The Canada Pension Plan And Your Retirement

Canadian-Pension-Plans

Note from Susie Q:  When I published my post on Social Security, I promised my Canadian readers a similar post about the Canada Pension Plan.  It took a while, but here it is!  Graeme Hughes, the Money Geek, was kind enough to write it for me.

Graeme Hughes is an accredited Financial Planner with 23 years of experience in the financial services industry. During the course of his career he completed hundreds of financial plans and recommended and sold hundreds of millions of dollars of investment products. He believes that financial independence is a goal anyone can aspire to, and is passionate about helping others to live life on their own terms.

The Canada Pension Plan (CPP) is a foundational part of all Canadians’ retirement plans, as it represents, for many, the single largest government benefit they will receive during retirement. Over the years, opinions on the plan have varied widely, with many suggesting that younger Canadians shouldn’t count on receiving CPP benefits in retirement.

As it stands today, is this a realistic opinion, or is the reality something different? How does the CPP work, and can it be relied upon to deliver a meaningful amount of pension income to future retirees?

How The Canada Pension Plan Differs From Old Age Security

There are two core retirement benefits that the vast majority of Canadians are eligible to receive: the Canada Pension Plan and the Old Age Security (OAS) benefit.

OAS is a benefit that is funded from tax revenue. Both eligibility and the benefit amount paid are based on the number of years an individual has been resident in Canada prior to his or her 65th birthday. Benefits may be reduced for high-income seniors.

The CPP, on the other hand, is a true contributory pension plan. This means that benefits are available only to those who have contributed, and the amount you receive is directly linked to the amount paid into the plan over your working life. CPP contributions are held separate and apart from other government revenue, and CPP benefits are not income-tested.

A Brief History of The Canada Pension Plan

The CPP has had more than 50 years of success in providing pension benefits to Canadian seniors. But a lot has changed along the way:

  • The CPP started in 1966 as a pay-as-you-go plan. In short, it was expected that contributions from workers each year would fully cover the benefits paid to retirees in the same year. The contribution rate for the first couple of decades was just 3.6% of a worker’s pay, which is a very modest amount, indeed.
  • In the mid-1980’s, it started to become clear to the federal government that this model would not be sustainable in the face of a large wave of baby boomers that would be retiring in future years, so changes had to be made. These involved increases to the contribution amounts, reductions in some benefits, as well as changes to the management of the plan itself.
  • These changes culminated in 1997 with the formation of the Canada Pension Plan Investment Board (CPPIB), an entity at arm’s-length from the government that would be entirely responsible for investing CPP assets and funding the distribution of CPP benefits going forward. This effectively removed the government from the management of the pension plan, and the new board was given one overriding mandate above all – to maximize the returns on invested assets while managing risk.
  • As of September 30, 2019, the CPPIB had $409.5 billion in assets under management.

Is the Canada Pension Plan Sustainable?

Many pension plans, both public and private, have been struggling with sustainability over the last many years given demographic changes (the retiring boomers) combined with very low yields on fixed-income investments which often form the backbone of pension assets.

Fortunately, the CPPIB has an oversight regime that continues to account for such changes. Canada’s Office of the Superintendent of Financial Institutions appoints a Chief Actuary, who has as one of their responsibilities a review of the sustainability of the CPP. This review is conducted every three years.

The last reported review, in 2016, concluded that the CPP would be able to fully meet its commitments for at least the next 75 years (the length of time covered in the review), as long as a target rate of return of 4% in excess of inflation was maintained.

In the CPPIB’s 2019 annual report, it was able to boast an average annual return over the preceding 10 years of 11.1% (net nominal). Portfolio investments include public equities, private equity, real assets and fixed-income instruments. The portfolio has widespread geographic diversification, with only 15.5% of assets invested in Canada.

The chart below, from the 2019 annual report, highlights the sustainability of the plan as reflected in the historical and forecast growth in assets:

Clearly, the CPP is in great shape to serve the needs of Canada’s current and future retirees. Even if this should change at some point in the future, the Chief Actuary has the authority to adjust contribution rates to maintain sustainability, should that be necessary at a later point in time.

