Pre-retirement and retirement
If you are already retired, the opportunity to add to your investment portfolio has probably passed and you are left to work with what you have. It is critical that you have eliminated all debt including mortgage debt and other consumer debt.
Servicing debt from an investment portfolio makes no financial sense.
Those who were disciplined and made the necessary sacrifices during the early and middle years of their lives should be well positioned. Those who didn’t may face struggles and could have some hard, unpleasant choices to make.
In your retirement years your focus on planning should shift to maintaining a suitable level of income. Some of this income may come from sources such as CPP, OAS and employer pension plans but if you are like most people, that income will need to be supplemented from your own personal investments.
In Canada, the sources of retirement income during the period from 2000 to 2002 are shown in the following tables. This data illustrates the relatively low reliance on income from RRSP investments but even more surprising may be the amount of income seniors derived from employment.
For some, employment may be by choice, while for others it may be necessity. Regardless of what your situation might be, it is an important source of income to keep in mind.
As Canadians we are fortunate to have programs like Old Age Security and the Canada Pension Plan to help fund our retirements to provide a very basic level of income. However, you will need to supplement that with income from your personal savings and your employer pension plan (if you have one) in order to generate enough income for a comfortable lifestyle.
You also need to examine the savings you have accumulated during your working years. It is these savings from which you will be deriving retirement income.
If you exceeded your goals, you can probably draw a larger income than you had planned for; if you fell short of your goals, you will have to develop a strategy to address your shortfalls.
If you are very near to retirement or already in retirement, what you have accumulated in your savings and pension plans will be what you have to work with. The ability to add significantly to either will have passed.
Your planning at this stage of life should revolve around developing detailed cash flow projections.
You need to know the sources of your income and the amount you can expect from each source. There can be varying levels of Old Age Security (OAS) and Canada Pension Plan (CPP) payments. You may have income from an employer pension and you may have personal accounts such as a RRIF, a TFSA and a taxable investment account.
Prior to retirement, your employment or business generated the income required to cover living expenses and the extra that you set aside in the form of savings. All of that changes with retirement.
There is no employment income to fall back on and there may be very little in the way of excess capital should things not work out as planned. In that situation it becomes even more critical to make the appropriate investment choices, and developing your investment profile through a risk tolerance analysis can be invaluable.
The importance of selecting a realistic withdrawal rate to generate income in your retirement cannot be overstated. Reaching for higher investment returns and basing your withdrawals on that higher estimated return can increase volatility, which in turn increases the probability of portfolio failure.
Even the most conservative portfolio will not have a consistent return over the course of many years.
There will be some variance in the rate of return and an appropriate withdrawal may require a compromise between income requirements and preserving the integrity of your portfolio.
Rather than choose a fixed amount from a portfolio each year, choose a percentage of the value of your portfolio.
RIF Withdrawal Strategy
The Canada Revenue Agency (CRA) already provides useful guidelines in the form of their minimum withdrawal requirements. It uses a percentage of account value to determine withdrawals as outlined in the following table. You can follow these guidelines or develop your own customized withdrawal strategy.
Using these CRA withdrawal requirements, at the end of each year multiply the year-end value of the account from which you are withdrawing income by the withdrawal factor (percentage). That will determine your income from that account for the subsequent twelve months.
Check the Information Center on MoneyPages at http://moneypages.ca/page/54/rrsp-rrif-tfsa-resp-information for up to date information on minimum RRIF withdrawals.
An example of a customized withdrawal strategy
When trying to determine a reasonable and sustainable level of withdrawal from your investments each year, the minimum RRIF withdrawal guidelines are a good place to start, or you can develop a customized withdrawal strategy.
The online calculator created by MoneyPages can be accessed at http://moneypages.ca/calculator/12/rrif-withdrawal-calculator can quickly provide you with customized calculations. There are online calculators available that can provide customized calculations.
The following example uses two simple calculations that provide a reasonable guideline:
• Step One – subtract your age in the year of withdrawal from age 90. At age 60, for example, the difference would be 30.
• Step Two – divide the value of your investments at the beginning of the year by the number calculated in step one. The answer will provide you with the level of withdrawal for the upcoming year.
Repeat the calculation at the beginning of each year to determine your level of withdrawal for the upcoming year.
If you have a shortfall between your income requirements and your actual retirement income, then more drastic action may have to be taken in order to ensure that your income will be sustainable throughout your life.
It can range from reducing your spending to downsizing your house or engaging in part-time employment if you are still able to do so. Another option is to postpone retirement for a year or two.
There are no easy answers but itnis better to make the decisions when you still have some control over the situation.
There can be resistance to those strategies because of human nature. Do others consider you a failure, or do you consider yourself a failure, if these are the options you choose? Does your social status decline? What will your friends think? Will they avoid you? The answer is probably “no” to most of these questions.
It is amazing, though, how much pressure these thoughts have on you and it may delay making a sound decision. It can become image over substance.
If you develop a sound retirement strategy you can make those decisions when they are right for you rather than when they are forced upon you.
Everyone needs to be realistic and everyone’s reality is different. If you can’t keep up with the Joneses, don’t try. Set your own standards for a lifestyle . . . one that you can afford without worry.
You need to examine all of your investment strategies to ensure the ongoing sustainability of your retirement income. The focus should shift from generating growth to generating consistent income.
