Income Splitting Strategies in Retirement
The Rule of
Written by Sarah Milton
“Compound Interest is the
eighth wonder of the world.” – Albert Einstein
Einstein described compound
interest as the eighth wonder of the world because he felt that those who
understood it, earned it and those who didn’t, paid it. Compounding is what
makes saving early and saving regularly such a powerful part of building wealth
and it’s also what makes it so hard to get out from under the mountain of
consumer debt that so many of us accumulate. In an nutshell, compound interest
is earning (or paying) interest on interest. When you earn interest at a
compounded rate, your money grows faster because you are earning interest on
your total balance (principal + interest) rather than on the principal alone.
Similarly, when you pay interest at a compounded rate (as you do with credit
cards) your interest charges grow much faster and your debt load gets larger.
We can see the power of compounding in
the table below, which shows how $1000 earning 5% annual interest grows
over time. The first column shows how the $1000 would grow earning 5% simple
interest (earned on just the $1000 principal) and the second column shows
how it would grow earning 5% interest compounded annually (earned on the
principal + interest).
5% SIMPLE INTEREST
5% COMPOUND INTEREST
The Rule of 72
The rule of 72 is a simple
way to estimate how long it will take your money to double in value at a given
interest rate. If you divide 72 by the annual interest rate, the answer is the number
of years it will take to double. For example, 72 divided by 5 is 14.4. This
means that, as you can see in the table above, it takes just under 15 years for
$1,000 to become $2,000. 15 years later (in year 30) the money has doubled
again to be just over $4,000 and, 15 years after that (in year 45) it has
doubled again to become more than $8,000. In year 60, it will have doubled yet
again and become $16,000. Using this rule, it’s clear to see that both time and
interest rate are two key factors in building wealth. At 8% interest, your
money will double in 9 years (72 divided by 8 = 9) but it will take 36 years to
double earning 2% interest. For a 20 year old, $100 invested at 7% is worth
$2,100 at age 65. For a 30 year old, that same $100 invested at the same rate
is only worth $1,068 at age 65 and for a 40 year old, $100 invested at 7% is
worth just $543 at age 65. This means that, at 40 years old, even though I’m
only twice the age of the 20 year old, I have to save four times as much each
year in order to achieve the same level of wealth at age 65. It’s a concept
that I wish I had understood as a teenager because I’m pretty sure it would
have motivated me to manage my money differently!
At the end of the day,
saving is always a very personal decision: the choices we make about whether to
save, where to save and how much to save, vary enormously from person to
person. However, all too often, I hear people in their twenties saying that
they’ll wait to save until they’re older because then they’ll be earning more.
When you consider how powerful a factor time is in the wealth building
equation, it just doesn’t make sense (especially when you consider that just
because you’re earning more doesn’t mean you have more discretionary income).
If you can do as much with $25 at 20 as you can do with $50 at 30 or with $100
at 40, it makes sense to start the saving habit early.
Even if you feel like you’ve “missed the boat”
because you should have started saving years ago, remember that whatever you
save today has a greater power to grow than money you save next month, next
year or 3 years from now. We can’t change our past choices but we always have
the power to choose to change our financial future by making different choices
Who Is Affected by the Ontario Retirement Pension Plan?
With the Ontario Retirement Pension Plan taking shape, the provincial government is giving Ontarians the chance to weigh in on the proposed provincial pension plan. The Ontario Liberals released a consultation paper on “key design questions” of the ORPP, such as low-income earners and the self-employed. The discussion paper provides more details on the ORPP, including who’s covered.Who’s Covered by the ORPP?
When the ORPP is in full swing, the provincial government anticipates three million people to make $3.5 billion each year in contributions. The ORPP looks to be mandatory for everyone except those with defined benefit pension plans and newer target benefit plans. Unlike defined contribution pension and group RRSPs, defined benefit pension plans provide you with a retirement benefit for your lifetime based on your earnings and your years of service. Target benefit plans are a middle ground between defined benefit and defined contribution – they act much like defined benefit, but your benefit could be reduced based on how the plan’s investments perform.
Employers that offer alternative retirement savings plans, such as defined contribution pension plans, group RRPSs and pooled PRPPs, would be forced to join the ORPP. This would be quite a financial burden for employers, who would have little incentive to continue to offer these plans, if they must also pay into the ORPP. The government looks to be open to discussion, mentioning employers may be able to adapt their pension plans to be exempt from the ORPP.Self-Employed Individuals
When the ORPP was first proposed, many self-employed individuals were concerned about the financial burden it would put on their business. According to the Ontario Ministry of Finance , 700,000 people in Ontario reported self-employment income in 2011. Currently, self-employed individuals don’t have the option of opting out of the CPP. If you’re self-employed, you must contribute both the employer and employee portion of the CPP.
If you’re self-employed in Ontario you can breathe a sigh of relief. It doesn’t look like you’ll be forced in to joining the ORPP. Self-employed individuals are ineligible to join because of the federal Income Tax Act. However, the provincial government is looking into a voluntary opt-in. This seems like a win-win situation for the self-employed. The ORPP would provide self-employed individuals with some stability in income in their retirement, provided they choose to join.
Unlike the self-employed, small business owners would be forced to join. When you’re starting up a business, cash flow is key. Forcing small business owners to join the ORPP could result in tough decisions. While many large employers are in the position to absorb the added cost of the ORPP, small businesses struggling to stay afloat may have to freeze wages or lay off employees to balance the books.Low-Income Earners
The ORPP looks to be similar to the CPP in many respects, including how low-income earners are treated. Similar to the CPP, if you earn below $3,500, you will not be required to contribute to the ORPP.