How Are CPP Contributions Calculated?

CPP contributions are based on an individual’s income, and split equally between employer and employee. Contributions are calculated on the amount of annual income earned that is between $3,500 (the lower cutoff) and $57,400 (the 2019 upper cutoff). Up until 2019, the contribution rate on these amounts had been 9.9%, but a new CPP enhancement that started in 2019 raised that to 10.2%.

As an example, an individual who earned $50,000 in 2019 would have a total CPP contribution of $4,743.00 ($50,000 – $3,500 = $46,500 x 10.2%). Half this amount would be paid by the employee and half by their employer. Of course, self-employed individuals are responsible for the full amount.

It’s important to note that, while the lower cutoff amount is fixed, the upper cutoff is adjusted each January to reflect changes in average Canadian wages. Remember too, that the contribution rate of 9.9% had been in place until last year, with the CPP “enhancement” starting in 2019. The impact of the enhancement will be looked at later in this article.

What Benefits Can I Expect from the CPP?

The “base” calculation for CPP benefits assumes an individual applies for benefits at the normal retirement age of 65. In 2019, the maximum benefit for new retirees under this base scenario is a CPP payment of $1,154.58 per month. All CPP benefits are adjusted each January to account for changes in the Consumer Price Index.

However, most Canadians do not receive that maximum benefit. The amount you actually receive is based on the contributions made to the plan from the age of 18 until the date you apply for CPP benefits. If your total contributions during those years averaged, say, 70% of the maximum contributions permitted, your CPP benefit at age 65 would be approximately 70% of the maximum amount payable.

In short, the higher your working wage, the more you will have paid into the plan, and the more you will receive in benefits, up to the applicable maximums.

There are also a variety of adjustments made to the calculation of your CPP entitlement. For instance, you are allowed to drop your 8 lowest-earning years from the calculation. There are also adjustments for years spent rearing children under the age of 7, for periods of disability and for other circumstances. For these reasons, calculating your potential future benefit at any point in time is virtually impossible to do on your own. Fortunately, the good folks at Service Canada are happy to do the work for you, and an estimate of your individual benefit can be obtained by phone, or online through your My Service Canada Account.

As of October 2019, the average CPP benefit Canadians were receiving amounted to just $672.87, or about 58% of the maximum.

Lastly, CPP benefits paid are fully taxable as regular income.

When Should I Apply for the Pension?

Although the “base” calculation for CPP benefits assumes retirement at age 65, in reality, you have the option of applying for benefits anytime between the ages of 60 and 70. However, the amount of benefit you receive will be adjusted accordingly:

  • If you decide to take your pension early, your pension will be reduced by 0.6% for every month prior to your 65th birthday that benefits begin. So, if you decide to start payments as early as possible, on your 60th birthday, you will receive a 36% total reduction in your entitlement (0.6% x 60 months).
  • Conversely, if you decide to delay the start of benefits, you will receive an extra 0.7% for every month after your 65th birthday that you delay taking benefits. So, delaying benefits all the way to your 70th birthday increases your monthly amount by 42% (0.7% x 60 months).

The chart below outlines the change in monthly benefit given the age at which benefits commence, assuming an individual was eligible for $1,000 per month at age 65:

As seen above, the difference between taking your Canada Pension at age 70 versus age 60 is significant. You’ll receive over double the monthly amount. But the decision as to when to apply depends on a number of factors.

A big factor is, of course, your views on life expectancy. If you enter your early 60’s in poor health, or with a family history of shorter life expectancy, you may want to take the CPP as soon as you are eligible. If the opposite is true, you may want to wait until age 70 to ensure you receive the maximum amount of this inflation-adjusted and government-guaranteed benefit, to protect against the risk of running short of savings and income later in life.

Of course, the amount and structure of your own savings, the amount and source of other retirement income, along with your actual date of retirement, will all weigh on your decision. If in doubt, consult a qualified financial planner to assess the merits of different options.

