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Essential Mass vs Critical Mass

Updated: Sep 17, 2021

When you start saving towards retirement there are two different ways to look at the end goal. Both goals will get you there, but one gives you more than enough, while the other gives you just enough. Effectively, you want to save towards a number you are comfortable with, is achievable, and provides you with enough money annually to cover your expenses over your retirement years. This can be a number which I term “critical mass”, whereby your portfolio generates enough income through dividend yields to cover all your expenses without ever requiring you to cash in your shares. Or, it can be a value I term “essential mass”, which is an amount that you achieve that will decline in value over your retirement years to support your annual expenses, both through the annual dividend yields and by cashing in shares. In reality it is likely a number between these two values, although a small percentage of people will achieve more than the critical mass (those 2 percenters). Also, both essential mass and critical mass values can shift around based on your supplemental income sources, expense levels, and retirement portfolio withdrawal rates. Critical mass, however, makes withdrawing your portfolio at lower tax rates more challenging and increasingly unlikely as you grow in value beyond this point. If you can maintain your expenses at a level lower than your dividend yields, and manage to save more than the portfolio critical mass, you will very likely continue to save and gain value over the course of your retirement. The latter goal, “essential mass”, is a value that does not fully support your expense needs, and will require cashing in portfolio shares to meet your income demands.

Today, with the availability of relatively low risk, tax-efficient, index-investing in an all-in-one retirement income ETFs, it is possible to consistently earn 4% or more a year in returns. If you can save up $1.25 MM and invest it conservatively in similar ETFs, it will provide you $50k/yr in dividends. If you can manage your annual expenses to $50k per year, then this is where your portfolio dividend earnings and expenses intersect (the porfolio critical mass).

This critical mass point marks an important intersection in your savings and expense planning. If you achieve this point, it means your retirement portfolio will cover your annual expenses regardless of whether or not you cash in the shares you hold. This is assuming your total annual expenses including taxes are $50k. The simple illustration above shows how these lines intersect in relation to your porfolio value. If you have savings greater than this value generating 4% income, you could in fact grow your portfolio over time, even in retirement.

However, not many people can save this much in their lifetime, or more importantly, may not be able to keep their expenses that low. Is this a problem? Not necessarily. You may have CPP or OAS supplementing your income upon retirement, or some other source of income like rental income or a part time job? Income from these sources effectively reduce your income requirements, and are icing on the cake. If you do get to this critical mass point, and are drawing CPP/OAS, it will give you an added level of comfort in your retirement towards an unpredictable market or rising inflation, but going beyond the critical mass point after this it is purely an income bonus, and at some point bites into your income through increased income tax and/or government program clawbacks e.g. OAS.

The conventional way of looking at your retirement savings is to hit a savings number that will support you throughout your remaining life while continuously drawing it down. But this can be confusing for people saving into RRSPs and TFSAs. If your expenses are hypothetically $50k/yr, and you expect to live 25 years, then it would seem logical you need to have $50k X 25 yrs = $1.25 MM. Although, in reality, your retirement may be supported by a much lower portfolio value, if you can keep your expenses low and in check and/or have supplemental income. As touched on before, if you and/or your spouse are getting CPP and/or OAS, you can subtract that value from your expense number used in the above calculation. This can bring the expense needs from your retirement portfolio down as much as $5-10-20k or more depending on your CPP entitlement/s, which depends on your lifetime contributions, and if you and your spouse are both receiving. This also might include OAS which you’re both entitled to at age 65. Assuming CPP/OAS is $20k/yr total (can be looked up on MyCRA or MyServices websites), then that further reduces your portfolio needs to $750k, or ($50k/yr expenses - $20k/yr CPP+OAS) X 25 yrs = $750k. Theoretically, this should be more than enough as this $750k continues to generate 4% per year, or $30k/yr. So, in essence, you can actually afford to withdraw more by cashing in shares from your portfolio annually to meet you income needs, and still have your money outlive you. If you took the dividend yields (4%) plus an amount in shares equivalent to $50k/yr out of a $750k portfolio, it will last you an estimated 23 years. And the savings can be used or moved to other tax efficient vehicles like your TFSA for use throughout your retirement. There are many calculators available to help you see this on the internet. I used this one.

As you slowly draw down the portfolio value and reduce the number of shares, assuming you are taking all dividends and cashing in shares to support the $50k annual withdrawals, your dividend yield will also slowly decline with less shares in play. At the start, you need to cash in less shares, and towards the end, need to cash in more shares, to meet the $50k expense line. Below is a rather simplistic view of “essential mass” starting at $750k. Add in any income from other sources (e.g. company pension income, TFSAs, CPP/OAS, rental income, part-time jobs, etc.) and you can see that you can shift your income to a level above the expense line quite easily, and the difference between your income and expenses are savings you can apply elsewhere where it makes you happy. It all becomes a finite balancing act, between income availability and expenses, over the course of your retirement.

Now you can start to see how “essential mass” and “critical mass” are two different values that can be looked at to support your retirement goals. Regardless of how you look at it, you can see how the moving parts of income and expenses versus your retirement timelines (life), and the draw on your overall plan after retirement. The more you are entitled to from any other source, the less you will have to achieve and withdraw from your retirement portfolio to cover your planned expenses. The lower your overall planned expenses are, the less you need to save to achieve a sustainable retirement. The longer you plan to retire, the more you’ll need to have in reserve to fund your annual expenses throughout. Retirement planning is about being realistic and proactive; knowing what you can achieve for savings and income versus what you are going to need to cover your planned expenses annually. This will be a very different goal for everyone, but your plan accuracy, with some contingency, will help you better achieve your goal, and more importantly, help you sleep much better at night.

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