As each year passes, the Canadian population becomes older on average. The well documented effect of the boomer generation means that there are more and more Canadians approaching the age of 71, which is the year in which a taxpayer is forced to convert their RRSP’s into some form of retirement plan.
Let’s take a look at the variety of accumulation accounts at the average Canadian’s disposal, and then explore the different methods that can be used to access the funds in retirement.
We’ll start with accumulation, because the options you have at your disposal when you convert your accumulation plan to a income plan depends on what kind of accumulation asset you have. There are two basic types of tax-deferred plan that you can have as you save for retirement, a personal plan, or an employer sponsored plan, or pension.
Registered Retirement Savings Plan (RRSP): This plan allows for contributions of 18% of income up to an annual maximum. A taxpayer must convert an RRSP into a retirement vehicle by December 31st in the year in which they turn 71.
Tax-Free Savings Account (TFSA): The federal budget that was read in February introduced a which is designed to augment the tax deferred savings available to Canadian taxpayers. Each taxpayer can contribute $5,000 per year into this, and there are no stipulations on withdrawal.
Locked-in Retirement Account (LIRA): This investment account is created when an employee leaves a company sponsored pension plan “rolls over” a certain portion of their pension into the LIRA. Like the RRSP, the investor can control the investment decisions, but there are strict guidelines as to how the funds must be withdrawn.
Employer Sponsored Accounts
Many companies will have a pension plan for their employees, but these can take a variety of forms.
Defined Contribution Pension: This plan simply states up front what amount the company and the employee are each going to contribute to the plan. Once the contribution is made, the funds are invested, and the employee has a variable pension depending on the investment performance of the pension fund.
Defined Benefit Pension: This plan uses a formula to determine what benefits are due to the employee upon retirement, based on years of service, income levels, etc. The employee or the employer, or both, can contribute to the plan. The corporation is liable to ensure that the plan is funded to meet the amounts that their employees are entitled to.
Group RSP: this is not really a group plan in the same manner that the pensions plans mentioned above are. The group RSP functions just like a personal RRSP, except that the employer usually bears some of the costs of investing in the plan (i.e. account fees, lower fund management costs), and may match contributions as an employee benefit.
Often, employees are given the option to “commute” their pension when they retire. This means that they will be given a sum of money in lieu of an income stream from the pension fund. This is most often made available to people given early retirement, and the funds are usually transferred a combination of a LIRA (tax free) and sometimes an open investment account (taxable).
A commuted pension can be a highly attractive option for a departing employee, specifically if they are planning to work again after they have left their current employer. However, too often investors are encouraged to commute their pension in search of high returns. However, when an investor commutes their pension, they often forgo other benefits that provide significant value.
For instance, an employee may have lifetime medical/dental benefits associated with their pension plan. If the employee commutes their pension, they usually lose the right to have such types of benefits. This leaves the investor open to significant long term risks of covering the cost of long-term care.
One final thought: the pension fund sees each pensioner as a liability. When it commutes a pension, it pays an amount out to the employee to relieve themselves of that long-term risk. When commuting a pension, be careful about taking that risk off the pension fund’s hands. In this process, greed is not good. A careful look at your risk management and tax planning options should be considered in this decision, not just the potential for big investment returns.
So what is an investor to do once they have reached the age of 71, and is faced with the choice between income options? Well, it depends on the account you have used to accumulate your retirement income.
Registered Retirement Income Fund (RRIF): this account is created when an RRSP is rolled over into a newly formed RRIF. The RRIF has an annual minimum withdrawal amount that is prescribed based on either the owner’s age, or the age of the owner’s spouse. Since the minimum withdrawals rise as the age increases, it is usually beneficial to calculate the RRIF payments from age of the younger spouse. The investment options are similar to an RRSP, and there is no maximum withdrawal amount that can be made in any given year.
Segregated Funds with Income Guarantees: these types of “variable annuities” have been available for many years in the US, but have really gained ground in recent years. These are segregated funds that offer guaranteed income streams (usually 5% simple interest), with an account value that rises and falls with the investments selected. This allows the investor to receive a guaranteed life income (usually available once investor reaches 65), while also participating in the upside of the market. On the upside, there is potential for capital appreciation, and on the downside, the market value of the investment could deteriorate to nothing, leaving the investor with little value beyond the annuity-like contractual guarantee. However, this is a powerful option for investors who wish to expose themselves to upside, without risk of losing an income stream.
Life Annuity: Converting to a Life Annuity will guarantee income for life, which provides security to the individual who is receiving the funds. However, this means that the (potential) estate value of the funds invested into the Life Annuity will be lost, should the investor die prematurely. The annuity option can also be selected to guarantee income to age 90 (of either spouses’ age), so that if both spouses die prior to the 90th birthday chosen, there will be some estate value.
Lifetime Income Fund (LIF):If an investor elects to have a LIF, withdrawal minimums are the same as for RRIFs. LIF’s however, have a maximum withdrawal amount whereas RRIFs do not. In some provinces, LIFs must be converted to a Life Annuity when the owner turns 80. This means giving up investment control at age 80, which may or may not be a good thing. Investors should be careful to manage volatility as age 80 approaches.
Locked-in Retirement Income Fund (LRIF): This is a more flexible version of the LIF, that eliminates the requirement to convert the account to an annuity at age 80 (not available in all provinces).
A note on small “locked-in” balances
If you are age 55 or older and the total value of all of your locked-in accounts is less than 40 per cent of the years’ maximum pensionable earnings (YMPE), you can request to have these locked-in funds transferred to an RRSP or RRIF, thus removing the locked-in status. The YMPE is currently $44,900, so this feature applies only to balances of $17,960 or less.
This is just a cursory look at all of the options available, but it should allow you to start to investigate the options that may or may not be available to you. As with everything, try and determine what your objectives are before you make the decision. Here are some basic points to consider in making your decision:
- What kind of retirement assets do I have at my disposal?
- Do I need a guaranteed income amount (i.e. x dollars)?
- Do I need a guaranteed income term (i.e. for x years)?
- Do I want to leave an estate value for my beneficiaries?
- Do I want to manage the asset?
- How is the asset going to be taxed if I leave a balance when I die?
For instance, an annuity might not provide the most attractive rate of return, but it will guarantee that you do not outlive your income. For others, a prudently managed RRIF will deliver the retirement income that is needed, and maybe more.