2019 Changes – The Canada Pension Plan Enhancement

Up until 2019, the CPP was designed to replace about ¼ of a person’s average employment earnings once they retire. The current government has decided that should be enhanced such that the CPP will eventually cover about ⅓ of pre-retirement earnings.

To accomplish this, and to ensure that the newly enhanced benefits are self-funding, the CPP enhancement is being operated almost like an add-on benefit to the existing CPP.  CPP contributions for employers and employees are being increased above the previous 9.9% rate, over time, as follows:

In addition to the increased premiums noted above, the maximum annual earnings for CPP contributions will have an additional, “second ceiling” amount that will allow higher-income earners to contribute proportionately more to the CPP, starting in 2024.

The extent to which this CPP enhancement will increase your retirement benefits is dependent entirely on how much you individually contribute to the enhanced portion prior to retirement, both as regards the increased premium amount, as well as within the elevated earnings cap. However, those who end up contributing to the enhanced amount for a full 40 years could see their CPP benefits increase up to 50%.

Of course, if you are retiring in the next few years, you won’t have enough credit toward the enhanced amounts to make much of a difference to your benefits. These changes are really designed to have the most impact on younger workers who are in the earlier stages of their careers. Given the added complexity this new benefit adds to benefit calculations, it makes more sense than ever to keep track of your entitlement by obtaining occasional estimates from Service Canada.

More information on the CPP enhancement can be found here.

CPP And Your Financial Planning

In this article we have looked exclusively at the CPP as it pertains to retirement benefits. In addition, there are survivor, disability, and other benefits to consider as part of a well-rounded approach to managing personal finances. More comprehensive information on the Canada Pension Plan can be found on the pension benefits section of the Government of Canada’s website.

Remember that a good retirement plan is holistic and accounts for all sources of income, whether from government pension and benefits, employer-sponsored plans, personal savings or business ventures. Ideally, the information above will help with your planning and give you confidence that the CPP will indeed be there for you, regardless of your retirement date.

Top Ten Posts in Our First Year

Financial IQ by Susie Q celebrated its first birthday last week. In the first year, we published 52 posts on our site, two of which were guest posts from other authors, and published two posts on other blogs. In case you haven’t had time to keep up with reading the posts as they are published, we provide you with a list of our ten posts with the highest page views. (We note that there were two periods during which our site wasn’t “talking” to Google Analytics, so there might be a few posts that should have made the top ten, but didn’t.)

#1 Advice We Gave our Kids

This post had almost 1,000 page views in large part because it is the only post we’ve had featured on Money Mix. It provides a list of 7 themes about money that my kids heard frequently as they were growing up or as they were starting to make their own financial decisions. In addition, I added two other pieces of advice I wished I had given them.

#2 Should Chris Pre-Pay His Mortgage

This post was one of my favorite ones to write! Chris @MoneyStir published a post given a lot of detail about his financial situation. He asked others whether their opinion on whether he should pre-pay his mortgage. In my response, I showed Chris that, given his particular circumstances, he would be substantially better off after he fully re-paid his mortgage a large percentage of the time if he invested his extra cash instead of using it to pre-pay his mortgage. One of the broader takeaways from this post is the importance of isolating a single decision and not confusing your thinking by combining separate decisions into one process.

#3 Introduction to Budgeting

Introduction to Budgeting was our very first post. I’m not sure how high on the list it would have been had we published it later, as many of our friends viewed the post just to see what we were doing. I still think budgeting, whether done in great detail or at a high level, is a critical component of financial literacy, so hope that it is valuable to our regular followers and not just our curious friends.

#4 What to Do Once You have Savings

This post is the first in a series of three posts intended to provide a framework and guidance once you have some savings. The series talks about how much to put in emergency savings, how to save for big-ticket items, savings for retirement and deciding whether to pre-pay your student loans. For each type of savings, it provides suggestions for appropriate asset choices.

