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FROM: SEP-OCT 2009 ISSUE | BY ANDREW ALLENTUCK
A Vancouver-based CGA we’ll call Joanne is 44 and thriving in her career in a mid-sized accounting firm. She makes a good salary in the mid-$80,000 range, has a husband who contributes $65,000 a year and has her family finances in perfect order. Yet she wonders what the future will hold.
“Neither of us has a company pension,” she explains. “We would like to retire at 65 and do some travelling. We don’t want to have a mortgage by the time we retire.”
It seems a routine wish and completely reasonable. Yet for the self-employed, who, according to the Canadian Association of Retired Persons, are part of the six out of 10 Canadians at work who have no workplace pensions, creating a financial base for retirement is essential.
Vital though the job may be, it is also a sophisticated exercise in economics, for any financial plan has to include a prediction of future inflation rates, what various asset classes will return, and how much part time work may be required to fill in gaps.
There are ways to cope with these challenging problems, explains Caroline Nalbantoglu, a financial planner at PWL Advisors Inc. in Montreal. “We can do weighted averages based on long term rates of return and long term inflation rates. But the problem is to include asset price volatility and to devise a way to smooth out cash flow in retirement. That means taking no more risks than required to pace inflation – usually estimated at two per cent to three per cent per year, and adding about two per cent for growth. That target allows for conservative large cap stocks and bonds.”
Pension Income
The problem of planning a retirement income ought to be quite direct: Figure out the total of Old Age Security and Canada Pension Plan benefits and subtract that from anticipated living expenses in retirement. The difference, if any, is what you will need in employment pension and investment income.
Currently, OAS pays $6,204 per year and the Canada and Quebec Pension Plans pay a maximum of $10,905 per year. In each case, payouts are indexed to changes in the all-in or headline rate of the Consumer Price Index. OAS payments begin to be clawed back when net income before adjustments (T-1 line 234) hits $66,335 and disappear when that income rises over $107,692.
The test for eligibility for CPP benefits is attainment of age 65. But early application, which used to require cessation of work between ages 60 and 65 for a couple of months prior to application for benefits, is expected to change. Recipients will be able to receive benefits and continue contributing to CPP. The effect will be to reduce the pressure to quit work and to add to the flow of funds into CPP’s coffers.
Early retirement penalties for taking CPP benefits increase from 0.5 per cent per month to 0.6 per cent per month for each month after one’s 60th birthday and before one’s 65th birthday. Thus an applicant for benefits at age 60 would lose 12 × 5 × 0.6 or 36 per cent of age 65 benefits compared to 12 × 5 × 0.5 or 30 per cent of benefits today. The phase-in of this change will be over a period of five years starting in 2012.
The reward for postponing application for benefits after age 65 grows from 0.5 per cent to 0.7 per cent per month after age 65. CPP benefits for each month after age 65 and prior to age 70 would rise to 0.7 per cent for each month after age 65, at which benefits begin. That change pushes the bonus from 30 per cent to 42 per cent for postponement. This part of the phase-in will be done over a period of three years starting in 2011. The effect of the boost is to push benefits at age 70 from $14,177 to $15,485 once the changes are in effect. (All figures are in 2009 dollars.)
How significant are the changes? Says Adrian Mastracci, a financial planner and portfolio manager who heads KCM Wealth Management Inc. in Vancouver, “for the person who has built up ample retirement savings, waiting five years before age 65 or 10 years after age 60 to cash in won’t make much difference – that person can wait and use personal savings. But for average workers, waiting will be too costly; those people are likely to take the money as early as they can.”
Changes will not affect existing CPP retirement beneficiaries or those receiving benefits before these changes begin to take effect, notes an announcement from the Department of Finance.
The changes are nevertheless quite important. For a couple, both of whom have worked enough to qualify for full CPP benefits at age 70, public pensions in 2009 dollars will rise to as much as $43,378 when the changes are in effect.
