Rate of Return

One of the misconceptions that plagues many investors is the actual rate of return they will be able to achieve on investments during their retirement.

For years, 10% seemed to be the standard. It is easy to calculate and seemed well within reach given the performance of the stock market and equity mutual funds during the 1980s and 1990s.

This is the one assumption that often draws the most attention and is likely to be the one that is the most inaccurate. Investors can become fixated on rate of return when it is the one over which they have the least influence.

It is counter-productive and can lead to poor investment choices.

Over-estimating your future rate of return and then hoping your investments will achieve those lofty expectations is a recipe for disaster. It leads to underfunded portfolios as you rely more on the returns your investments achieve and less on the contributions you make.

Everyone is susceptible to this trap.

Numerous pension plans at both the government and corporate level are underfunded because their expectations for growth were too optimistic. In many cases, corporations don’t have the money to top up the plans and some governments may not be able to honour their pension commitments. There is no magic pool of capital to fund some of these payments as they now stand.

The dilemma of an underfunded retirement plan can lead to poor decisions.

You may be tempted to abandon your strategy and become far more aggressive than your situation dictates. In an effort to make up for less than expected returns, some investors take on more risk in their portfolios than they should, often unknowingly. Do not fall into that trap.

The projected rate of return for a portfolio will depend on its asset mix which is something that needs to be discussed in more detail. For the purposes of estimating rates of return it is sufficient at this point to assume that more conservative portfolios should have lower rates of return over long periods of time and more aggressive portfolios should have higher rates of return.

An example of unrealistic returns can be found in ‘The Wealthy Barber’.

Author David Chilton is careful not to predict rates of return for a portfolio, but returns like 15%, 12% and 10% are alluded to in the whimsical conversations. These conversations imply that rates of return at these levels were possible.

In the days when the book was written, it didn’t seem so far-fetched. North American and European stock markets were in the middle of the greatest bull market (period of high growth) that anyone had ever seen. Double digit returns were being achieved year after year.

Since the beginning of the new millennium, the story has been far different and stock markets in 2012 were barely any higher than they were twelve years ago. Investors who had expected the double digit returns may have been more than sorely disappointed; they may have faced financial hardship.

Unrealistic expectations can lead to unintended consequences.

So which numbers more accurately reflect what the future might hold? Is it the double digit returns of the 80s and 90s or is it the disappointment of the first twelve years of the new millennium? The truth is that both situations must be considered.

Pension plans use consulting firms and actuaries to estimate future returns on their plans. These estimates use discount rates which in turn are used to determine whether a pension plan has adequate funds to meet future needs.

Individual investors don’t have the same kind of information at their fingertips but a little bit of basic research can be revealing.

Setting Expectations

One of the biggest challenges facing investors and advisors is setting the level of expectations for portfolio performance.

It is not only the expectations regarding the rate of return that need to be established, it is also necessary to establish the expectations of the consistency of the returns. This consistency (or inconsistency) in the returns from one year to the next represents the volatility of your portfolio.

If there was a golden age for the individual investor, it was probably in the twenty-year period from 1980 to 2000. Without going into all of the reasons behind why it happened, stock markets experienced unprecedented growth and the average investor jumped on board. The popularity of mutual funds exploded as they offered investors an easy way to access the market.

That period shaped the expectations for many and some still cling to the belief that those were normal years. They believe what we have experienced since then is an aberration.

History tells us otherwise. In the long term, markets have experienced long periods of above average growth followed by long periods of below average growth. Both periods have to be accounted for when trying to estimate what long term returns might be. Only taking the optimistic side or the pessimistic side leads to disappointment or missed opportunities.

Using a twenty-year time frame on which to base estimates misses a good part of the last bull market which began in the mid 1980s. Using a ten-year time frame misses all of it.

A longer term is required to measure the full historical impact of long bull markets and long bear markets. A fifty-year time frame is sure to include all kinds of market conditions and allow us to draw conclusions using a vast amount of data.

An excellent source for all kinds of financial and tax information is www.taxtips.ca.  It can take some time to find what you are looking for but the information is exceptional. Coincidentally, they provide information on market returns and inflation.

Historical Long Term Trends

When considering what long term returns might be, it is important to factor in the good times as well as the bad times over a complete cycle, which is often about 30 years in length. Using a shorter time period on which to base your estimates can skew your perception to being overly optimistic or overly pessimistic.

The following chart illustrates long term periods of growth followed by long term periods of stagnant returns. Focusing only on the growth or only on the stagnation would give you a false impression of how the markets deliver returns to investors.

Those contrasting periods of time result in emotional highs and lows that need to be moderated in order for you to make rational investment decisions.

Those who based their rate of return expectations on the average annual stock market returns from 1982 to 2000 would have been severely disappointed on the returns since that time. A better choice would have been to use the average annual rate of return from 1966 to 2000 which would take into account both a long bull market and a long bear market that lasted 35 years in total. By doing this you are factoring in both the good times and the bad into your calculations.

Real rates of return

The real rate of return you achieve on an investment is the amount by which your actual (nominal) rate of return exceeds inflation.

