Planning helps choices. Few people can do the arithmetic to find out, and fewer still know how to connect the variables that matter. Eventually, people end up with too little because they gave up or considered too few problems, or too much because they considered too few opportunities. Either is wrong.
What’s it for? is a valid question. Money saved becomes money to spend in the future. It’s effortless to get caught up in the complexity trap that bankers, advisors, and governments like to present to you. Think about deferred income plans like an RRSP. What do you know other than you get a tax-deductible piece of paper when you contribute to one? You don’t need a deferred income plan; you need groceries and gas someday. If you think about the need for gas and groceries, the accumulate money problem becomes a little easier to think about.
If nothing else, you will be a little more motivated.
To live well in retirement, you must set aside resources today. The question is two-fold. How much and how? Once you notice the two-part nature of the question, all potential hows become easy enough to understand.
An RRSP lets me transfer pretax income to the future. I want income in the future so transfer income today. Always notice tax effects.
A Tax-Free Savings Account lets the money grow without income taxation, but you get no deduction for the contribution.
Some forms of income have tax preferences. A dollar of eligible dividend income attracts less tax than a dollar of interest income.
Picking investments within the container you have chosen is complex. You could buy ETFs or Funds and pay the management fees to avoid the hassle. Similarly, you might have an advisor who can do the arithmetic and bring other people’s experiences to your desk for consideration.
Fees and taxes are two things you must consider but in context. Do-it-yourself is cheaper in dollars but more expensive in time and risk of serious error.
Systems work very well when addressing slow-moving problems.
Systems have big building blocks and small engines that make them work. Most people have four big blocks in the accumulating phase of their life.
Assuming the first three steps are satisfied, the question of how much becomes easy enough to answer.
It’s just arithmetic. Start with when you want to retire and what spontaneous income will arise.
Suppose you are a married person who wants to retire at 65. Your income need is a function of lifestyle spending and the duration of it. Suppose you choose 30 years as how long. Today only about 10% of couples would have one remaining alive by then.
How much is the amount that replaces lifestyle spending plus a security fund? A security fund is a margin for error.
Suppose you decide lifestyle is $7,000 monthly after taxes, $84,000 a year. If you are 40 now, how much would you need to save this month to start accumulating the right amount of money? That leads to more questions. How much can I earn with my money, and what about inflation?
Again just more arithmetic. Notice if you stop here, you will get a huge number, and you won’t be able to do it. Think about spontaneous income.
In Canada, two government plans happen automatically. Old Age Security and Canada Pension. OAS is the same for everyone at about $8,000 per year each. CPP depends on earnings while you work. Suppose you, as a couple, would get about 1.5 times the maximum. That’s about $22,000 a year combined. So the government expects to send you $38,000 a year. These are indexed to inflation.
You may have employer pensions as well. They may or may not be tied to inflation. It complicates things a little if they’re not, but it isn’t insurmountable.
For this example, suppose they come to another $3,000 a month or $36,000 a year and change with inflation. No matter who receives the payment, you can split them for taxes any way you want. That matters. Split income is cheaper for income taxes.
At this point, you can imagine $74,000 of income, and with a bit of research, you can find that $37,000 each of income attracts tax totalling about $5,500. So, of your $84,000 goal, $68,500 looks like it’s there regardless of what you save.
The other $15,500 is your responsibility.
If you use RRSPs, the lowest cash cost now, all the income that appears will be taxable when you get it. That might not matter. If you can deduct the contributions and save 40% or so, and you will pay taxes at 20% when you take it out, it is likely a wise choice.
Tax-Free Savings Account contributions are not tax deductible now but attract no tax in future. That is a good thing in your estate. More control and more capital later, but more costly now.
Both RRSPs and TFSAs have investment eligibility rules and maximum contributions. We can usually assume there will be no conflict with what you would invest in, and the limits are high enough that you need not care.
Open account savings are more flexible than either, but you get no deductions now, and the income is taxable.
That matters but maybe not as much as you think. Taxes are more of a factor with higher income, and your cost of living will be more, but it might not matter as much as you think. If you save a share of your income instead of a dollar amount each month, you will eliminate much of the problem as you accumulate.
Step 1: How much will $15,500 be 25 years from now? If inflation is 3%, about double. The rule of 72 helps. 72 divided by the rate of change gives the number of years to double. So $31,000 to start
Step 2 how much do you need over 30 years? That changes with inflation too. You need to know the present value of the future cash flow required at 3% inflation and some rate of return. Suppose we can get 3% over inflation pretax and 4.5% after tax. That is not a trivial problem, but 30 years is a long time, and things tend to average out. It does make the assumption that the future will be somewhat like the past has been.
There’s a formula for that, or you could use a spreadsheet. Be sure you notice that most NPV formulae are based on drawing the money at the end of the year. It says you’ll need $822,000. This will tend to be high because most people don’t have their lifestyle inflate at the CPI for the whole 30 years. We’ll leave that adjustment to adapt to higher taxes if one dies before 95. It will add to the margin of error for advanced ages.
Suppose you decide a margin for error is 20%, so you will want $986,000.
Step 3. What should happen today? Your mission is to accumulate $986,000 in 25 years. There is a formula, or you can use a spreadsheet to determine the monthly amount. In a taxable investment account, you will need about $1,400 monthly to begin. You add inflation to that each year as you go along. So the second year will be 3% higher or $1,442.
That’s likely less than the payment on your mortgage that you just paid off.
With no tax advantages, you need about $1,400 a month.
The monthly payment to an RRSP costs less out-of-pocket cash, even though there will be taxes on the withdrawals. That’s because of the tax deduction for the contribution and the higher rate of return within the plan. You would need to save about $1,100 monthly to start, plus annual inflation adjustments. That’s around $750 after the tax deduction. On the downside, RRSPs increase the risk of adverse tax consequences for a survivor if one spouse dies early, and they can create estate problems.
A TFSA is different again. $820 a month out of pocket should do it. The TFSA Limit for a couple is $12,000 a year, so that should work, but we don’t know the future. TFSAs pose no estate problem, nor do they affect the survivor’s tax position when the other dies.
It is a close call between RRSPs and TFSAs. I don’t see open investment accounts as a good choice unless flexibility is your paramount decision factor or you cannot fit within the other plans’ limits.
Retirement income planning is just organized common sense. You know you’ll need money, so you must set some aside.
You need not replace all of your income today, just the part that isn’t already provided for.
There are tools to deal with your particular variables.
You can mix and match them.
You can change your method during accumulation if circumstances change.
The future will be different, so pay attention and update often.
RRSPs and TFSAs each have contribution limits. The discussion assumes the contributions to each plan will fit.
It’s easier if you know the meaning of each step.
You will be more motivated if you know the purpose, the particular method(s), and the amount you need to save.
The future will be different. You can adapt better if you understand what you are doing.
I build strategic, fact-based estate and income plans. The plans identify alternate ways to achieve spending and estate distribution goals. In the past, I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning. I have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, and Banks – from CIBC to the Business Development Bank.