#5 Getting Started with Budgeting

This post is the first in a series of nine posts on how to create a detailed budget. The process starts with tracking your expenses to see how you are spending your money.  Subsequent posts talk about setting financial goals and figuring out how you want to spend your money.  The series finishes with monitoring your expenses to see how you are doing relative to your budget. This post includes a spreadsheet that allows you to track your expenses.

#6 New vs Used Cars

This post totals up all of the costs of owning a car to help you understand how much better off you might be by buying a used car rather than a new car.  For some cars, it is much less expensive to buy used, whereas for other cars it doesn’t cost much more to buy new especially if you plan to own it for a long time.

#7 Traditional vs Roth Retirement Plans

This post provides lots of information about Traditional and Roth IRAs and 401(k)s. It also explains in what situations a Roth is better than a Traditional plan and vice versa, including some examples. The biggest determinant of that decision is your expectations about your marginal tax rate at the time you save relative to your marginal tax rate at the time you make withdrawals. The post provides lots of information on taxes, too, to help you make that decision.

#8 New Cars: Cash, Lease or Borrow?

This post explains the costs related to buying a new car with cash, leasing a new car and borrowing to pay for a new car. It provides a detailed illustration for three different models.  The best choice among those three options depends on your ability to pay cash, how many miles you plan to drive, and the terms of each individual offer. For some cars and situations, leasing is less expensive than borrowing whereas, for others, borrowing is better. It also provides a spreadsheet that allows you to compare your offers.

#9 Car Insurance

I was surprised that this post made the top 10.  I spent my entire career in the insurance business so probably have forgotten how complicated car insurance is! This post describes all of the important terms and coverages you’ll find in a car insurance policy. It also provides some insights on how to decide what coverages, deductibles and limits to select.

#10 Health Insurance

On the other hand, it didn’t surprise me at all that this post made the top 10. In fact, I would have expected it to rate higher than it did. As with #9, this post explains all of the terms included in health insurance policies. Its companion post explains how to select the health insurance plan that best meets your needs and your budget.  That post includes a spreadsheet that follows along with the calculations. I recently had to select an individual health insurance plan as my COBRA benefits expired.  I used exactly the process described in this post to make my decision!

Retirement Savings: How Much Do You Need

Retirement Savings

Retiring is one of the riskiest financial decisions you will make. On the day you retire, you can calculate your net worth. You won’t know, however, how much retirement savings you need because you don’t know:

  • how much you will actually spend on day-to-day expenses
  • how much those expenses will be impacted by inflation
  • whether you’ll have significant medical or other expenses
  • how long you will live or
  • what returns you will earn on your investments.

I retired a little over a year ago and realized that, even though I have a lot of money saved, it wasn’t enough to give me confidence we wouldn’t run out.  I took on a large consulting project to help cover our expenses for the next year or two. Researching this post, though, added even more confidence as we have more than enough to meet some of the simple rules of thumb.   We will see what happens.

In this post, I’ll provide some insights about how to think about a target you might want to set for your retirement savings.  As a follow up, I talk about how much you need to save to meet your retirement savings goal in this post.

4% Rule and Multiply by 25 Rule

As I checked to see what others were saying on this topic, I found a very common theme for determining how much you need to save for retirement.  In some places, it was called the 4% Rule and, in others, the Multiply by 25 Rule.  Being the math geek that I am, my first thought was that 4% = 1/25 so they are the same thing!  It turns out that, in the nitty gritty details, the Multiply by 25 Rule is intended to tell you how much you need to have available on the day you retire while the 4% Rule guides you in how much you can spend in your first year of retirement.  Nonetheless, as explained below, they both result in the same amount needed in savings on your retirement date.

4% Rule for Retirement Spending

The 4% rule is intended to tell you how much you can spend from your retirement savings each year.  Let’s say you have $1,000,000 in invested assets when you retire.  It says you can spend 4% of that amount or $40,000 (including all of your expenses and taxes) in your first year of retirement.  In each subsequent year of your retirement, you can spend $40,000 increased for the cumulative impact of inflation since you retired.   The 4% Rule assumes that you are invested 50% in stocks and 50% in bonds.