We have already seen the danger of using short term returns as a guide for estimating long term returns. It is important to consider the returns achieved over a long market cycle to ensure that you are including periods of average growth, above average growth and below average growth in determining a reasonable estimate.

There is no fifty-year information on Canadian stock market returns but the US market, as measured by the S&P 500 index, achieved average annual returns of 9.6% in Canadian dollars for the period ending December 31, 2012. Over that same period of time, the long term Canadian bond market achieved annual returns of 7.6%. In that same 50 year time period, inflation averaged 4.1% per year.

That means the US equity market provided returns that were 5.5% over and above inflation, while the long term Canadian bond market provided returns that were 3.5% over and above inflation.

Source: www.taxtips.ca

For the purposes of estimating long returns in their retirement plans, investors are well advised to use a rate on equities that is 5% over inflation and a rate on bonds that is 3% over inflation. These two numbers are far more relevant than an arbitrary number that has no relationship to the cost of living.

Keep in mind that investment fees and other costs mean that investors will rarely achieve the returns they see in the markets.

The Financial Planning Standards Council of Canada (FPSC) provides guidelines with respect to rates of return they feel are appropriate for use in financial planning exercises. You might be surprised at how conservative they are – but it is far better to underestimate growth than overestimate growth.

http://www.fpsc.ca/docs/default-source/FPSC/projection-assumption-guidelines-2016.pdf

Sideways markets

There are always temptations in the investment world and those temptations may lead investors to the asset class with the highest returns over the long term. In this case, equities far surpassed bonds in terms of performance over the past fifty years but in the past ten years the roles have been reversed.

Using the same source of data, www.taxtips.ca, the ten-year returns for the period ending December 31, 2012 on the S&P 500 were 2.3% per year. When inflation is factored into the equation, 1.9% per year in purchasing power was lost. The inflation adjusted return was only 0.4% per year!

Yes, the stock market has provided superior long term returns, but it is not always the best place to invest and no one has yet discovered a way to determine if stocks or bonds will be the best performer in any given year. The best that can be done is to allocate investments prudently among different types of investments or asset classes.

Those who advocate sticking to a pure equity portfolio because ‘the stock market always bounces back in the long run’ may have failed to explain what the long run really means. For many, ten years is the long run. What would the reaction be if investors were told it would take 15 or

20 years for their portfolios to bounce back?

Inconsistent returns

While these long term returns are useful for making projections, they create an illusion that the returns will consistently fall somewhere close to these numbers. Nothing could be further from the truth. Returns will swing wildly from one year to the next and investors must prepare themselves for this psychological roller coaster.

Single asset portfolios that include only equities will experience more wild swings than portfolios with multiple complementary assets. The psychological roller coaster will be much less exciting.

Summary

If equities are expected to earn 5.0% per year over inflation and it is assumed that inflation will average about 2.5% per year, the expected gross return on equities over the long term would be 7.5%. Similarly, if bonds are expected to earn 3% over inflation, the expected gross return over the long term would be 5.5%.

These numbers may be far below what some investors hope to achieve but they are based on long term historical data. Even using this data, the return expectations may be optimistic. The danger for investors is that they base their savings on the expectation of higher returns only to fall short. It is far better to be conservative with estimated returns, and if they are exceeded it makes for a more comfortable or earlier retirement.

Long term historical rates of return will change over time as economies move through cycles of expansion and recession, so the basis for making rate of return assumptions also changes. It is good practice to review rate of return assumptions once a year to determine if they are still reasonable.

A change in assumptions might require a change in strategy but making small, timely changes is far better than a nasty surprise when retirement is just around the corner.

The Effect of Investor Behaviour on Portfolio Returns

Although it is worthwhile discussing the returns provided by the various markets, as well as the returns achieved by the various mutual fund managers, even those numbers may be overly optimistic.

One reason for that is investor psychology. As a group, we tend to invest more readily only after the markets have gone up and shown a semblance of stability for a period of time. On the other hand, we tend to sell when we are disappointed because the markets have corrected.

Dalbar Inc. is an organization that develops standards and measurement systems designed to improve the quality of communications and service in the healthcare and financial services industries. You can learn more about Dalbar at www.dalbar.com.

They quantified the effect of irrational investor behaviour in a study published in April 2012. In that study Dalbar found that over the twenty year period ending in December 2011 the average investor underperformed the equity index (S&P 500) by 4.32% per year and underperformed the bond index (Barclay’s Aggregate Bond Index) by 5.56% per year.

You can access Dalbar’s reports from their website at http://www.qaib.com/public/default.aspx

The biggest challenge facing investors in their attempts to achieve reasonable returns on their investment portfolios is not minimizing fees and it is not trying to pick the next best stock or mutual fund; it is overcoming our emotions that tell us to buy only when we are comfortable and sell when we are uncomfortable.

The danger in averages

Using average returns may be a suitable way to define long term targets but returns are inconsistent from one year to the next. Those seeking a 5% annual return may see a gain of 15% one year, a loss of 10% the next and a gain of 12% in the third year.

