Retirement and You (PART II) – by Louis Erlichman

II Beyond the poverty line
 
In the first part of this series, we talked about how universal public benefits do a reasonable job of bringing most Canadian seniors into the vicinity of the poverty line.  But do they allow you to maintain your standard living, if you were above the poverty line when you were working?
 
If you were earning $60,000 a year before you retired, then $22,000, $32,000 or even $38,000 is still a big drop in income.  Even though there can be some savings and tax advantages you get on retirement, most of your expenses (shelter, food) do not get smaller when you retire, and there may be new expenses as you get older, if you need to deal with health or mobility problems.
 
You also can look at your “replacement rate” – your income after you retire, compared to your income before you retire.  It’s not hard to calculate.  Let’s say you are the one-earner couple we just looked at, with public benefits of approximately $32,000 a year. If you were earning $60,000 when you retired, your replacement rate is $32,000/$60,000 or 53%.  There is no magic number for the correct replacement rate, though the higher the rate, the more likely you will be able to maintain (or even improve) your lifestyle after retirement.  
 
If this couple wanted to increase their replacement rate to 75%, they would need an extra $13,000 a year.  
 
To improve the replacement rate beyond public pension benefits, you need to look at the other two sources of retirement income.
 
2. Workplace Pensions
All workplace pensions are based on the same principle – putting money away over your working life, investing it to get a good return, and drawing a pension when you retire.  Contributions (within limits) to registered pension plans are not taxable, but the benefits are taxable when you receive them.
 
There are two types of workplace pension plans:
a) A Defined Benefit Plan, which promises you a benefit based on a formula, like $40 per month per year of service or a percentage of your final average earnings.
b) A Defined Contribution Plan, which is basically a personal fund, where contributions by your employer (and possibly you) are deposited and invested.  
There is no benefit promise.  The amount in your fund when you retire depends on what goes in, and what your investments have earned.  You receive the benefit that can be purchased by your fund when you retire, but it is difficult to even estimate in advance what you will be able to draw from the fund as retirement income, since your funds may be invested in markets that go up and down constantly.
 
In general, the main risk factors for all pensions are:
 
i) Investment risk – what kind of return will you get on your investment?  This is important, because typically more pension benefits come from investment income than from the money directly deposited.  If you expect to earn 5% a year, but you only end up earning 2%, you will have a lot less to spend than you expected.
 
ii) Longevity risk – this is the risk that you will outlive your money.  If you expect to live for 20 years and draw your pension as planned, you will run out of money in the 21st year, even if you meet your investment expectations.
 
A key advantage of Defined Benefit plans is that they pool both of these risks.
 
They promise a benefit for life, so that you don’t have to worry about living “too long” and being left with an empty fund.
 
In a Defined Contribution plan, you have to worry, not only about the long-term return on your investments, but also timing – whether you will be caught in a market downturn when you plan to retire and be forced to either take a pension hit or postpone retirement.  On the other hand, because the funds in a Defined Benefit plan are all invested together, your benefit is not likely to be affected by a temporary market downturn.  And in a single employer plan, the employer is responsible to make up funding shortfalls, if necessary.
 
Because Defined Benefit plans pool both investment and longevity risks, they normally give a better “bang for your buck”, allowing better investment returns, lower investment fees (which are a big factor), and higher benefits.
 
Many people have no idea of the investment fees they are paying in their Defined Contribution Plans (or their RRSPs).  Some people even believe that they are paying no fees , because the banks and other providers do their best not to clearly disclose their fees.  The impact of fees on your final retirement income can be enormous.   If you are paying 1% a year (look at the management expense ratios (MERs) for your funds), you are losing about 1/6th of your pension.  At 2%, you lose about a third, and at 3%, you lose about half.
 
You can see why your “financial advisor” might not be eager for you to find out that your money may be doing a better job of funding their retirement than your own.
 
If you participate in a Defined Contribution Plan or an RRSP, insist on finding out what all of the fees are.  There are now available Exchange Traded Funds (ETFs) that match broad market indexes and charge less than 0.5% a year.  If you are paying more, demand to know why, whether it is your own RRSP, a group RRSP or a Defined Contribution Plan.
 
Multi-employer Defined Denefit plans, like the IAM Labour-Management Plan and the IAM Multi-Employer Pension Plan offer the advantages of defined benefit plan when a single-employer defined benefit plan is not possible.  More about multi-employer plans in the final instalment of this series.
 
3.Personal Savings
 
The third common source of retirement income is personal savings.  
 
Most personal retirement saving takes place in Registered Retirement Savings Plans (RRSPs).  Contributions to RRSPs are tax-deductible (within limits), and taxes on RRSP investment income are deferred until you start drawing a benefit.
 
Like a Defined Contribution Plan, an RRSP builds up a fund from contributions and investment earnings which is used, at retirement, to buy a pension annuity (basically a lifetime pension from an insurance company) or you can withdraw benefits over time through a Registered Retirement Income Fund.
 
The downsides of RRSPs are the same as for Defined Contribution pension plans.  You individually carry all of the longevity risk (if you don’t buy an annuity) and the longevity risk, and face losing a big chunk of your money to investment fees.
 
So a Defined Benefit plan is always the best alternative.
 
So how do you figure out how well prepared you are financially for retirement?  And we can you do about it?  We’ll discuss those questions in the final instalment of this series.