Fiscal sustainability is a hot topic these days. It is central to the European debt crisis and the government debt problem in the U.S. But lately it has entered discussions about Canada’s upcoming federal budget, as well as the Report of the Commission to Reform Ontario’s Public Services headed by Don Drummond.
In the Canadian context, fiscal sustainability is how governments can provide the goods and services that the population wants and needs, without going broke. To avoid insolvency, government expenditures must be matched by tax revenues over the long haul. In other words, government borrowing is acceptable to deal with short-term problems, but governments are supposed to repay what they borrow. Yes, governments are expected to pay off those credit cards just like us.
Understand that fiscal sustainability is easier said than done. It’s important to the economics of retirement for at least two reasons. A good deal of the market volatility that has been distressing investors is the direct result of the uncertainty felt by financial markets over the lack of fiscal sustainability around the world.
At the same time, achieving fiscal sustainability—for at least some governments—may have a direct effect on the economics of retirement. The cost of dealing with increasing public sector burdens, such as pensions and healthcare, resulting from an aging population, is a prime example.
If we can’t directly fix government fiscal sustainability issues, we had better try to deal with the issues that affect retirement sustainability.
For illustrative purposes, let’s remember a simple equation: savings plus investment income equals spending in retirement. I would argue that you need to start by addressing spending.
The amount of spending in retirement will be partly a function of what the retiree wants to do, but very much a function of what income is available to them. And the ‘discretionary’ part of spending in retirement will be dictated by the cost of necessities such as food, clothing, shelter and very likely some part of healthcare.
This takes us to the left side of the equation—savings and investment income. Obviously, the two are related. The higher the rate of return, the less savings are required. From here on, solving the equation becomes more and more client-centric.
Clearly, investment income for any given level of savings depends in part on the behaviour of the markets where the underlying investments are held. But other than choosing what markets and securities to invest in, there is no control on the part of the retiree.
It is asset allocation where control can be exercised. Much has been written about asset allocation, but the basics—stocks, bonds and cash—don’t seem to change much over time. It is a client-centric issue and the specific allocation, both among the broad categories and within them, depends on the individual client’s risk tolerance, age (a factor in risk tolerance) and timeline to retirement.
Regardless of the specific asset allocation that is appropriate for each client, in this environment it seems prudent to keep expectations about investment returns on the conservative side.
Finally, the savings; arguably the hardest part of the equation to solve partly because there are competing demands on cash flow and partly because things that we can acquire now seem more attractive than those we will buy in 20 years when we retire.
In addition, it’s tricky for clients to understand what savings rates will achieve their personal goals: they are looking for that “magic number”.
General rules around how much an individual should save for retirement are not very useful—the rate is too tied to individual circumstances to allow for general rules. But a couple of numbers from a 2010 C.D. Howe Institute report by former Bank of Canada Governor David Dodge and co-authors Alexandre Laurin and Colin Busby put things in perspective.
The main finding was that an individual will need to save between 10% and 21% of their pre-tax earnings, even if they save for 35 years, depending on the pre-retirement income replacement rate they desire. There are two important points to consider about this conclusion. One is that the assumptions, including expected rate of return, are important. The other is as an advisor you may have clients saving 10% of their income, but do you have any saving 21%?
So, how do we tie it all together? For governments, fiscal sustainability can only be achieved by allocating scarce resources (tax revenue) in a way that it covers all expenditures over the long-term, which will include periods of good economic performance, which will raise tax revenue, and periods of poor economic performance, which will deplete it.
For individuals, retirement sustainability depends on setting a level of spending in retirement in the future that can be supported by the appropriate combination of saving and investment return rates. And, just as government finances need to take account of both good and bad economic times, individuals need to consider both good and bad financial markets and, quite possibly, periods of varying employment income, which can adversely affect saving for retirement.
One last thing—if you, as an advisor, are going to give your clients really strong advice around the issues I have been discussing, you are going to have to do a retirement income plan for them.
Some of you already have, but Fidelity’s 2011 Retirement Survey’s results include depressingly-familiar statistics on just how few clients have them. For the record, the percentage of respondents who told us they had a retirement income plan was 25% for non-retirees and 23% for retirees. These numbers have hardly changed in the seven years we have done the survey.
It’s time they did, and only advisors have the ability to do that. Your clients’ retirement income sustainability demands it.
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