps:
Find out their retirement needs
To figure out how much money is needed for retirement, take an investor’s estimated annual expenses, subtract any benefit payments they will receive – from the government or their employer – and multiply that by 25. For example, if you found out that they will need $100,000 a year to maintain their lifestyle and they will receive $5,000 in benefits payments, they will need to save about $1 million. However, that example assumes a retirement age of around 65.
Early retirement will mean even more aggressive saving. To help you figure out what they need by a certain age, you can use a retirement calculator available online for free.
Help them create their investment portfolio
Investing often provides higher returns than leaving one’s money in a savings account. One way of saving for early retirement is through investing in the stock market. Although investing in stocks is inherently risky, historically, it has an average return of 8%, according to Wealthsimple.
Help investors figure out what their portfolio should look like. For young investors, create a diverse, balanced portfolio full of index funds and set that portfolio to growth by investing in emerging markets and companies. They should start out being aggressive investors because they have a long investment horizon that will enable them to ride out market fluctuations. In a previous article, we discussed some strategies that are suitable for aggressive investors.
As they get close to their retirement date, your job is to help them dial things back by making their portfolio more and more conservative.
Encourage them to use RRSP to save taxes
Canadian Dividend Investing explains how early retirees can capitalize on the tax advantage of using their registered retirement savings plan (RRSP): For those who amass a $1-million portfolio come age 50 and would want to retire, one-quarter of their imaginary portfolio is wrapped up in RRSPs. Once they retire, they will have very little in active income, which is taxed the worst compared to any other income. Passive income will make up the rest.
This is when they can start taking money out of their RRSP: Withdrawing $30,000 annually from their retirement accounts and getting $40,000 annually in dividends would create a tax liability of under $6,000 per year in Alberta, for instance, which is a total tax rate of below 8%. Making $70,000 from employment income would cost 21% in taxes alone (never mind the extra expenses from deductions such as CPP and EI). It could easily creep up to losing 30% of their income each year.
This is how they can keep the tax advantage from RRSPs successfully: If they saved 20% tax on the contribution and then paid 8% on the withdrawal, they have put 12% in their pocket and gotten to keep all those tax-deferred gains. It works out to thousands of dollars over the life of that RRSP.
It gets even better the sooner they retire. A 50-year-old has 21 years before they have to convert their RRSP to RRIF (registered retirement income fund), while a 40-year-old has 31 years to do the same thing. However, both can easily do a little tax planning to keep their total bill owed to the government at a minimum.
The time has come to answer the second question: Do they really want to retire early?
If a person can retire early, why not? The FIRE movement is deeply compelling, but it has its critics, the most famous of which is financial expert Suze Orman, who thinks that FIRE savers tend to underestimate their needs grossly when they are older. Some FIRE proponents say that a person needs about $1 million in the bank, but Orman insists that it should be more like $5 million, according to MarketWatch.
Besides, past results cannot guarantee future ones. Nobody knows what will exactly happen to the stock market or the world economy in the next 10, 20 or 30 years. Crises, for instance, could topple one’s early retirement plans.
In the end, early retirement is a great dream that requires tonnes of work. If investors are up for some serious, personal austerity and willing to put off some of the joys of life, early retirement may be the right move to make.