Income in Retirement

When it comes to retirement income planning, there is no perfect strategy or simple solution. Every individual’s situation is different and, as such, everyone will have a different strategy on how best to generate their required income in retirement.

However, there are a few fundamentals that apply to everyone when designing a retirement income planning strategy. First and foremost, it is important to understand and analyze each possible source of income:

Government Income Entitlements

There are two main types of government pensions that most Canadians can expect to receive during their retirement years: Old Age Security (OAS) and the Canada Pension Plan (CPP).

Old Age Security (OAS)

The current maximum OAS payment is $727.67 / month – ($808.44 age 75 years of age and over). To receive the maximum OAS pension, you must have resided in Canada for periods totaling 40 years after reaching the age of 18.

Unlike CPP, OAS is an income-tested benefit. OAS begins to be clawed back (Old Age Security pension recovery tax) when your taxable income reaches $93,454 and is fully clawed back when your taxable income reaches $151,668 ($157,490 – age 75 and over). In addition, OAS payments cannot be split with your spouse.

You can defer receiving OAS pension until you are 70 years of age. Every month you defer your OAS pension, it will be increased 0.6% (7.2% per year) up to a maximum of 36% at age 70.

Canada Pension Plan (CPP)

Currently, the maximum CPP benefit is $1,433.00 / month. CPP can be taken as early as age 60 or delayed until age 70.

If you take CPP before age 65, it will be reduced by 0.6% per month (7.2% per year). Thus, if you start your CPP pension at age 60 it will be 36% lower than if you started it at age 65.

If you take CPP after age 65, it will be increased by 0.7% per month (8.4% per year). Thus, if you delay your CPP pension until age 70, it will be 42% higher than if you had taken it at age 65.

You can both collect and contribute to CPP if you are under the age of 70. Any contributions made to CPP when you are collecting CPP will go towards post-retirement benefits which will increase your retirement benefits.

In addition, CPP benefits can be split with your spouse. For example, if you are receiving $800/month and your spouse is receiving $100/month, together you can split the CPP benefits so that you would both receive $450/ month (800 +100 = 900/2 = $450 each). You are only able to split CPP benefits that have accrued while you were together.

The average CPP benefit for new beneficiaries is currently $808.14 a month (age 65).

Note that CPP benefits are based upon your contributions over time and are not affected by other income you may receive.

Both OAS (quarterly) and CPP (annually) benefits are indexed to inflation as measured by the year over year change in the Consumer Price Index (CPI).

Employer Pension Plan

Many Canadians belong to employer-sponsored pension plans. There are two main types: 1.) Defined Contribution Plan (money purchase plan), and 2.) Defined Benefit Plan.

Defined Contribution Plan

A defined contribution plan, or money purchase plan, is very similar to a regular RRSP. Both the employer and employee contribute to the employee’s pension account and typically, the employee is allowed to make some decisions on various investment options. This way, the employee participates not only in the upside but also the downside of any investment risk for monies that may be in “the market”.

Defined Benefit Plan

A defined benefit plan is a pension where the retirement income benefit is calculated based upon years of service and salary level. It is up to the employer to contribute enough to the pension fund, and up to the pension fund portfolio manager to invest the funds wisely.

As noted above, the employee is entitled to a certain monthly income upon retirement. Therefore, the company bears all the investment risk.

It is not unusual for employees of these plans to take the “commuted value” of the plan upon retirement. The “commuted value” is a cash value offered to the employee instead of receiving the monthly income.

In most circumstances, we do not recommend taking the “commuted value” of a pension plan upon retirement. Most employees that choose this option do not fully understand the risks involved with this strategy.

Personal Savings

Personal savings is also divided into two main categories: 1.) Registered Retirement Savings Plans (RRSPs) and 2.) Non-registered personal savings (bank accounts, etc.).

Registered Retirement Savings Plan (RRSP)

All funds within an RRSP must be converted into a RRIF, Life Annuity, or withdrawn as a lump sum (cash) in the year you turn age 71 at the latest. The income from the RRIF or annuity does not need to start until the year you turn 72.

A Registered Retirement Income Fund (RRIF) is almost exactly the same as an RRSP with the exception that with a RRIF, you are required by law to withdraw a set minimum percentage of the RRIF account each year.

The following table illustrates the minimum percentage of your RRIF account which must be withdrawn as income each year. (Note: you may also start a RRIF prior to age 71).