Similar to the CPP, the ORPP will count as taxable income toward means-tested government benefits like the Guaranteed Income Supplement. Instead of helping low-income earners, the ORPP could result in claw-backs to the GIS. Not only will low-income earners lose a portion of their GIS, they’ll also be forced to start contribution to the ORPP. With many of these folks struggling to pay for the necessities of life like rent and food, contributions to the ORPP will take money out of the pockets of those most in need.
There’s still plenty of time to weigh in on the newly-proposed ORPP.
ORPP is now a Legislative Requirement
Bill 56, an Act to require the establishment of the Ontario Retirement Pension Plan was introduced and received first reading in the Ontario Legislature on December 8, 2014.
With this Act, the Ontario Government is now committed to the implementation of the Ontario Retirement Pension Plan (ORPP) no later than January 1, 2017.
While the legislation is short on detail, it is specific on the broad base structure of the Plan and the requirements that will be part of the final legislation.
The Act requires:
• Establishment and implementation no later than January 1, 2017
• An obligation to create an administrative entity to administer the Plan
• Implements a requirement for any Employer, public body or the federal government to provide information, including personal information, deemed required by the Minister
• The collection of information is exempt from subsection 39(2) – Freedom of Information and Protection of Privacy Act
The legislation also establishes basic requirements of the Ontario Retirement Pension Plan:
• Maximum contribution rate of 3.8% combined from employee and employer
• Maximum threshold equal to $90,000 (in 2014 dollars), adjusted to reflect increases established from 2014 to 2017 under the Canada Pension Plan.
• Minimum threshold to be established
• The obligation to deduct contributions from salary and wages will provide for transition rules concerning the rates.
The Ontario Government intends, through questionnaires and public consultations, to collect the feedback of Ontario residents and employers on the final aspects and implementation of the Ontario Retirement Pension Plan
The Power of the TFSA
As the calendar year changed on January 1, so did the Tax Free Savings Account (TFSA) contribution room available to all adult residents of Canada.
Although indexing did not increase the earned contribution room, everyone can now contribute at least $5,500 more to their TFSAs. Those who made withdrawals in 2013 can now put back the money withdrawn in addition to the extra $5,500. For those who have never made a TFSA contribution, the accumulated TFSA room is now $36,500 (less if they are between 19 and 24).
Through the power of tax-free compounding the TFSA can yield spectacular results, especially for those who are young enough for compounding to do its magic.
If you’ve put the maximum into your TFSA at the beginning of each year and it earned 5% income in each year, your current balance (after your last deposit) will be over $40,800. See the table below.
YearContributionInterest EarnedEnding Balance2009$5,000$250.00$5,250.002010$5,000$262.50$10,512.502011$5,000$525.63$16,038.132012$5,000$801.91$21,840.032013$5,500$1,092.00$28,432.032014$5,500$1421.60$35,353.632015$5,500$1767.68$42,621.32
For the younger generation, consider the potential for a tax-free retirement. Making the maximum contribution each year starting at age 19 would yield a nest egg of about $900,000 at age 60 (assuming 5% annual return, 2% inflation, no change in maximum contribution levels and no withdrawals). Even in today’s dollars, that’s $400,000 in spending power. For a couple that’s $1.8 million dollars. Even assuming an extended 40-year retirement, that’s an indexed tax-free pension of over $74,000 a year ($33,000 in current dollars).
Four reasons why you should still take CPP early
I’ve written extensively about the issues around taking CPP early. It’s one of the big conundrums of Canada Pension Plan and my conclusion is that it still makes sense to take CPP as early as you can in most cases. Here’s four questions to ask yourself in determining if it makes sense to take CPP early.Will you still be working after 60? Under the old rules, you had to stop working in order to collect early CPP. The work cessation rules were confusing, misinterpreted and difficult to enforce so it’s probably a good thing they will be a thing of the past.
Starting January 1, 2012, you can start collecting CPP as soon as you turn 60 and you no longer have to stop working. The catch is that as long as you’re working, you must keep paying into CPP even if you are collecting it. The good news is that paying into it will also increase your future benefit.What is the mathematical break-even point?
Under the old rules, the decision to collect CPP early was really based on a mathematical calculation of the break-even point. Before 2012, this break-even point was age 77. With the new rules, every Canadian needs to understand the math. Here’s the example of twins that I used before, with the break-even point updated to 2015 values.
“Janet and Beth are twins. Let’s assume they both qualify for the same CPP of $502 per month at age 65. Let’s further assume, Beth decides to take CPP now at age 60 at a reduced amount while Janet decides she wants to wait till 65 because she will get more income by deferring the income for 5 years.
Under Canada Pension Plan benefits, Beth can take income at age 60 based on a reduction factor of 0.58% for each month prior to her 65th birthday. Thus Beth’s benefit will be reduced by 34.8% (0.58% x 60 months) for a monthly income of $327.30 starting on her 60th birthday.