While the average return will be somewhere close to 5%, it won’t feel like that to the investor. It will feel like a roller coaster and it will be difficult to make objective investment decisions.

Emotion is something that is often forgotten in the mathematical world of financial planning and is almost impossible to quantify.

Where do you fit?

The next challenge facing the investor lies in determining what category they fall into. In many cases investors have an idea of which category reflects their personal situation. If it is chosen honestly, then the projected rate of return associated with that category provides a reasonable starting point.

This process in itself faces problems. First, some investors have no idea whether they should be conservative, growth oriented or somewhere in between. Second, even when some feel comfortable in classifying their tolerance to risk, they don’t know how to equate that profile to a long term rate of return.

The result can be the expectation of a rate of return that has no basis in fact.

As a guideline, investors might want to consider the following long term returns based on the asset mix that is appropriate for them. That asset mix (which will be discussed in more detail later) may be labelled and loosely estimated as follows:

While these numbers seem surprisingly low for some, they are based on the long term historical returns of various asset classes. Combining the various investments available to the average investor into a mix that suits their tolerance to risk provides guidelines as to what they should expect over the long term, irrational behaviour aside.

Of course, the tables are backwards looking. In other words, they reflect what has already happened and there can be no assurances that history will repeat itself. Still, using some kind of guideline is better than using none at all.

The whole process of choosing an appropriate rate of return to use in retirement projections may seem like overkill but it isn’t. It may be the one variable that investors over-estimate more than any other and it can lead to a serious shortfall in the quest to accumulate investment assets for retirement.

The actual rate of return you will achieve will depend on the investment choices you make and those choices should fit with your investment profile.

Equally important to the rate of return you are earning is the amount of capital you are able to accumulate. That accumulation comes from a combination of deposits and growth. Sometimes one has to compensate for the other.

It would be hard to find many people who want to save everything for retirement and not enjoy life now. The question is how to approach the problem. A balance has to be struck and compromises made.

Rate of Return

One of the misconceptions that plagues many investors is the actual rate of return they will be able to achieve on investments during their retirement.

For years, 10% seemed to be the standard. It is easy to calculate and seemed well within reach given the performance of the stock market and equity mutual funds during the 1980s and 1990s.

This is the one assumption that often draws the most attention and is likely to be the one that is the most inaccurate. Investors can become fixated on rate of return when it is the one over which they have the least influence.

It is counter-productive and can lead to poor investment choices.

Over-estimating your future rate of return and then hoping your investments will achieve those lofty expectations is a recipe for disaster. It leads to underfunded portfolios as you rely more on the returns your investments achieve and less on the contributions you make.

Everyone is susceptible to this trap.

Numerous pension plans at both the government and corporate level are underfunded because their expectations for growth were too optimistic. In many cases, corporations don’t have the money to top up the plans and some governments may not be able to honour their pension commitments. There is no magic pool of capital to fund some of these payments as they now stand.

The dilemma of an underfunded retirement plan can lead to poor decisions.

You may be tempted to abandon your strategy and become far more aggressive than your situation dictates. In an effort to make up for less than expected returns, some investors take on more risk in their portfolios than they should, often unknowingly. Do not fall into that trap.

The projected rate of return for a portfolio will depend on its asset mix which is something that needs to be discussed in more detail. For the purposes of estimating rates of return it is sufficient at this point to assume that more conservative portfolios should have lower rates of return over long periods of time and more aggressive portfolios should have higher rates of return.

An example of unrealistic returns can be found in ‘The Wealthy Barber’.

Author David Chilton is careful not to predict rates of return for a portfolio, but returns like 15%, 12% and 10% are alluded to in the whimsical conversations. These conversations imply that rates of return at these levels were possible.

In the days when the book was written, it didn’t seem so far-fetched. North American and European stock markets were in the middle of the greatest bull market (period of high growth) that anyone had ever seen. Double digit returns were being achieved year after year.

Since the beginning of the new millennium, the story has been far different and stock markets in 2012 were barely any higher than they were twelve years ago. Investors who had expected the double digit returns may have been more than sorely disappointed; they may have faced financial hardship.

Unrealistic expectations can lead to unintended consequences.

So which numbers more accurately reflect what the future might hold? Is it the double digit returns of the 80s and 90s or is it the disappointment of the first twelve years of the new millennium? The truth is that both situations must be considered.

Pension plans use consulting firms and actuaries to estimate future returns on their plans. These estimates use discount rates which in turn are used to determine whether a pension plan has adequate funds to meet future needs.

Individual investors don’t have the same kind of information at their fingertips but a little bit of basic research can be revealing.

Setting Expectations

One of the biggest challenges facing investors and advisors is setting the level of expectations for portfolio performance.

It is not only the expectations regarding the rate of return that need to be established, it is also necessary to establish the expectations of the consistency of the returns. This consistency (or inconsistency) in the returns from one year to the next represents the volatility of your portfolio.

If there was a golden age for the individual investor, it was probably in the twenty-year period from 1980 to 2000. Without going into all of the reasons behind why it happened, stock markets experienced unprecedented growth and the average investor jumped on board. The popularity of mutual funds exploded as they offered investors an easy way to access the market.