RRIFs are designed to provide an income for both the annuitant and his or her spouse. With this in mind, the minimum withdrawal percentage can be based upon your younger spouse’s age to reduce the required minimum withdrawal percentage.

Life Income Fund (LIF)

Many Canadians have funds that have been transferred from a pension plan into a “locked-in” RRSP (often referred to as a LIRA or locked-in retirement account). These funds must be converted into a LIF or life annuity in the year you turn 71.

Locked-in retirement funds can be quite complicated. The rules governing these types of funds are based upon the jurisdiction where they were earned. For example, if you worked in Saskatchewan and then moved to BC and transferred your pension to a “locked-in” RRSP, these funds are still governed by Saskatchewan pension legislation.

A LIF is very similar to a RRIF; there is a required minimum percentage that must be withdrawn every year. However, unlike a RRIF, there is also a maximum annual withdrawal limit. The government is trying to ensure that you do not spend all your money early in your retirement years.

For both the RRIF and LIF, you have full investment control of your portfolio; the funds can be invested in a wide range of investment products including stocks, bonds, mutual funds, GICs, etc. Both the RRIF and to some extent the LIF allow you to tailor your income to match your current lifestyle expenses. If you want to spend more funds early in retirement to travel, for example, both the RRIF and LIF plans allow you to do this.

Life Annuity

A life annuity is simply a vehicle that guarantees a certain income for the remainder of your lifetime. Life annuities can only be issued by a life insurance company. They are very similar to a defined benefit pension.

With a life annuity, you give up control of your capital in exchange for a guaranteed income (usually paid monthly) just like a defined pension. The risk of outliving your money is shifted to the insurance company. If you die prematurely however, your estate may not receive any funds from the annuity. In addition, once the annuity is purchased, you lose control of the funds forever; you cannot go back to change your mind.

There are many different types of life annuities. When you retire, you can buy an annuity that is based solely on your age or one that is based upon the ages of both yourself and your spouse (joint-life annuity). A joint-life annuity means the income will last for the remainder of both of your lifetimes.

In addition, you have the option of adding a guarantee period to the annuity to protect your estate. It is very common for a couple to choose a joint life annuity with a 10-year guarantee when they retire. This means that the income will last the longer of either spouse’s lifetime or 10 years. The estate is protected because there will be at least 10 years’ worth of payments under any circumstances.

Why would you consider a life annuity when current interest rates are so low? When purchasing a pension the amount of your payment is made up of the current interest rate and your age – thus, the lower the interest rate or the younger you are the lower your monthly pension will be.

It really depends when you buy a life annuity. If you purchase a pension at age 65, the pension payments would be made up of approximately 70% of the current interest rate and 30% in mortality credits (your age).

However, if you buy a pension at the age of 75, then the current interest rates only make up approximately 25% of the total payment and 75% of the payment is made up of mortality credits.

How does a pension or life annuity work? Imagine there are ten 77-year-old males who buy an annuity. The life expectancy of a 77-year-old male is 11 years. Thus, on average, a 77-year-old male will live 11 years. But you need to understand life expectancy – life expectancy is an average number therefore five will die before age 89 (life expectancy) and five will live longer than age 89. 50% of us will live beyond our life expectancy and 50% will die before our life expectancy – the problem is that we don’t know which side of life expectancy we will end up on.

Thus a life annuity is just risk sharing or pooling of longevity risk. The individuals that do not live to life expectancy will fund the payments for individuals that live longer than life expectancy. The funds do not go directly to the bottom line of the insurance company.

None of us know how long we are going to live but by using some of your registered funds to purchase a pension might make sense even at these low interest rates to ensure that you do not outlive your money.

Income Splitting

A Canadian resident can split up to 50% of any income with their spouse that qualifies for the existing pension income tax credit. For those under the age of 65, these payments include annuity payments made under a registered pension plan (RPP) and certain death benefits. For those over the age of 65, the payments include any income derived from their registered plans (RPP, RRIF, LIF, PRIF, LRIF, and DPSP).

It is important to note that CPP & OAS cannot be split under this provision. However, CPP can be split with your spouse – this declaration must be made directly with the government.

In addition, income splitting should allow many Canadians to avoid or reduce the OAS clawback. For example, if your income is $120,000 and your spouse’s income is $25,000 your OAS would be completely “clawed” back. However, if you split income with your spouse you would be able to receive the full OAS benefit.

Non–Registered Funds

It is generally more tax effective to generate retirement income from your personal or non-RRSP savings and investments first, allowing your RRSP savings to remain tax sheltered for as long as possible.