Let’s fast forward 5 years. Now, Beth and Janet are both 65. Over the last 5 years, Beth has collected $327.30 per month totaling $19,638. In other words, Beth has made $19,638 before Janet has collected a single CPP cheque. That being said, Janet is now going to get $502 per month for CPP or $174.70 per month more than Beth’s $327.30. The question is how many months does Janet need to collect more pension than Beth to make up the $19,638 Beth is ahead? It will take Janet 113 months to make up the $19,638 at $174.70 per month. In other words, before age 74.4, Beth is ahead of Janet and after age 74.4, Janet is ahead of Beth.”
This math alone is still a very powerful argument for taking CPP early. Another way to phrase this question is, “How long do you expect to live?”
Note that under the new rules, the mathematical break-even point will change again in 2016, when the reduction factor will increase from 0.58% per month to 0.6%. So for the above example, in 2016, Beth would get $321 instead of $327.30 at age 60. This will move the break-even point from age 74.4 to age 74.When will you most enjoy the money?
When are you most likely to enjoy the money? Before age 74 or after age 74? Even though the break-even point is three years sooner, for most people, they live the best years of their retirement in the early years. I call these the ‘go-go’ years (which is one of three phases of retirement).
Some believe it’s better to have a higher income later because of the rising costs of health care. Whatever you believe, you should plan for. It might be worthwhile to look around your life and see the spending patterns of 70, 80 and 90 year olds to assess how much they are really spending. Are they spending more or less that they did when they were in their active retirement years.What happens if you Leave money on the table?
Let’s go back to Beth who could collect $327.30 at age 60. Let’s pretend that she gets cold feet and decides to delay taking CPP by one year to age 61. What’s happened is that she ”left money on the table.” In other words, she could have taken $3,927.60 from her CPP ($327.30 x 12 months), but chose not to, to be able to get more money in the future. That’s fine as long as she lives long enough to get back the money that she left behind. Again, it comes back to the math. For every year she delays taking CPP when she could have taken it, she must live one year longer at the other end to get it back. By delaying CPP for one year, she must live to age 75 to get back the $3,927.60 that she left behind. If she delays taking CPP until 62, then she has to live until 76 to get back the two years of money she left behind. Why wouldn’t you take it early given this math? The main reason is that you think you will live longer and you will need more money the older you get.My two cents
I think if people understand the math of Canada Pension Plan, most people will take it early. In 2012, you can take it early even if you are working. The bad news is you will get hit with a bigger reduction with the new rules. Some say its also bad news because you will have to keep paying into CPP if you are working (under the new rules). To me, that’s not such a bad thing because paying into it also increases your future benefit so it’s not like you are not going to get your money back. I don’t think the increased reduction is enough of a deterrent because a bird in your hand is better than two in the bush.
Four Financial Numbers You Really Need To Know
When tracking your own financial progress from year to year, there are four financial numbers that you focus on in particular. They’re easy to calculate using information that’s readily available (mostly from your T4 slip and bank/investment statements) and it takes very little time:Your Net Worth
To calculate your net worth you take the value of everything you own and subtract the value of everything you owe. (Assets – Liabilities). This simple calculation is a great benchmark to track from year to year because it clearly shows you if you’re making progress in building wealth and creating financial security.Your Net Income
Thanks to taxes and other deductions there’s often a dramatic difference between our gross income and the amount we actually take home each pay cheque. Too often we focus on the gross amount rather than the net and this can lead to an over inflated view of how much we actually have available to spend. Basing your lifestyle on the $75,000 you make gross rather than the $50,000-$55,000 you take home (depending on which province you live in and your benefit premiums) gives you a distorted view of your financial situation and may leave you wondering where on earth all your money goes. Focusing on your net income figure allows you to make real plans for your money and helps you track whether your financial situation is improving year by year.Your Savings Rate
Taking the amount that you save each year and dividing it by your gross income gives you your savings rate. The savings rate in Canada has been less than 5% for a long time which is a big problem when you consider that experts have long recommended saving 10% of our gross income for retirement. It’s an even bigger problem when you factor in saving for other goals. Simply put, if you’re not saving then you’re not building a “buffer zone” to protect yourself against an unexpected drop in income or increase in interest rates. This makes you vulnerable. Putting a spotlight on your savings rate and doing what you can to maintain or increase it each year will help you stay out of debt and build a solid financial foundation.Your Credit Score
Your credit score is a reflection of how much debt you are currently carrying, how much you have available and your payment history. Creditors use your score as an indicator of whether you can handle new debts and how likely you are to default on loans. A low credit score makes it hard to access credit and can mean that you pay higher interest rates than someone with a higher score. Keeping track of your credit score and monitoring the information in your credit report helps you stay on top of your finances and detect any errors or any issues relating to identity theft. You can order a free copy of your credit report once a year by mail from Equifax and Trans Union. Equifax also allows you to access your credit score online for an additional charge.
Taking a look at each of these financial numbers at the start of each year, gives you a candid snapshot of your personal financial situation and allows you to identify any areas that you especially need to focus on over the next 12 months. It also lets you to see your progress from year to year which can be a great motivator.
CPP – Now or Later?
One of the more difficult decisions for those approaching retirement is when to start receiving their CPP retirement pension.
In part 1 of this article, we will look at a number of factors that must be weighed to make that decision.
You can elect to begin receiving your CPP retirement pension as early as age 60 – but at a price. There is a penalty of 0.6% for each month the pension starts before your 65th birthday. Those who start at age 60 will suffer a penalty of 36% of their pension entitlement. Thus, if your Statement of Contributions from Service Canada shows that you would be entitled to a $1,000 per month pension at age 65, your pension will only be $640 per month if you start at age 60. If you continue to work after you receive your pension, you must still continue to contribute to CPP until age 65. After you reach 65, you can opt out of contributing if you’re already receiving your pension. On the bright side, those extra contributions will earn you a small additional pension called a post-retirement benefit.