4% Rule Illustration

The graph below shows the amount you can spend each year (blue bars which use the left axis scale) and the amount you’ll have remaining at each age (red line which uses the right axis scale) if you retire at 65, inflation is 3% per year, bonds earn 2.5% and stocks earn 7% annually. These assumptions are similar to long-term average assumptions that are common these days.

As you can see, in this scenario, the amount you can spend increases from $40,000 when you are 65 to almost $100,000 a year when you are 95 solely due to inflation. In the first few years, your spending is less than your investment returns, so your savings increases.  After you turn 72, your savings exceeds your investment returns so your savings starts to decrease.

4% Rule Background

The 4% rule was developed by William Bengen and is presented in detail in a 1994 study published in the Journal of Financial Planning.  (If you like numbers and graphs, check out this paper. It is a surprisingly easy read.)

Using historical data from 1926 to 1991, Bengen found that there were no 50-year periods in which a retiree would run out of money if his or her initial withdrawal rate was 3.5% or lower.  With a 4% initial withdrawal rate, the shortest time period in which the savings ran out was 33 years.  In only 10% of the scenarios did the money last for less than 40 years.

If you turn this rule around and know how much you want to spend in your first year of retirement, say $60,000, you can calculate the amount you need to have saved by dividing that amount by 4% (=0.04).  In this example, you need $1,500,000 (=$60,000/0.04) in savings on the day you retire using this rule.

Multiply by 25 Rule for Retirement Savings

The Multiply by 25 Rule says that the amount you need in retirement savings is 25 times the amount you want to spend in the first year of retirement.  Using the example above in which you want to spend $60,000 in your first year of retirement, you would calculate that you need $1,500,000 (=25 x $60,000) in savings.  As I said, the math is the same for determining how much you need to save because multiplying by 25 is the same as dividing by 0.04.  It is just that the rules are stated from different perspectives (how much you can spend given the amount saved as opposed to how much you need to save giving how much you want to spend).

When do you need more or less?

As indicated, those rules make assumptions that might not be right for you. There are a number of personal factors that impact how much you need in retirement savings.

Your Risk Tolerance

The 4% Rule assumes that you invest half in bonds and half in stocks. Some people are willing to take more risk by investing more heavily in stocks. Other people can’t tolerate the ups and downs of the stock market, so invest more heavily in bonds. As shown in this chart below, taken from my post on diversification and investing, the higher percentage of stocks in your portfolio, the higher your average return (the blue lines) but the more likely you are to lose some of your principal (the portion of the whiskers that fall below 0).

If you plan to put more than 50% of your retirement assets in stocks, you can withdraw a bit more than 4% each year. Turning that around, it means you need a bit less than 25 times your estimated expenses in your first year of retirement. The table below was copied with permission from a March 19, 2019 article from Schwab found at this link.  It shows how your time horizon (see below) and investment risk impact the 4% Rule.

Life Expectancy and Retirement Age

The analysis underlying the 4% Rule focuses on a retirement period of 30 years.  If you retire in your mid-60s, it would imply that you would most likely have enough money to last through your mid-90s.  If you are in poor health or have a family history of dying early, you could consider spending a bit more than 4% (that is, multiply by less than 25 to determine how much you need to save).

On the other hand, if you plan to retire at 45 and want to have enough money to last until you are 95, you’ll need to save more.  The Schwab table above shows planning horizons up to 30 years.  Based on the numbers in the table, it looks like you could subtract about 0.1 percentage points from the numbers in the 30-year row for each year your planning horizon extends beyond 30 years to estimate how much you need to save.

For example, if you want to be highly confident (90% sure in this case) you will have enough money to last for 50 years, you would be looking at 20 years beyond the 30-year horizon.  Multiplying 20 years by 0.1 percentage point is 2.0%.  According to the table, you can spend 4.2% of your savings in the first year with a Moderately Conservative portfolio and 90% (highly) confident that you won’t run out of money in 30 years.  My approximation would subtract 2.0% from 4.2% to estimate that you could spend about 2.2% of your savings in the first year if you wanted to be 90% confident you won’t run out of money in 50 years.  You could then divide your estimated first year expenses by 2.2% or multiply by 45 to estimate how much you need to save.