That period shaped the expectations for many and some still cling to the belief that those were normal years. They believe what we have experienced since then is an aberration.

History tells us otherwise. In the long term, markets have experienced long periods of above average growth followed by long periods of below average growth. Both periods have to be accounted for when trying to estimate what long term returns might be. Only taking the optimistic side or the pessimistic side leads to disappointment or missed opportunities.

Using a twenty-year time frame on which to base estimates misses a good part of the last bull market which began in the mid 1980s. Using a ten-year time frame misses all of it.

A longer term is required to measure the full historical impact of long bull markets and long bear markets. A fifty-year time frame is sure to include all kinds of market conditions and allow us to draw conclusions using a vast amount of data.

An excellent source for all kinds of financial and tax information is www.taxtips.ca.  It can take some time to find what you are looking for but the information is exceptional. Coincidentally, they provide information on market returns and inflation.

Historical Long Term Trends

When considering what long term returns might be, it is important to factor in the good times as well as the bad times over a complete cycle, which is often about 30 years in length. Using a shorter time period on which to base your estimates can skew your perception to being overly optimistic or overly pessimistic.

The following chart illustrates long term periods of growth followed by long term periods of stagnant returns. Focusing only on the growth or only on the stagnation would give you a false impression of how the markets deliver returns to investors.

Those contrasting periods of time result in emotional highs and lows that need to be moderated in order for you to make rational investment decisions.

Those who based their rate of return expectations on the average annual stock market returns from 1982 to 2000 would have been severely disappointed on the returns since that time. A better choice would have been to use the average annual rate of return from 1966 to 2000 which would take into account both a long bull market and a long bear market that lasted 35 years in total. By doing this you are factoring in both the good times and the bad into your calculations.

Real rates of return

The real rate of return you achieve on an investment is the amount by which your actual (nominal) rate of return exceeds inflation.

We have already seen the danger of using short term returns as a guide for estimating long term returns. It is important to consider the returns achieved over a long market cycle to ensure that you are including periods of average growth, above average growth and below average growth in determining a reasonable estimate.

There is no fifty-year information on Canadian stock market returns but the US market, as measured by the S&P 500 index, achieved average annual returns of 9.6% in Canadian dollars for the period ending December 31, 2012. Over that same period of time, the long term Canadian bond market achieved annual returns of 7.6%. In that same 50 year time period, inflation averaged 4.1% per year.

That means the US equity market provided returns that were 5.5% over and above inflation, while the long term Canadian bond market provided returns that were 3.5% over and above inflation.

Source: www.taxtips.ca

For the purposes of estimating long returns in their retirement plans, investors are well advised to use a rate on equities that is 5% over inflation and a rate on bonds that is 3% over inflation. These two numbers are far more relevant than an arbitrary number that has no relationship to the cost of living.

Keep in mind that investment fees and other costs mean that investors will rarely achieve the returns they see in the markets.

The Financial Planning Standards Council of Canada (FPSC) provides guidelines with respect to rates of return they feel are appropriate for use in financial planning exercises. You might be surprised at how conservative they are – but it is far better to underestimate growth than overestimate growth.

http://www.fpsc.ca/docs/default-source/FPSC/projection-assumption-guidelines-2016.pdf

Sideways markets

There are always temptations in the investment world and those temptations may lead investors to the asset class with the highest returns over the long term. In this case, equities far surpassed bonds in terms of performance over the past fifty years but in the past ten years the roles have been reversed.

Using the same source of data, www.taxtips.ca, the ten-year returns for the period ending December 31, 2012 on the S&P 500 were 2.3% per year. When inflation is factored into the equation, 1.9% per year in purchasing power was lost. The inflation adjusted return was only 0.4% per year!

Yes, the stock market has provided superior long term returns, but it is not always the best place to invest and no one has yet discovered a way to determine if stocks or bonds will be the best performer in any given year. The best that can be done is to allocate investments prudently among different types of investments or asset classes.

Those who advocate sticking to a pure equity portfolio because ‘the stock market always bounces back in the long run’ may have failed to explain what the long run really means. For many, ten years is the long run. What would the reaction be if investors were told it would take 15 or

20 years for their portfolios to bounce back?

Inconsistent returns

While these long term returns are useful for making projections, they create an illusion that the returns will consistently fall somewhere close to these numbers. Nothing could be further from the truth. Returns will swing wildly from one year to the next and investors must prepare themselves for this psychological roller coaster.

Single asset portfolios that include only equities will experience more wild swings than portfolios with multiple complementary assets. The psychological roller coaster will be much less exciting.

Summary

If equities are expected to earn 5.0% per year over inflation and it is assumed that inflation will average about 2.5% per year, the expected gross return on equities over the long term would be 7.5%. Similarly, if bonds are expected to earn 3% over inflation, the expected gross return over the long term would be 5.5%.

These numbers may be far below what some investors hope to achieve but they are based on long term historical data. Even using this data, the return expectations may be optimistic. The danger for investors is that they base their savings on the expectation of higher returns only to fall short. It is far better to be conservative with estimated returns, and if they are exceeded it makes for a more comfortable or earlier retirement.