If you delay starting your pension beyond your 65th birthday, you’ll receive a larger monthly benefit. Your pension will be increased by 0.7% for each month you delay – for up to 60 months. If you delay until your 70th birthday, your pension will be increased by 42%. For example, if you were entitled to a $1,000 per month pension at age 65, and you delay until age 70, your pension will be $1,420 per month. On the down side, you’ll have to continue contributing to age 70 if you continue to work. Those extra contributions will earn you an additional post-retirement benefit.
Perhaps the most difficult question to answer is “How long will I live?” The longer you live, the longer you’ll receive your pension and therefore the more you’ll get from CPP. A general rule of thumb is that if you’ll live beyond age 74, you will benefit from delaying the start of CPP. If you live to age 80 or beyond you’ll get more from CPP if you delay starting to age 70. The average Canadian who makes it to age 65 will live to about age 85.
When you die, the maximum death benefit from CPP is $2,500. If you have a spouse, they will be entitled to a survivor pension of 60% of the deceased taxpayer’s pension entitlement.
The maximum CPP retirement pension for 2015 is $1,065 per month (excluding any post-retirement benefit and increase for delaying). That maximum includes both the taxpayer’s own CPP retirement pension and any survivor pension that they are entitled to. This means that where both spouses have CPP pension entitlement, the amount of the survivor pension may be reduced or even eliminated.
Here is the basic information
regarding withdrawals from a tax-free savings account:
will create additional contribution room equal to the amount of the
withdrawal, for deposits in future years
(not in the year of the withdrawal).
earned in and withdrawals from a TFSA will not affect eligibility for
federal income-tested benefits and credits such as
income supplement (GIS)
exemption tax credit
paid related to the TFSA will not be tax-deductible.
can be made, with the investments being transferred to a non-registered
account, or as a contribution to an RRSP, subject to available RRSP
contribution room. When in kind withdrawals are made, the value of
the transaction will be the current market value of the investment.
This will be the contribution amount if the investment is transferred to an
RRSP. If the investment is transferred to a non-registered account,
the current market value at time of withdrawal will be the cost basis for
the non-registered investment. Any subsequent capital gain or loss
when the investment is sold will use this value as the cost basis.
If the maximum has been
contributed to a TFSA, and then a withdrawal is made, no further amount can be
contributed (without penalty) until the following year. On January 1st of
the following year, the withdrawal amount from the previous year will be used
to increase your regular annual contribution room.
How to Convert Your RRSP to Income
Registered Retirement Savings Plans
represent one of the most significant retirement planning
tools for Canadians. There are a number of ways to put your RRSP money to work during retirement, but they all boil down to a simple concept. The money you accumulated during your years of saving and investing is converted to a vehicle that provides you with retirement income
. Instead of making contributions, you will rely on withdrawals from your nest egg to subsidize your retirement expenses. Instead of saving money
it’s time to spend it!
When is the best time to convert your RRSP into income?
The best time to convert your RRSP into income is when you need to. Typically, this occurs when you retire and have no paycheques from work. The ideal situation
is to contribute to an RRSP in your ‘earning years’ when you are paying taxes in a higher marginal tax rate
and then withdrawing the money later when you have no other sources of income (like in retirement). Taking income from the RRSP while you are still working can be very costly and will negate the benefits you derived from contributing in the first place.
That being said, you could convert RRSPs to income as early as age 18, but should wait until later in your life.
How long can you defer the RRSPs?
Many pundits will advise that you should defer your RRSPs for as long as you possibly can. While this may be true in most circumstances, it is a rule of thumb and does not apply in all circumstances. Most people defer the decision to convert RRSP into income so they can defer the tax. Canadians hate to pay taxes so much that they avoid any withdrawals from the RRSP until they are forced to do so. Sometimes deferral can be the costly alternative
. Government rules stipulate that you must wind up your RRSP by the end of the year in which you turn 71.
Basically, you must convert your RRSP into a Registered Retirement Income Fund (RRIF) or life annuity in the year you turn 71, but you do not have to start that income in the year you turn 71. It must start in the following year.
If you turn 71 this year and you have not converted your RRSP into an income vehicle, you need to see your financial advisor or financial institution before December 31.
What are my income options?
Today, most people will convert the RRSP into a RRIF, but this is not the only option you have available to you. In fact you, have four alternatives:
1. Cash out the RRSP
. While this may be an option, it is not usually a good one. Cashing out means that the full value of your RRSP is added to your income and taxed accordingly. Unless you have a very small amount, this can mean a significant part of your wealth will go to the government. Remember that when you cash out the RRSPs withholding tax
is applied but the total tax owed is based on your marginal tax rate.
3. Life Annuity
. Think about a pension plan and that will help you to understand what an annuity is. Just like a pension plan, an annuity is simply a tool that provides you with a fixed stream of income that is guaranteed for the rest of your life. Regardless of markets, interest rates, inflation or the economy, your cashflow remains stable and fixed for your lifetime. There are also reasons why annuities make sense
4. Fixed Term Annuity. Unlike the life annuity, the fixed term annuity does not pay you an income for a lifetime. Instead, you choose a fixed term like 5, 10, 20 years, etc. The only stipulation is the term cannot extend past the age of 90.
