In preparing for retirement, each individual’s circumstances will impact when they can retire and how much income they will have during retirement. Let’s look at two individuals earning the same income and working for 30 years. Both are age 60. They each have five years to prepare for retirement.
Marta is age 60 and has worked for the Federal Government for the last 30 years. She is currently earning $60,000 per year and has group benefits that will continue into retirement. She also has a defined benefit pension plan with indexing. Marta’s pension will provide 2% of the average of her highest three years of income. Thus, if she continues to work until age 65, she will be entitled to 70% (35 years x 2%) of her highest three year average of earnings. By retirement, at age 65, it is possible to predict the highest average income will be $60,000. Thus her annual income, starting at age 65, when she retires will be $42,000 (70% of $60,000) and will continue to increase annually with inflation.
Note: An indexed pension’s income is increased annually by inflation, much the same way as CPP (Canada Pension Plan) and OAS (Old Age Security) are. It is rare in the public sector today.
Marta has very little in RRSP’s because her RRSP contribution room was very low during her working years. The most she could contribute each year for the past 25 years was $1,000. As a result, she has accumulated $64,000 in her RRSPs.
Other investments, outside of her RRSP, have a current value of $80,000. She also owns her home with her husband. The value of her home is approximately $415,000.
Since Marta has contributed the maximum to CPP for the last 15 years, she will receive the maximum benefit of approximately$934 per month at age 65. As well she will also begin to receive OAS of approximately $522 per month. Thus Marta’s annual income in the first year of retirement will be $59,472. The next year her retirement income will increase with inflation. Marta is in an optimal situation. Her income will remain close to what is was prior to retirement and her group benefits will continue during retirement.
All of her income will be taxable as earned income with the exception of the small dividend and capital gains income she will earn on her non-registered investments.
If we assume she will earn approximately 4% on her non-registered investment portfolio, she will earn another $3,200, taxed as interest, dividends and capital gains income.
Marta is leaving the income earned on her non-registered investments to reinvest. Thus she will have to plan to pay the income tax on her investment income each year out of her retirement income.
At age 71, Marta will have to transfer her RRSP to a RRIF (Registered Retirement Income Fund).
Like Marta, he is age 60 and worked 30 years. John works for a large Canadian corporation. Like Marta, he has a defined benefit pension but his income will remain unchanged during his retirement. John’s pension is also based on his the average of his best three years of income. At retirement, John can expect a pension income of $42,000 per year and it will remain the same throughout his retirement.
John also maximized his CPP contributions over the years and will receive the maximum benefit.
For the first year of his retirement, John will receive the same annual income as Marta: $42,000 of pension income plus CPP and OAS for a total of $59,472. However, John’s pension income will not increase. Over 20 years, if inflation is at 3%, Marta’s pension income will have increased to $73,647 annually and John’s will remain at $42,000. When CPP and OAS are added Marta’s total income before RRIF income would be $94,216 while John’s would be $62,589, a 33.6% difference in income.
Luckily John accumulated $367,000 in his RRSP. His pension adjustment number was lower than Marta’s which allowed him to contribute more to his RRSPs. On average John was able to contribute $5,000 each year to his RRSP for 25 years. With the high interest rates in the 80s and early 90s, John’s RRSPs grew substantially over the years.
While inflation remains low, John does not need to start withdrawals from his RRSPs. However, if John were to start withdrawals from his RRSPs, does he have enough to supplement his income for life? If John continues to contribute to his RRSPs or TFSAs (Tax Free Savings Accounts), earning a 4% rate of return, he should be able to offset the impact of inflation on his retirement income.
This does not take into consideration increased health costs. Not all costs are covered by OHIP. In addition, as John will no longer be a member of a group benefits plan, he will now be responsible for all dental costs, glasses and prescription medications not covered by government programs.
Planning for the costs of health care during retirement should not be neglected.
Marta’s and John’s situations are ideal. Very few people work for the same organization for 35 years. As well, the Baby Boomers benefited from high interest rate periods that are not available today. What they do illustrate is the need to save for retirement. How much should you save? A good rule of thumb… The lower your PA (Pension Adjustment) number, the more you need to save. The PA can be found each year on your T4.
And don’t be fooled by Marta’s situation. To meet her pension obligation, her source deductions would have been high over the years and resulted in a lower annual take home pay.
J McPherson CFP, CLU, TEP, providing consultations to individuals in planning their financial lifestyles.