Long term historical rates of return will change over time as economies move through cycles of expansion and recession, so the basis for making rate of return assumptions also changes. It is good practice to review rate of return assumptions once a year to determine if they are still reasonable.

A change in assumptions might require a change in strategy but making small, timely changes is far better than a nasty surprise when retirement is just around the corner.

The Effect of Investor Behaviour on Portfolio Returns

Although it is worthwhile discussing the returns provided by the various markets, as well as the returns achieved by the various mutual fund managers, even those numbers may be overly optimistic.

One reason for that is investor psychology. As a group, we tend to invest more readily only after the markets have gone up and shown a semblance of stability for a period of time. On the other hand, we tend to sell when we are disappointed because the markets have corrected.

Dalbar Inc. is an organization that develops standards and measurement systems designed to improve the quality of communications and service in the healthcare and financial services industries. You can learn more about Dalbar at www.dalbar.com.

They quantified the effect of irrational investor behaviour in a study published in April 2012. In that study Dalbar found that over the twenty year period ending in December 2011 the average investor underperformed the equity index (S&P 500) by 4.32% per year and underperformed the bond index (Barclay’s Aggregate Bond Index) by 5.56% per year.

You can access Dalbar’s reports from their website at http://www.qaib.com/public/default.aspx

The biggest challenge facing investors in their attempts to achieve reasonable returns on their investment portfolios is not minimizing fees and it is not trying to pick the next best stock or mutual fund; it is overcoming our emotions that tell us to buy only when we are comfortable and sell when we are uncomfortable.

The danger in averages

Using average returns may be a suitable way to define long term targets but returns are inconsistent from one year to the next. Those seeking a 5% annual return may see a gain of 15% one year, a loss of 10% the next and a gain of 12% in the third year.

While the average return will be somewhere close to 5%, it won’t feel like that to the investor. It will feel like a roller coaster and it will be difficult to make objective investment decisions.

Emotion is something that is often forgotten in the mathematical world of financial planning and is almost impossible to quantify.

Where do you fit?

The next challenge facing the investor lies in determining what category they fall into. In many cases investors have an idea of which category reflects their personal situation. If it is chosen honestly, then the projected rate of return associated with that category provides a reasonable starting point.

This process in itself faces problems. First, some investors have no idea whether they should be conservative, growth oriented or somewhere in between. Second, even when some feel comfortable in classifying their tolerance to risk, they don’t know how to equate that profile to a long term rate of return.

The result can be the expectation of a rate of return that has no basis in fact.

As a guideline, investors might want to consider the following long term returns based on the asset mix that is appropriate for them. That asset mix (which will be discussed in more detail later) may be labelled and loosely estimated as follows:

While these numbers seem surprisingly low for some, they are based on the long term historical returns of various asset classes. Combining the various investments available to the average investor into a mix that suits their tolerance to risk provides guidelines as to what they should expect over the long term, irrational behaviour aside.

Of course, the tables are backwards looking. In other words, they reflect what has already happened and there can be no assurances that history will repeat itself. Still, using some kind of guideline is better than using none at all.

The whole process of choosing an appropriate rate of return to use in retirement projections may seem like overkill but it isn’t. It may be the one variable that investors over-estimate more than any other and it can lead to a serious shortfall in the quest to accumulate investment assets for retirement.

The actual rate of return you will achieve will depend on the investment choices you make and those choices should fit with your investment profile.

Equally important to the rate of return you are earning is the amount of capital you are able to accumulate. That accumulation comes from a combination of deposits and growth. Sometimes one has to compensate for the other.

It would be hard to find many people who want to save everything for retirement and not enjoy life now. The question is how to approach the problem. A balance has to be struck and compromises made.


Sources of Income

For almost every Canadian, retirement income will come from more than one source. There are government benefits, such as CPP and OAS, there are employer sponsored pension plans and there are personal savings in the form of RRSPs, TFSAs and investment accounts. For others there may be business income, rental income or part time employment.

Statcan data illustrates the various sources of income relied upon by seniors in the past.

 

All of these possible sources of income must be taken into account when trying to determine how much of that retirement income will come from personal savings. At the same time, each of these sources of income will be infuenced by a variety of factors.

Canada Pension Plan (CPP)

As of January 2, 2013, the maximum monthly benefit available at 65 years of age was $1012, while the average benefit paid was about $530 per month.

The general theory behind CPP is that those who worked continuously to age 65 during their adult years will collect up to 25% of their annual employment income each year. You can begin to draw reduced benefits as early as age 60 or defer drawing benefits until as late as age 70.

Of course, there are a number of restrictions, exceptions and limitations, but the Service Canada website (http://www.servicecanada.gc.ca/eng/isp/cpp/cpptoc.shtml) provides you with the tools to calculate what your CPP benefits might be upon retirement.