How do you know which option is best for you?
The easiest answer is good planning. Different people will have unique circumstances and needs. These issues will determine which option(s) is best suited for you.
Remember that it is not an all or nothing situation where picking one of the options means you cannot choose other options. Sometimes a combination may be the ideal solution.
I can offer some important considerations when comparing RRIFs to annuities.
· Flexibility of income or investment choice – If you are looking for flexibility to set up the income the way you want, with the option of making changes in the future, the RRIF winds hands down. On the other hand, flexibility and choice can be a curse for some who prefer to keep it simple and secure. In these cases, an annuity might make more sense.
· Control – Some people want control, while other just want to be able to set something up and let it run on autopilot. Annuities have the distinct advantage of being easy to set up and understand. RRIFs require more decisions and more management.
· Estate preservation – Generally, the best alternative to provide an estate benefit is usually through the RRIF. You can provide an estate with life annuities if it is set up with proper guarantee periods, but these options can reduce your level of income.
· Spousal protection – Providing survivorship options for your spouse can be facilitated under any route you choose (RRIFs or annuities). However, in the case of annuities, you must make sure they are set up properly.
3 Important Pension Plan Changes for Alberta
There are big changes on the way for pension plans in the province of Alberta. Alberta is the latest province to modernize its pension legislation, following in the footsteps of Ontario. These pension plan changes have been on the works for quite some time. B.C. will soon come out with new rules of its own.
Effective September 1, 2014, a number of new rules come into effect in Alberta. The new rules are far-reaching, impacting not only pensions plans registered in Alberta, but any provincially-regulated pension plans with Alberta members.
If you’re a plan sponsor with employees in Alberta, you’ll need to start following the rules. There are many pension plan changes but in this post, I highlight three key changes plan sponsors will need to follow effective immediately.
Following provinces like Manitoba, Ontario, and Quebec, effective September 1, 2014, Alberta members are now immediately vested. What is vesting? It means members are entitled to their full pension benefits when they leave an employer. Before the new rules, Alberta members had to wait two years to become vested. If an employee leaves on or after September 1, 2014, they’ll receive a pension payout. The new rules make it more costly for plan sponsors – members who were previously non-vested will receive a payout.
There are a number of things plan sponsors can do counteract the change. Plan sponsors may want to extended membership eligibility to two years. That way a member will have to accrue service for two full years before they can join the pension plan and be entitled to a payout. With the trend towards immediate vesting, to make pension administration easier, plan sponsors may want to consider offering immediate vesting across the board.
Unlocking: Small Pensions
The small benefit test has been changed in Alberta. If a member is vested and terminate their employment before their earliest retirement date, they’ll be able to choose to receive a pension payout in the form of a deferred pension or the commuted value. Normally a member’s pension is locked-in until retirement, unless it falls under the small pensions threshold.
Previously, there were two tests to see if a pension would be considered a small benefit. The first test that compared to the current year’s YMPE (Years Maximum Pensionable Earnings) to the annual pension at normal retirement date (NRD) has been eliminated.
The only test to see if a pension qualifies as a small benefit is now whether the commuted value is 20% or less of the YMPE in the year of termination. For example, if the annual pension at NRD is less than $10,500 (2014 YMPE: $52,500 X 20% = $10,500), then it’s considered a small benefit and the member is entitled to receive is as a cash lump sum or transfer their pension to a non-locked in savings vehicle like their RRSP. The new rules means there will be less small pensions, which means a greater number of plan members on the books.
Effective December 31, 2014, pension plans with Alberta members must start issuing inactive statements. The new rules require that annual statements are to be provided to retirees in pay (pensioners and surviving spouses). Similar to active statements, inactive statements must be provided 180 days after the pension plan’s year end (starting June 2015). Although this will create additional work for plan sponsors, the good news is that statements are not required for deferred vested members
3 adjustments made to CPP after it’s in pay
I did some calculations for a client recently to help her decide when to take her Canada Pension Plan (CPP) retirement pension. She decided to take her pension now, but the amount showing in the letter she received from Service Canada wasn’t what she expected.
Mary (not her real name) was born in July 1954. She had relatively low earnings until age 28 and then earnings above the YMPE (Year’s Maximum Pensionable Earnings) level ever since. She had been planning to retire next year when she turned 61 and was wondering whether she should take her CPP now at age 60, next year when she retires, or at age 65.
Based at least partly on my calculations, Mary decided to take her pension now, at age 60. However, when she received her award letter from CPP, she was surprised to find that it showed an amount less than I had said she would be entitled to.
I reminded her that my calculations included credit for her 2014 earnings, and that she should receive a retroactive adjustment to her CPP once Service Canada has confirmation of those earnings when she submits her income tax.
I realized that she was going to have several adjustments made to her CPP next year and such adjustments are not always well explained by Service Canada. These same adjustments will be made for most people who are still working in the year that they start receiving their CPP, so I thought this issue might be a good subject for this month’s article.
I told Mary that she should have three adjustments made to CPP in 2015, which should occur in the following order:
1) Annual cost of living adjustment
In January 2015, her CPP should increase from her 2014 amount based on any increase in the cost of living as measured by the CPI (consumer price index). Based on recent years, this increase will likely be in the range of 1 to 2%. This annual cost-of-living adjustment will be made to her CPP every January.
