Income in Retirement

The Financialist • Issue 94 • July 2007
BY CLAY GILLESPIE BBA CFP CIM FCSI

When it comes to retirement income planning, there is no perfect strategy or simple solution. However, there are a few fundamentals that apply to everyone when designing a retirement income planning strategy.

GOVERNMENT INCOME ENTITLEMENTS

Old Age Security (OAS)

The current maximum OAS payment is $491.93/ month, and starts the month after your 65th birthday. 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 when your taxable income reaches $63,511, and is fully clawed back when your taxable income reaches $102,865.

Canada Pension Plan (CPP)

Currently, the maximum CPP benefit is $863.75/ month. CPP can be taken as early as age 60 or delayed until age 70. If taken prior to age 65, the pension amount is reduced by 6% for each year you are under the age of 65.

The payment amount is reduced if you start taking the pension early because it is paid for a longer period of time. In addition, CPP benefits can be split with your spouse.

Both OAS and CPP 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

In a defined contribution plan, or money purchase plan, 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.

The employee is only entitled to a certain monthly income upon retirement. Therefore, the employee does not have any upside or downside investment risk for monies that may be in "the market".

PERSONAL SAVINGS

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

(1.) Registered Retirement Savings Plan (RRSP)
All funds within an RRSP must be converted to a RRIF or Life Annuity, or withdrawn as a lump sum (cash) in the year you turn age 71, at the latest.

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 at least a set minimum percentage of the RRIF account each year.

The minimum withdrawal percentage can be based upon your younger spouse’s age to reduce the required minimum withdrawal percentage.

At age 71, the minimum withdrawal percentage increases to 7.38% (an increase of 47.6% over the previous year). As a result, after the age of 71, it becomes increasingly difficult to preserve the capital in your RRIF. (See table on page 4.)

These percentages were set by the government when interest rates were approximately 10%. In recent years, interest rates have decreased dramatically, forcing RRIF account holders to dig into their capital at a much earlier age than originally anticipated.

Life Income Fund (LIF)
Many Canadians have funds that have been transferred from a pension plan to a "locked-in" RRSP (often referred to as a LIRA or locked-in retirement account). These funds must be converted to a LIF or life annuity in the year you turn 71 years of age.

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, so that you can not spend all your money early in your retirement years.

For both the RRIF and LIF, you have full investment control of your portfolio; you can invest the funds 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.

With a life annuity, you give up control of your capital in exchange for a guaranteed income. The risk of outliving your money is shifted to an insurance company.

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 you 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 guaranteed period to the annuity to protect your estate. You can also arrange to have an annuity that is indexed either at a set percentage or to inflation. All things being equal, the more features you add to an annuity, the lower the monthly income.

In today’s low interest rate environment, most people do not choose the annuity option when they retire.

However, even with today’s low interest rates, it may make sense to transfer your RRIF (or LIF) into a life annuity in your late 70s or early 80s.

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 regular income derived from their registered plans (RRSP, RPP, RRIF, LIF, PRIF, LRIF, DPSP).

(2.) 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, given that any funds inside a RRIF are fully taxable when withdrawn, I 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.