Other Sources of Income

Some people’s employers provide defined benefit retirement plans.  These plans generally pay a flat amount every month starting at normal retirement age (as defined by the employer) until death.  In the US, people who have worked or whose spouses have worked are eligible for Social Security benefits, as discussed in this post.  Similarly, Canadians are eligible for Canadian Pension Plan benefits. Many other countries have similar programs.

When you are estimating how much you need to save for retirement, you can consider these sources of income.  If all of your other sources of income increase with inflation, it is a fairly straightforward adjustment.  You just need to subtract the income from these other sources from your first-year-of-retirement expenses before applying the 4% Rule (as adjusted for other considerations).

For example, if you plan to spend $100,000 a year in retirement and have $40,000 of Social Security and defined benefit plan benefits,  you would subtract $40,000 from $100,000 to get $60,000.  Using the Multiply by 25 Rule, you would multiply $60,000 by 25 to get $$1.5 million instead of multiplying the full $100,000 by 25 which would indicate you need $2.5 million in savings.  In this example, you need $1 million less in savings because you have other sources of income.

Unfortunately, most defined benefit plan benefits do not increase with inflation.  The math for adjusting the Multiply by 25 Rule is fairly complicated.  I’ve developed a simple approximation that you can use that will get you close to the correct percentage.  To approximate the adjustment to the amount you Multiply by 25, divide your defined benefit plan income by 2 before subtracting it from your first-year expenses.

You Want to Leave Your Assets to your Beneficiaries

I remember being a teenager and having my father explain to me how much I needed to save for retirement.  The approach he proposed was that you could spend 2% of your assets which is equivalent to a Multiply by 50 Rule.  (No wonder I was nervous about my finances when I retired!)  His logic was as follows:

  • Invest in the stock market and get a 10% return.  (He did this analysis a long time ago, when stock market average returns, inflation and taxes were all considered to be a bit higher than they are today, but not by so much as to make the logic faulty.)
  • You will pay taxes of 40% of your returns, which makes your after-tax return 6%.
  • Inflation will be 4% per year.  Because he wanted his investment income in every year to cover his expenses without dipping into the principal, he had to re-invest 4 percentage points of his investment return so he would have 4% more investment income in each subsequent year.
  • Subtracting the 4% reinvestment from the 6% after-tax return leaves an amount equal to 2% of his investments that he could spend each year (excluding taxes because he separately considered them).

So, if you are like my father, you will want to save closer to 50 times your first-year retirement expenses, rather than 25 times.  It is important to remember that my father’s Multiply by 50 rule applies to your expenses excluding income taxes and the Multiply by 25 Rule applies to your expenses including income taxes, so they aren’t quite directly comparable.

Liquidity of your Assets

As indicated above, the 4% Rule assumes your assets are invested 50% in stocks and 50% in bonds. You may have other assets that contribute to your net worth, such as equity in your home, your personal property, a family farm and rental property, among others. These other assets are all consider illiquid – that is, you can’t convert them to cash easily. Further, some of them are assets that you never want to have to convert to cash to cover expenses, such as your home and personal property.

As you project how much you will have in retirement savings, you’ll want to exclude any equity in your house as it isn’t available to invest.  A portion of it may be available at some point if you plan to downsize, but you’ll want to be cautious about including it in your savings plan.  Other of these assets, such as rental property, could be liquidated to cover retirement expenses.  In your planning, though, you’ll need to make sure you consider the selling costs (e.g., real estate agent’s commission) and taxes you need to pay on capital gains and that they may not generate a return as high as underlies the 4% Rule.