Mary will be eligible for the full annual increase for 2015, even though her CPP only started in August 2014.
2) Post-retirement benefit increase
Since Mary’s CPP was effective August 2014, and since her 2014 earnings exceeded the YMPE, her prorated earnings from January to July will be used to calculate her regular CPP retirement pension, and her prorated earnings from August to December will be used to earn her an additional PRB. This PRB will be effective January 2015, but she shouldn’t expect to receive it until sometime between April and June 2015, with retroactivity to January.
A similar PRB adjustment will be made for her in 2016 (based on her 2015 earnings) and in any subsequent years that she has earnings from salary or self-employment and makes a CPP contribution on those earnings.
3) Increase for 2014 earnings prior to CPP
When Mary’s CPP was first approved, the award letter explained that it was an “interim” calculation which may not include all of her earnings. This is because her 2014 earnings details won’t be available to Service Canada until after her 2014 income tax return is filed and assessed by Canada Revenue, sometime in 2015.
This adjustment should likely happen sometime between September and November 2015, with full retroactivity to August 2014. Sometimes however, Service Canada seems to “forget” to make this adjustment without a reminder telephone call.
At a minimum, CPP pensions will be adjusted at least once a year. The letter from Service Canada (if any) doesn’t always do a good job of explaining the reason for the adjustments made to CPP.
Hopefully this article will help explain the reasons for and the timing of possible adjustments, but fire away if you have any questions!
Retirement income options for a DC Pension Plan?
Recently I wrote about theoretical retirement income options from a Defined Benefit Pension and a Defined contribution Pension.
This week, I would like to look at this from a more practical perspective via a case study of Paula.
Paula has turned 60 this year and is getting ready for retirement. Although she has a pension through work, it’s a Defined Contribution pension and her biggest concern is knowing how much income she will get from her pension plan. Let’s take a look at her retirement income options.
The DC Pension plan is at Sun Life. It is invested in a few different mutual funds and sitting with about 65% equities and 35% fixed income investments. The pension has done quite well because of the strong market growth over the past 3 years. She has made over 12% compound annual returns over the past few years which has helped her to accumulate $450,000 in her pension. Paula is divorced with 2 adult children who are both financially independent. She has owns her own home and has no debts. She has another $110,000 in RRSPs
and $38,000 in her TFSA
Pension to Life Annuity
When Paula retires, she will be faced with a number of different retirement income options. The first option to explore is the Life Annuity. With a Life Annuity it’s important to get quotes from a financial advisor or from different insurance companies.
Life Annuity rates will change on a daily basis so it’s important to always shop around for the best deal. After getting some quotes from a financial advisor licensed to sell Life Annuities, here’s a summary of three quotes:
· Great West Life = $2201.57 per month
· Sun Life = $2173.83 per month
· Manulife = $2015.69 per month
Obviously, the best deal for Paula is GWL who will pay Paula about $26,418 per year in pension income. This is a lifetime income which means it pays until she dies. She will never outlive her income. The income is secure and predictable. However, if Paula passes away early, there is no return of capital to her after 5 years.
Pension to LIF
A Life Income Fund (LIF) is a little more flexible but as a result also a little more complicated. With the LIF, you can set the income to whatever you want as long as it is within a minimum and maximum. While that may sound simple, the complexity comes in that the minimum and maximum changes every year. Here’s some scenarios to look at:
1. Minimum income LIF
. The minimum income levels for the LIF are exactly the same as the minimum income levels for the RRIF
. Here’s a look at what the minimum income LIF would look like for $450,000
As you can see, the minimum income starts much lower than the Life annuity ($15,173 vs $26,418 per year) but increases as Paula gets older. I used a very conservative return assumption of 2% for illustration purposes only. Remember that the minimum income will change as rates of return change. This chart was produced with financial calculators from Mackenzie Financial
. You can play with this data and use your own set of assumptions.
2. Maximum Income LIF. Unlike a RRIF where there is no maximum income restriction, the LIF has an annual maximum that also changes year by year.
From this illustration, you can see that the initial income is much higher than the Life Annuity ($33,592 vs $26,418) but the income decrease over time. Again, this is based on a very conservative 2% rate of return assumption. A higher return can dramatically change the income values over time.
The LIF offers much greater flexibility from the perspective that you can set your income amount (subject to minimums and maximums) and you can change your income anytime. With the LIF, you are responsible for making investment decisions which for some is an advantage but for others a disadvantage.
A Life Annuity will benefit those that live a long time because the income is guaranteed for life. Those that have shorter life expectancies will benefit with the LIF because there is always an estate value. What you don’t use in the LIF will be passed on to beneficiaries. If will be taxed first to the estate but beneficiaries are likely to get something.
3. Level income LIF. Most people prefer to have a level consistent income in retirement as opposed to one that increases or decreases over time. If we set the income at the same level as the Life Annuity ($26,418 per year), we can see the breakeven point based on a 2% return.
As you can see in this illustration, money runs out at age 81. If you think you will live longer than age 81, then a Life Annuity might make more sense. If you think you will die before age 81, the LIF will make better sense.
To complicate matters a little more, Alberta has pension unlocking rules. As you can see from the information above, pension rules can make it quite restrictive to access extra money from a pension plan. Given that many people were unable to use all their pension money in their lifetime, some provinces introduced unlocking rules. In Alberta, were Paula lives, she is able to unlock 50% of the pension funds and transfer it to a RRSP or RRIF which has no withdrawal restrictions or income maximums.