Regardless of when you begin to draw your CPP benefits, the amount is adjusted for inflation each year. Benefits are based on the amount of contribution made and those contributions are based on your pensionable earnings up to a yearly maximum (YPME). A person’s CPP retirement pension is calculated as 25% of his average pensionable earnings during his contributory period. The contributory period starts when he turns 18, or 1966, whichever is later. The contributory period ends upon retirement.

You can begin to draw CPP as early as age 60 but recent changes to CPP legislation requires those who continue to work while drawing CPP must still contribute to CPP until they cease to work or until they reach age 70. This is known as the Post Retirement Benefit or PRB.

Canadians working outside of Quebec who receive a CPP or QPP retirement pension will begin making CPP contributions toward the PRB on January 1, 2012. The benefit will be paid to you the following year, starting in 2013.

These contributions are mandatory for CPP and QPP retirement pension recipients aged 60 to 65. If you are at least 65 but under70 years of age, you can choose not to contribute.

You can learn more about CPP benefits at: http://www.servicecanada.gc.ca/eng/isp/cpp/prb/index.shtml.

The calculation required to determine your benefits is not straightforward.

In order to qualify for maximum benefits, your maximum pensionable earnings would have to be greater than, or equal to, the amount listed in the table in each of the years you were eligible for employment since age 18.

For example, an individual born in 1952 would be eligible to make contributions beginning in 1970. But some low earning years can be disregarded. Starting in 2012, you can drop up to 7.5 years of your lowest earnings from your calculations. This may result in an increase to your benefit amount.

In 2014, this will increase again to up to 8 years of your lowest earnings from the calculation. The actual number of years that you can drop is based on the number of years in which you made contributions.

You can set up an account with Service Canada to view and print a history of your earnings and contributions to the Canada Pension Plan. You can also review estimates of benefits you may be eligible to receive.

For a reasonably accurate estimate of the CPP benefits that you may be eligible for check the CPP & OAS Optimizer on MoneyPages.

Early withdrawal

If you choose to retire before age 65 and begin to draw your CPP benefits immediately upon retirement, the CPP payments are reduced. The earliest age at which you can begin to draw CPP is 60.

The following table illustrates the impact of drawing your benefits early.

 

 

For example, an individual who was born in 1954 and chooses to begin drawing their benefits at age 60 will receive 33.6% per year less than if they had waited until age 65. If their full benefits at age 65 were expected to be $1000 per month, their actual benefits would be $664 per month.

It is one of the prices you pay for early retirement.

General estimate

If you want a very general estimate before receiving your information from Service Canada, you can try the following calculation.

Your average income (in today’s dollars) multiplied by 25% will give you an estimate of benefits you may be eligible to receive at age 65. If you worked for fewer than 40 years during that time and/or you begin to draw benefits before age 65, the benefit amounts will be reduced.

Even using this approach, estimating your income from CPP is not a simple task and should be used for only very rough estimates. Your best bet is to establish an account at Service Canada and obtain your historical data. The information you need is available through Service Canada at

http://www.servicecanada.gc.ca/eng/isp/common/cricinfo.shtml or you can contact them by phone at 1-800-622-6232 (1–800–O-Canada).

 

Since CPP benefits are such an important part of retirement income for many, it is worth reiterating that a reasonably accurate estimate of the CPP benefits that you may be eligible can be checked using the CPP & OAS Optimizer on MoneyPages.

Deferring benefits

Those who choose to defer their first withdrawal until after age 65 will receive increased benefits.

The following is a summary of the comments from the Service Canada factsheet at www.servicecanada.gc.ca/eng/isp/pub/factsheets/ISPB-348-11-10_E.pdf:

. . . your monthly CPP retirement pension amount will increase by a larger percentage if you take it after age 65. From 2011 to 2013, the Government of Canada will gradually increase this percentage from 0.5% per month (6% per year) to 0.7% per month (8.4% per year). This means that, by 2013, if you start receiving your CPP pension at the age of 70, your pension amount will be 42% more than it would have been if you had taken it at 65.

Old Age Security (OAS)

As of January 1, 2012, the maximum OAS benefit available in Canada was $545 per month, with the average benefit paid at approximately $515 per month.

Unlike the Canada Pension Plan, Old Age Security benefits are not reliant on the level of income you earned while you were employed. Most Canadians will qualify for maximum benefits. The exception occurs if you were not a Canadian citizen for your entire adult life.

Pensioners with a net income in excess of approximately $70,000 in 2012 are subject to having some of their OAS benefits clawed back by the government. Those who had a net income in excess of $113,000 in 2012 would have had all of their OAS benefits clawed back.

Changes in OAS Benefits

Recent changes to legislation in Canada will raise the qualification age for OAS benefits to sixty-seven from the current level of age sixty-five. (These changes have subsequently been repealed and the OAS qualification age now remains at 65)

Additional Issues

The age of retirement must be chosen carefully. The financial benefits of waiting an extra year or two can be surprising. This has to be balanced off with lifestyle decisions or compromises. Rather than going from full employment one day to full retirement the next, one option is a transition into retirement. In the semi-retired phase of this transition, part-time work can supplement income and reduce the erosion of one’s life savings.