Irregular Large Expenses

The analysis that supports the 4% Rule assumes that you have the same expenses every year and that they change due only to inflation. That’s not how life works! You may want to be like me and want to take an expensive vacation every three or four years in retirement, you’ll likely have to replace your car at least once in retirement or you could have major home repairs if you own your home.  In addition, end-of-life medical bills can be very expensive.

As you are determining your first-year retirement expenses, you’ll want to include amounts for any such expenses in your budget at their average annual cost.  For example, let’s say I want to take a vacation (in addition to my already budgeted travel expenses) every five years that has a total cost of $10,000.  I need to add $2,000 (= $10,000 per vacation divided by one vacation every 5 years) to my regular annual expenses for these big vacations.  Similarly, if I plan to buy a $25,000 car every 15 years, I need to add $1,667 (= $25,000/15) to my annual expenses.  In both cases, you would add these amounts to your budgeted expenses before you divided by 4%.

How to Set Your Personal Target

So, what can you do to estimate your personal retirement savings target? Follow the following steps.

Make a Budget for Today if You Don’t Already Have One

It is hard to estimate your expenses in retirement, but it is very helpful to understand what you are spending today.  If you don’t have a budget or haven’t tracked your expenses to see where your money is going, I suggest starting there.  Here is a link to a post I wrote with a spreadsheet to help you monitor your expenses.

Estimate Your Expenses in Your First Year of Retirement

Next, look at your current budget and/or spending and estimate how it would change if you were retired today.  On what types of things might you want to spend money in the future that you don’t spend now?  Might you want to buy special gifts for your grandchildren that are more extravagant than what you spend for your children’s gifts now?  Also think about expenses you have now that you won’t have in the future, such as commute expenses and possibly a separate wardrobe for work.

Be sure to think about Social Security (or equivalent) and income taxes. In addition to Federal income taxes, you may pay state or provincial and possibly local income taxes.  If you plan to live somewhere else in retirement, it might have a higher or lower tax rate.  In the US, Social Security taxes are 6.2% (12.4% I you are self-employed) of your wages up to the limit ($128,400 in 2019).  As you adjust your budget, you can eliminate Social Security taxes and will want to think about whether your state or provincial and local tax rate will be substantially different from their current rates.

Some people say that your expenses will decrease by 20% when you retire.  In my very short retirement, I find I’m spending more than I expected as I have more time to do things and many of them cost money.  This post from Financial Samurai provide some insights as to how retirement might impact your expenses.

Increase Your Retirement Expenses for Special Purchases

Do you want to travel? How often do you think you’ll need to buy replacement cars and how much do you think you’d spend if you bought one today? What other expenses might you have that aren’t in your budget? For each of these expenses, divide the amount by the time between them to estimate an average annual cost, as I illustrated earlier in this post.

Adjust Your Budget for Inflation

All of the amounts you’ve estimated so far are in today’s dollars.  That is, they reflect the current prices of every item.  You’ll want to increase these amounts for inflation between now and the time you retire.  Over long periods of time, annual inflation has averaged 3% to 3.5% though it has been a bit lower recently.  To adjust your budget for inflation, you’ll want to multiply it by 1.03n, where n is the number of years until you retire.  Don’t like exponents?  The table below provides approximate multipliers by number of years until you plan to retire.

Years51015202530354045
Factor1.151.351.551.802.102.452.803.253.80

Subtract Other Sources of Income

If you think you’ll have a defined pension plan benefit or will receive social insurance (Social Security) benefit, you can subtract those amounts from your inflation-adjusted budget.  My post on Social Security provides insights on how to estimate your benefits for my US readers.

Figure Out your Risk Tolerance and Length of Retirement

If you want to be almost 100% confident you will have enough money to last for your full retirement, regardless of how long it is, and leave most or all of your principal to your heirs, multiply the difference between your inflated budget (excluding income taxes) and other sources of income by 50 to derive your retirement savings target.

If you plan to be retired for only 10 years, you can multiply by a number as low as 10, according to the chart from Schwab. Where between those two numbers you choose is up to you. The longer you expect to be retired, the more conservative your investments and the more confident you want to be that you won’t run out of money, the higher your multiplier.