However, when designing your retirement income strategy, in some circumstances, it might make sense to withdraw funds from your RRSP early so you can pay tax at a low rate now rather waiting and withdrawing funds from your RRSP or RRIF later at a higher rate.

In addition, given that any funds inside a RRIF are fully taxable when withdrawn, we generally recommend that you keep a significant portion of non-registered funds available for lifestyle expenses later in life (new car, vacation, motor home, etc.). It is generally inadvisable to make fully taxable lump-sum withdrawals from a registered plan.

There are three types of investment income that can be generated from non-registered savings: interest income, dividends, and capital gains. Interest income is fully taxable, dividends are partially taxable because of the dividend tax credit, and only 50% of capital gains are taxable.

Consequently, retirees should look to a more balanced distribution of their non-registered savings and investments in order to achieve more favorable after-tax results.

Retirement Risks

To design an effective retirement planning strategy, you need to understand some of the variables involved; 1) life expectancy, 2) inflation, 3) how much do you need 4) stock market risk and 5) health care costs.

Life expectancy

Life expectancy is one of the most misunderstood aspects of retirement income planning – yet, it is one of the most important factors.

Most people assume that life expectancy is the same as lifespan. This is not correct. Instead, life expectancy is a median number of years – such that 50 percent of a particular age group will die before this number of years, and the other 50 percent will die after this period.

For example, a male who is 65 years of age today has a life expectancy of 21.4 years; this means that he is expected to live until age 86.4.

There is, however, a 50-percent chance that he will live longer than 21.4 years. A female who is 65 years of age today is expected to live for another 24 years (age 89). But, she has a 50-percent chance of living longer than 24 years.

Even more interesting is the result for a couple, both age 65. In this case, their joint life expectancy is 27.6 years – this means that, on average, one of a couple age 65 today is expected to be alive at age 92.6.

Thus, when planning for retirement, it is important to look beyond your life expectancy – because there is a 50 percent chance you will exceed it.

Inflation

The inflation rate is usually measured by the year-over-year change in the Consumer Price Index (CPI). It measures how much a “basket of commonly purchased goods and services” increases in price over time.

For example, if the inflation rate were four percent (the historical long-term average), you would need an income of $109,556 in 20 years’ time to buy the same basket of goods that you could buy today for $50,000.

How much do you need?

There is a “general principle” that states you will need 60 percent to 70 percent of your income immediately preceding retirement in order to maintain your standard of living during retirement.

The rationale behind this principle is that in retirement, you are no longer saving, nor would you have employment-related expenses. It goes without saying that this number will be different for everyone. It depends on what you intend to do with your life in retirement; this will drive your particular income requirements.

Stock market risk

In retirement, you should be prepared for a stock market correction every single day.

When you are working and accumulating retirement savings over a long period, stock market volatility is not a concern as long as your portfolio is properly diversified. One of the greatest risks in retirement planning, however, is having the stock market drop substantially just before or just after you retire. Proper diversification techniques alone will not offset this problem.

If you are unlucky enough to retire when the stock market is performing poorly (and you need to generate income from your portfolio), then you could deplete your capital at an alarming rate.

Ultimately, this will reduce the chances of your portfolio being able to generate your required net spendable income throughout your remaining retirement years.

Health care costs

Finally, as the baby boomer generation retires, our health care system will continue to be under increasing strain. It is very possible that you may have to spend a substantial portion of your retirement income on health care costs.

It is very difficult to predict how much of your additional savings you should allocate to health care, but it would be imprudent to ignore this potential problem.

Summary

To design an effective retirement income strategy, it is necessary to look at all possible sources of income.

While you are working, you typically have only one source of income (your job). In retirement, you will have a mixture of different income sources that need to be integrated. You will probably be entitled to some type of government benefit (e.g. OAS, CPP, etc.), you might have a company pension plan, or you may have your own investment assets (RRSPs, real estate, bank accounts, etc.).

It is important that you use these income sources in the most effective manner to generate the highest possible after-tax income in your retirement years.

Clay Gillespie BBA, CFP, CIM, FCSI
Managing Director, Financial Advisor & Portfolio Manager
RGF Integrated Wealth Management
Ph. 604 732 6551
Fax 604 732 6553
[email protected]
www.rgfwealth.com

Clay Gillespie is a Financial Advisor & Portfolio Manager with RGF Integrated Wealth Management. The views expressed are those of the author and not necessarily those of RGF Integrated Wealth Management, which makes no representations as to their completeness or accuracy.