Retirement Budgets
How much more will a CGA need to get by? There is no hard and fast rule. Many financial planners use the so-called replacement ratio, which says that a pre-tax retirement income 60 per cent of gross income before retirement will have the same purchasing power. After one’s home is paid for, the kids have finished post-secondary education, retirement savings and CPP contributions, EI and work-related expenses such as commuting and a closet of suits stop, what’s left is basic expenses for food, heat and power, phone, and internet.
However, retirement expands the amount of time available for spending money. For those who have worked 10 or 12 hour days and collapsed on the weekend, there could be a dramatic surge in spending.
An alternative to averages is a life cycle spending model that predicts folks find a comfortable level of spending and stick with it in retirement. “It’s a personal thing, says Malcolm Hamilton, a Toronto-based actuary with Mercer. “There may be a catch up principle that leads people to make up for lost time and to do the things that, as young retirees, they wanted to do but did not have the time to do. But that fades with age. The very elderly tend to do less discretionary spending than younger retirees either for lack of time or lack of energy. The large expenses of paying for a house and raising children leave most working families with a fairly austere life. When they get to retirement, notwithstanding that their incomes are lower, they are content just to live as they have.”
Rather than trying to pick among models that say retirees spend less, more, or just the same, it’s reasonable for potential retirees to spreadsheet their expenses. Early in retirement, from age 55 or 65 to perhaps age 75, there will be opportunity and energy for travel, sailing, skiing, or whatever. From 75 to 85 or beyond, the energy for jetting off to Paris and trying to climb mountains is likely to be gone. Testamentary plans for money could be implemented with the difference, which could grow if retirement investments are successful, if one has carried a surplus of cash flow over spending, or if indexation has exceeded spending.
Investment Plans
What separates financially successful retirements from those that are flops will be return on investments. Stock, bond, or mutual fund picking is part of the challenge, but in a larger sense, the issue of what assets to buy is about risk management over time. In turn, that is about balancing investments that have market risk – all of the above – with those that have no market risk – annuities.
Annuities are contracts made with insurance companies to pay returns from a fixed investment price. The periods may be life and no more or, more commonly, life that includes a number of years so that the early death of the annuitant does not prevent the spouse from receiving support.
The advantage of an annuity is that you can’t run out of money no matter what capital markets do. The disadvantage is that money is tied up. Today, with interest rates at historic lows, buying a contract that basically pays interest income is not ideal, says Derek Moran, a financial planner who heads Smarter Financial Planning Ltd. in Kelowna, B.C. Moreover, when inflation rises, annuitants will be hurt, for most annuity contracts do not provide purchasing power indexation, he notes.
An alternative that removes inflation risk are real return bonds, which are a handful of federal issues, all long-dated, that base payouts on the CPI. As inflation rises, so does RRB income. But RRBs are thinly traded and, outside of registered plans like RRSPs and TFSAs, can create large and unpredictable tax bills for investors, Moran adds.
And yet, seen as part of an investment plan, having some guaranteed or inflation-hedged income is not a bad idea. For anyone whose guaranteed flow of CPP and OAS or other pensions is a small part of income, adding certainty via an annuity or RRB for a fraction of assets is not a bad idea. Then adding conventional bonds or a bond fund with reasonable fees under one per cent per year, and finally layering on a diversified portfolio of stocks can be a good solution.
What to do? “Break your retirement income flows into four quadrants,” suggests Don Forbes, a financial planner who heads Don Forbes & Associates/Armstrong & Quaile Inc. in Carberry, Manitoba. “Public pensions are one quadrant, RRSPs and TFSAs are another, bonds are a third, and annuities are a fourth. You can start with a quarter of required income from each quadrant and vary the weights according to your investment management skills. There is no best way to do this, for stocks may beat bonds over a time or vice versa, high inflation could return and devastate both stocks and bonds – but not RRBs, and, who knows, currencies could weaken and gold soar. But dividing your expected income into slices of a pie provides insurance against most kinds of mayhem and gives some predictability to retirement cash flows for people who have no one to depend on for most of their income but themselves.”
“What you have to do is to plan for the worst,” Nalbantoglu says. “Use the most conservative investments that you can. And if things turn out better, then the rest is gravy.”
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