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.
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.
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.
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)
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.
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.