The importance of earning a reasonable rate of return generated by your portfolio is obvious but an often over-looked concern is the effect of volatility on a portfolio from which income is being drawn.
Just as volatility can be helpful when building a portfolio with a dollar cost averaging strategy, withdrawing funds from a volatile portfolio can have a disastrous effect.
Your portfolio should be analyzed to ensure that it has an appropriate balance between rate of return potential and volatility characteristics.
Considering only rate of return in the absence of volatility misses an important part of the picture. Considering only the safety of principal without protection against the rising cost of living overlooks another important issue.
Your taxable investment accounts and your TFSA can remain intact upon retirement; however, you may want to change the overall makeup of these accounts somewhat to reflect your need for income over growth.
RRSP options at retirement
When you want begin to withdrawing income from assets accumulated in your RRSP account, you have three basic options. Whatever option you choose you must make a choice by the end of the year in which you turn71.
You can make the decision earlier but Canada Revenue Agency regulations mandate that you make your choice no later than age 71.
• You can collapse the RRSP and withdraw all of the cash, minus taxes owing which will be substantial. This is the least attractive option.
• A second option is to use the proceeds from your RRSP to purchase an annuity.
• The third (and most common) option is to convert your RRSP to a Registered Retirement Income Fund (RRIF).
Annuities are a life insurance product and while they have some advantages, they are very inflexible. If a circumstance arises where you need additional income in a given year, you will not be able to increase your annuity income.
Retirement income funds are much more flexible but they lack the guarantees provided by an annuity.
Each has their own unique features and it is a good idea to discuss these features with your financial advisor in order to have a better understanding of any account limitations
Pension Plan options at retirement
Should you have a defined benefit pension plan, it should remain in place. It will provide you with a guaranteed income for life regardless of how long you live. These plans are becoming less common because of the high and uncertain cost to the employer.
Defined contribution pension plans are another story. Upon retirement they are treated in a similar manner to an RRSP and as an investor you have a decision to make. You can choose an annuity or you can move them into an account that is similar to a RRIF.
Depending upon the jurisdiction it may be a Life Income Fund (LIF), a Locked-in Retirement Income Fund (LRIF) or a Prescribed Retirement Income Fund (PRIF).
Portfolio volatility and the effect on income
Volatility is the enemy of an income oriented portfolio.
Without describing the process in detail, a Monte Carlo simulation tool can compare the results of various portfolios by combining their rate of return and volatility characteristics. Results of Monte Carlo simulations illustrate a direct relationship between the volatility of a portfolio and its ability to survive over a long period of withdrawals.
These simulations clearly show that portfolios with increased volatility have an increased chance of failure over less volatile portfolios that generate an equivalent rate of return.
Even a sophisticated calculator cannot predict a safe withdrawal rate with absolute precision because a safe withdrawal rate depends on two factors: rate of return AND volatility.
In order to minimize the detrimental effect of volatility on your portfolio, every effort should be made to minimize volatility and, in conjunction with that, a sound withdrawal strategy needs to be developed.
A simple hypothetical comparison between two portfolios can illustrate the effect of volatility. Using the same two portfolios as in the previous illustration, you can see that withdrawals from a volatile portfolio can exacerbate the situation.
The difference in value of the two portfolios after only three years is almost $6,000. Over the entire period of your retirement the effect of volatility would be even more dramatic.
The SmartPlanner from MoneyPages employs a Monte Carlo simulation to help illustrate the impact of volatility on a retirement plan. It can be accessed at https://moneypages.ca/smart-planner/index.
In many cases life insurance will not be necessary at this point in your life.
Your retirement funds should be in place and in the event of your death any assets in your RRIF can roll over tax-free to your spouse. You can also name your spouse as the beneficiary of your TFSA and even if you don’t, there are no tax consequences associated with collapsing that account.
Your taxable investment accounts can be held in joint names and can continue to generate income for the surviving spouse.
If you don’t have a spouse upon your retirement or if your spouse pre-deceases you in retirement, your RRSP will be collapsed upon your death and taxes will be due. At that point it doesn’t matter.
Remember the definition of insurance:
Life insurance is protection against the loss of income in the event that the insured person dies. Those who survive you, and who depend on that income, benefit from the insurance policy.
Since you are either unmarried or have no surviving spouse, there should be no one dependent on the income from your RRIF.
Long term care insurance may be more applicable for those who are recently retired. However, premiums have risen in recent years even for existing policy holders. The cost of coverage can be expensive, especially for those who purchase that coverage later in life, and several insurance carriers have chosen to discontinue long term care insurance in 2012.
Transition to Retirement
The transition to retirement is a step into the unknown. Not only does your employment income come to an end, the entire structure of your day changes. Your social network may change dramatically since you will no longer have co-workers. Your sense of accomplishment may also change in retirement.
Being well-prepared emotionally, socially and financially is the key to an enjoyable retirement.
• Volatility of returns is an important consideration if you are retired.
• Cost of living increases must also be considered.
• A sound strategy for withdrawing income from your investment portfolio is imperative. Consider a percentage withdrawal rather than a fixed amount withdrawal and adjust your lifestyle accordingly.
• Develop a plan to deal with any shortfalls between your income requirements in retirement and your actual income in retirement.
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