Delaying retirement for one year allows investments to grow for one additional year and it allows for one additional year of contributions to a savings plan. It also reduces the need for income from investments by one year. Those two factors alone make a big difference, even if it is only a one year delay.

The challenge is finding a way to compare the various options because of all the factors that come into play. It can be done but it can be a lot of work.

A quick way to evaluate your plan and assess the effect of any changes you want to make is to use the retirement planning tools at www.moneypages.com. They can give you a relatively accurate idea of where you stand. From there you may want to pursue a comprehensive financial plan or you may find the MoneyPages projections sufficient.

Employer Pension Plans

If you are completing a financial plan using a simple financial planning calculator, you will be asked to provide your pension plan information. For those who are members of an employer-sponsored pension plan, the impact of that plan on the total retirement plan can be significant but pension plans can be very confusing to evaluate.

Part of the problems stems from the fact that there are two completely different types of pension plans. In fact, they are as different as black and white.

The first step is recognizing whether your pension plan is a defined benefit plan or a defined contribution plan. They sound almost the same but they are not. Some corporations may offer defined benefit plans but they are becoming increasingly rare. Or they may offer a defined contribution plan.

The same applies to government agencies; the plan offered may be a defined benefit or a defined contribution plan.

Defined Benefit Plans

As the name implies, the benefits received by these pension plan members will be defined or known.

The benefits received by the member at retirement are not dependent on how well the investments within the pension plan perform. The benefit is defined and doesn’t change whether the pension plan achieves big gains or suffers losses. If the defined benefit is $2500 per month for life, then that is what the pension will pay, regardless of how long the plan member lives or what the rates of return within the plan may be.

For the most part, a defined benefit pension plan provides worry-free income for life; however, there are a couple of caveats. One is the potential bankruptcy of the pension plan’s sponsor and the other is inflation.

Potential bankruptcy: If the company sponsoring the pension plan goes into bankruptcy and can no longer make contributions, the viability of the plan could be jeopardized.

It is less likely that governments will default on their pension contributions but even that is not unheard of. Several US municipalities have run into funding problems because of an eroding tax base. Simply raising taxes to maintain funding is not always an option. It can chase taxpayers to more friendly jurisdictions, further eroding the tax base and exacerbating the problem.

On the other hand, these municipalities have contractual obligations to their pension plan members.

Disagreements on how to handle these delicate situations can result in long and costly court battles which neither side can win.

Defined benefit plans present a risk for the plan sponsor and are supposedly risk-free for the plan member. The sponsor takes the risk of such things as poor returns and the unexpected longevity of its plan members.

No investment decisions are required by the plan members; the outcome is pre-determined.

A pension plan that is not large enough to fund future payment is said to have an unfunded pension liability. The sponsors are responsible for ensuring the pension plan is fully funded and none of this responsibility falls on the plan member. This represents a huge potential cost for the plan sponsor.

For this reason, defined benefit plans have become less common as companies and governments seek more cost certainty for their pension liabilities.

In simple terms, a defined benefit plan has a variable input or contribution by the plan sponsor and a pre-determined output or payment received by the plan member.

Inflation: The second caveat involves inflation. Some defined benefit plans allow for an inflation adjustment factor but many do not. Members of a defined benefit plan that does not include a provision for cost-of-living increases need to be aware that the purchasing power of their pension declines every year.

While income remains constant, purchasing power does not.


Defined Contribution Plans

These plans are the mirror image of defined benefit plans. A defined contribution plan has a pre-determined input or contribution by the plan sponsor and a variable output or payment received by the plan member.

In this case, the risk of lower than anticipated returns impacts the plan member rather than the plan sponsor.

Defined contribution plans are gaining favour over defined benefit plans among employers.

In many ways, a defined contribution pension plan is similar to an RRSP. Its characteristics are more comparable to an RRSP than to a defined benefit pension plan. Plan members are given a menu of investments from which to choose in much the same way that an investor chooses investments for their RRSP accounts. The growth of their plan is largely dependent on the performance of the investments they choose. There is no guaranteed income upon retirement.

Because plan members are required to make investment choices, it is important to make the best choices possible. These members face the same challenges as with the RRSP and a similar process for choosing investments should be employed.

Using a risk tolerance questionnaire is a good approach.

A defined contribution pension plan also requires a major decision at retirement. Whereas the defined benefit plan simply begins to generate income based on some limited choices, the defined contribution plan ends at retirement.

The plan member then has a variety of options from which to choose. These can include purchasing an annuity or selecting a variation of a retirement income fund, such as a:

• Life Income Fund (LIF)

• Prescribed Retirement Income Fund (PRIF)

• Locked-in Retirement Income Fund (LRIF)

The choices available will depend upon the legislation governing the pension.

Even when the choice of investment options is made, there is still another decision. Plan holders may have the option of leaving the investment with the plan administrator or they may be able transfer the management of those assets to their financial advisor.

There are benefits in choosing to transfer your pension assets to your financial advisor upon retirement. It becomes more efficient to monitor all of your holdings and develop an overall investment and withdrawal strategy. It reduces the likelihood of overlap and gaps in your investments which can result in sub-optimal performance and excess volatility. It also ensures that you will receive personalized service from someone who is familiar with your situation.