Issues and considerations
In looking at these numbers, the Life annuity looks not too bad but it does not give Paula any flexibility. Life annuities are great for their predictability and simplicity but most people are not choosing life annuities because of low interest rates and lack of flexibility. Life annuities are also great if Paula lives for a long time.
Choosing the LIF gives Paula much more flexibility in choosing income. These projections are using a 2% return so any increase in returns can increase the income.
Paula could always transfer the LIF to an annuity in the future if interest rates increase. She could not move from an annuity to a LIF because once she purchases the annuity, she is locked in for life.
Choosing a life annuity is not great for estate planning purposes as her children may not get any money from the annuity. That’s where the LIF has a greater appeal because any money Sally does not use can be given to the children or grandchildren at death (subject to taxation).
After showing Paula all the information, she decided the LIF was the best way to go. She decided to unlock 50% to a RRIF and move the other 50% to a LIF. With the LIF, she chose a maximum income ($1400 per month) and then set the RRIF at $1085 per month.
What do you think of the new Ontario Retirement Pension Plan (ORPP)
The Ontario Liberals’ recent majority victory means the Ontario Retirement Pension Plan (ORPP) will soon be a reality. The labour market in Ontario isn’t any different from the rest of Canada – there are the pension have’s and the pension have not’s.
Targeting The Pension Have Not’s
With each passing year, the number of workers covered by a workplace pension plan dwindles. Today only one-third of workers have a workplace pension plan, leaving two-thirds of workers on their own when it comes to retirement savings. The ORPP is designed to level the playing field, providing retirement income to those without a workplace pension plan.
What is the Ontario Retirement Pension Plan (ORPP)?
The ORPP is targeted at workers in the province of Ontario earnings up to $90,000 a year, who are not covered by a workplace pension plan. The ORPP would be a forced savings vehicle designed to help those struggling to keep up with the rising cost of living save for retirement. Similar to RRSPs
, the ORPP would provide employees with a tax efficient way to save for their golden years.
Not everyone is a fan of the ORPP. The Canadian Federation of Independent Business has been especially critical of the pension plan, calling it a tax on small business. In fact, the ORPP could lead to job loss, as employers may choose to set up shop in different provinces to avoid joining the mandatory plan. When introduced, employers without a workplace pension plan will have to contribute to the ORPP, on top of Canada Pension Plan (CPP) contributions.
How Costly Will the ORPP Be for Employers?
Under the ORPP, an employer would have to match an employee’s contributions of 1.9 per cent per year in earnings up to $90,000. Similar to CPP, the maximum earnings of $90,000 covered by the ORPP will increase each year based on the CPI.
For a worker earning $45,000 annually, the employer would have to match contributions of $66 per month ($788 annually). For a worker earning double that amount annually, $90,000, the employer and employee would each have to contribute $137 per month ($1,643 annually).
Similar to CPP, the ORPP isn’t designed to fund a worker’s entire lifestyle in retirement. Much like CPP, it’s aimed at replacing 15 per cent of an employee’s working income in retirement. The middle-class and Millennials without the benefit of a pension plan would benefit most under the plan.
Workplace Pension Plans as an Employee Retention Strategy
A job for life may no longer be a thing of the past. Job stability is near a record high – about 50 per cent of Canadian workers have been with a single employer for five years or more, according to a new report from CIBC World Markets
. In fact, the likelihood of workers remaining with their employer rises with each year of seniority, starting at 60 per cent for those on the job for a single year, rising to 95 per cent for those on the job for five years or more. This flies in the face of reports that say job hopping is the new norm.
Why are employees remaining with their employer longer than ever before? Although a mediocre job market might have something to do with it, group benefits like workplace pension plans clearly matter to workers. Over three-quarters of new hires at employers offering traditional defined benefit (DB) pension plans said the retirement program gives them a compelling reason to stay on the job, according to the Towers Watson Retirement Attitudes Survey
. This doesn’t just hold true for older workers – 63 per cent of workers under age 40 said their retirement program was an important factor in accepting their job.
The ORPP will help level the playing field by forcing employers to join if they currently don’t offer a workplace pension plan. However, there’s nothing to stop employers from going above and beyond the bare minimum by offering workplace pension plans. From traditional defined benefit plans to newer Target Benefit Plans (TBPs)
, there is no shortage of choices. Although offering these plans may be an expensive right now, they’re likely to pay off in the long-run, as employers will have a better chance of retaining their most talented employees.
Employers Have Plenty of Time to Prepare
Although the ORPP will be an added expense for employers in Ontario, the good news is employers have plenty of time to prepare. The Liberals don’t plan to introduce the ORPP until 2017, when federal Employment Insurance premiums are expected to be reduced. The ORPP won’t be introduced in one fell swoop – contribution rates will be phased in over two years. Enrollment will be staggered, with the largest employers enrolling first, allowing small businesses plenty of time to budget. The ORPP will be mandatory for any employer who does not offer a registered pension plan.
A case study on CPP combined benefits
I provided calculations for a client recently, and I think his situation might provide a good example of how receiving a CPP survivor’s pension can affect the decision of when to start receiving your CPP retirement pension.
When you’re eligible for both a CPP retirement pension and a CPP survivor’s pension, you get CPP combined benefits. If you want to know more about how these CPP combined benefits are calculated, read Understanding CPP Survivor Benefits
John has been receiving a CPP survivor’s pension since his wife died three years ago. The current amount of this pension is $500 per month. He has been a maximum contributor to CPP every year since he was 18; he will turn 60 this year.