It is also important to remember that defined contribution plans contain no guarantees with respect to future income. Choosing to remain with the pension plan provider rather than transferring to your financial advisor does not change that.

Sample Financial Plan

At the very least a financial plan should include information about your current situation, the income goals for your retirement, certain financial assumptions, and solutions for any shortfalls. The following example represents what a simple financial plan may look like. It can provide you with a good starting point and if you feel it is necessary, you can have a detailed financial plan prepared.

You can prepare your own plan at no cost using the SmartPlanner tool from MoneyPages. Highly detailed financial plans can be prepared for you by a fee only financial planner.

In a detailed plan additional information would identify yearly income from various sources and take other factors, such as the sale of business, an inheritance, or the downsizing of your home into consideration.

The following table represents a summary of a hypothetical situation where an individual has a slight shortfall in their retirement plan.

 

 

The free QuickPlanner from MoneyPages produces a simplified plan very similar to this example.

The following two charts illustrate a hypothetical situation of a couple saving for retirement. They provide a visual representation of how the value of the couple’s investments and income change over time.

The first chart illustrates how the value of the investments will grow until they reach retirement and how it gradually declines during retirement.

 

The second chart illustrates the income required in each year of retirement and how that requirement grows with inflation. It also illustrates the sources of income and if there is any shortfall. In this case, there is no shortfall.

 

A good financial plan will also allow you to measure your progress and I have included two sample scorecards in the next chapter. They would be a part of your financial plan and allow you to evaluate whether your plan is on track or if adjustments need to be made.

The SmartPlanner from MoneyPages creates charts and tables similar to these to provide you with a visual reference for your retirement plan.

Summary

You should now be aware of many of the variables that can affect your retirement plans but the big question remains. How much capital (money) do you need to accumulate to fund your retirement and avoid the worry of running short of money?

The trick is to find a way to incorporate all of these moving parts into your calculation.

Those who advocate the do-it-yourself approach often overlook the complexities of these various issues that can overwhelm the average investor. Some focus solely on the fees associated with various investment products without considering the many other issues you may face in planning and investing for retirement. Others retreat to low risk, low return investments without considering the long term effects of inflation.

For every story of someone who successfully fired their financial advisor, there will be a story of someone who is thankful they have one – but those rarely make the news.

Assembling all of the required information may seem like a daunting task but reading about it might take longer than doing it. Sitting down with a financial advisor can help. The answers to many of the questions may be right at their fingertips.

Once that information is assembled it must be put to work. Generally speaking, the goal at this stage is to estimate the approximate amount of savings or capital required to fund retirement. Somewhere in all those numbers lies the answer to that question. There are a number of ways to take the next step.

• Attempt to estimate your needs using a calculator, a pencil and a piece of paper.

• Build a spreadsheet using a program like Excel and input your data.

• Use financial planning software or a website that provides financial planning (such as http://moneypages.ca)

• Enlist the services of a fee-based financial planner to develop a comprehensive financial plan.

Some of these approaches will be time consuming and perhaps inaccurate; others may be expensive and provide overwhelming amounts of information.

If you have accumulated all the necessary information and want an estimate that provides an uncluttered snapshot of your situation, you can use the free QuickPlanner from MoneyPages. It will also provide an estimate of the annual contributions necessary to accumulate the capital required and the results are on one page. Assumptions can be changed easily, making it simple to compare the impact that these changes will have.

None of these estimates, calculations or calculators is meant to replace a comprehensive financial plan. They are merely designed to be tools to help investors get started along the right path by identifying broad targets.

The SmartPlanner from MoneyPages provides you with far more detailed calculations an analysis in a 12 page report. As with the QuickPlanner, the SmartPlanner is free to use.

Once realistic targets and solutions are determined

the investor can choose to follow that path or can develop a more detailed financial plan. In either case, you will have developed a standard by which progress can be measured and that measurement will determine a course of action to be followed in the future.

Don’t Delay

Many don’t start planning the accumulation phase in detail until the distribution phase is almost upon them. When that happens, a sense of urgency can develop. The goal is to start the process early and avoid panic as retirement approaches.

But there are still no guarantees. Factors can conspire to throw the best laid plans offside. Rampant inflation could make the purchasing power of your guaranteed investment certificates almost worthless. Stock market corrections could throw equity portfolios offside. Poor health could see your medical costs soar. No one knows exactly what the future will hold but those reasons should not be an excuse to avoid laying out a blueprint for your retirement.

You can still make reasonable assumptions and provide a margin for error. These assumptions or estimates are the variables used in setting targets for capital accumulation.

If you still want an estimate for the amount of savings you require, here is a very quick rule of thumb if you are retiring at age 65. Estimate the annual income you will need to generate from your investments in retirement.

Multiply that number by 20 and the result will be the amount of savings you will need to accumulate. Any income from government benefits, pension plans or other sources will be added to your investment income.

If you retire before age 65, the number will need to be larger.

NEXT: Retirement Planning - The Effects of Inflation

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