His CPP statement of contributions (SOC) indicated that his retirement pension would be $689.45 if he took it at age 60, $1,038.33 if he waited until age 65, or $1,474.43 if he waited until age 70.
John’s understanding of his choices
John knew that the above retirement pension choices from the SOC did not apply to him, due to the combined-benefit rules. He thought that combined benefits were “capped” at the maximum of a single retirement pension ($1,038.33 for 2014). So he thought that his choices were either to take a combined benefit of $1,038.33 at age 60 or continue receiving his CPP survivor’s pension of $500 until age 65 and then to take his combined benefit of $1,038.33.
In his mind, this made for a simple decision between taking his retirement pension at age 60 or 65; he thought he would always be ahead if he took it at age 60.
However, he wasn’t sure what would happen if he waited until age 70 to start his CPP, and that’s where he wanted my help.
The truth about John’s choices
The first thing I had to clarify with John was that due to the combined-benefit rules, he would only receive $976 monthly if he took his CPP at age 60, not the maximum of $1,038.33. The second thing I had to clarify was that if he took his CPP retirement pension at age 60, the combined benefit amount would be recalculated to $862.27 when he reached age 65.
Putting these two calculations together with the fact that he would continue to receive his CPP survivor’s pension of $500 monthly if he waited until age 65 to take his retirement pension, it appeared that waiting until age 65 might be a viable option. This is because the “breakeven age” for waiting until age 65 would be age 79 (this is the point in time that the total dollar payout of CPP under the two choices is equal).
The whole truth about John’s choices
The final thing that I had to clarify with John was what he would receive if he waited until age 70 to started receiving his CPP retirement pension. This is where he was really surprised.
If John waited until age 70 to start receiving his CPP retirement pension, his combined benefit at that time would be $1,474.43. In the meantime, he would continue receiving his CPP survivor’s pension of $500.00 until age 65, at which time it would be recalculated to $514.33 and continue at that rate until he applied for his retirement pension at age 70.
The breakeven age for this choice compared to taking it at age 60 would be age 77, which is even earlier than the age-65 breakeven age calculated above.
Summarizing John’s choices
1. John could start receiving his retirement pension at age 60. He would receive a combined benefit of $976 from age 60 to age 65, at which time it would be recalculated to $862.27.
2. John could start receiving his retirement pension at age 65. At that time he would receive a combined benefit of $1,038.33, and in the interim he would continue to receive his survivor’s pension of $500.
3. John could start receiving his retirement pension at age 70. At that time he would receive a combined benefit of $1,474.43. In the interim he would continue to receive his survivor’s pension of $500 until age 65, at which time it be recalculated to $514.33.
From a total payout perspective:
· If he doesn’t live past age 76, he is better off taking his CPP at age 60.
· If he lives at least until age 77, he is better off taking his CPP at age 70.
· Taking his CPP at 65 is never the optimal age, when compared to the other two choices.
The combined benefit rules are an important factor in deciding when to start receiving your CPP retirement pension. If you are receiving a CPP survivor’s pension and are trying to decide when to take your own CPP retirement pension, know what your true choices are.
Note that the above breakeven calculations were accurate in John’s situation, but may not apply to you if the amount of your survivor’s pension and/or if your retirement pension choices are different from the above amounts.
If you are in this situation, and want to find out more about your choices, contact me at DRpensions@shaw.ca
. I can calculate (for a fee) what your combined benefit would be at the various ages, along with the breakeven ages for each choice.
Ontario moves ahead with ORPP
July 30, 2014
The Government of Ontario is moving ahead with its mandatory provincial pension plan, the Ontario Retirement Pension Plan (ORPP), after the provincial budget received royal assent last week.
“The federal government has consistently refused to commit to an enhancement of the CPP, so Ontario is leading the way with the ORPP,” says Associate Minister of Finance Mitzie Hunter. “Without help, that future is discouraging for many, especially since two-thirds of Ontario workers don’t have access to a workplace pension and many are unable to save enough on their own to provide for a secure retirement.”
The province says the ORPP will:
- Provide a predictable stream of income that is indexed to inflation and paid for life in retirement.
- Be mandatory for the more than three million Ontarians without a workplace pension plan, and require equal contributions from employees and employers.
- Operate at arm’s length from government and be responsible for managing investments associated with annual contributions of approximately $3.5 billion.
- Support long-term economic growth as pension payments from the ORPP would help people maintain their standard of living in retirement and continue spending.
- Be developed in consultation with pension experts, business, labour, individuals, families and communities across the province in order to ensure that a broad range of perspectives is heard.
The ORPP aims to provide a replacement rate of 15% of an individual’s earnings, up to a maximum annual earnings threshold of $90,000.
Contributions will be shared equally between employers and employees and not exceeding 1.9% each (3.8% combined) on earnings up to a maximum annual earnings threshold of $90,000. The ORPP maximum earnings threshold would increase each year consistent with increases to the CPP’s maximum earnings threshold.
Since the provincial plan is intended to assist individuals most at risk of undersaving, particularly middle-income earners without workplace pensions, those already participating in a comparable workplace pension plan would not be required to enroll in the ORPP.
The ORPP would be introduced in 2017 to coincide with the expected reductions in Employment Insurance premiums.