Tag Archives: savings

Retirement Income Options – So Many Ways

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.

Personal Accounts

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RRSP, the investor can control the investment decisions, but there are strict guidelines as to how the funds must be withdrawn.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.

Commuted Pensions

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. 

Retirement Options

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.

Management Fees – Are you paying for Bondage or Advice?

Each year, Canadians decide how and where they will invest.  Other than asset allocation, the fees that are paid will likely have the largest impact on their account.  For some, fees will be paid to an advisor involved at some point in the process.  That advisor might be a planner or a broker who takes commissions or trailer fees as a result of managing a clients’ account.  Or, fees may be paid to an investment manager, either indirectly through ownership in mutual fund, or directly as a result of a discretionary or segregated account with that manager.

Outside of fees, you may also want to explore whether or not your advisor has a fiduciary duty to you, and if there are any conflicts of interest in your relationship.  Conflicts can arise as a result of the business structure (i.e. only recommending products from that company), but can also also arise out of compensation structures.

Essentially, the amount and type of fees you pay are what determines the kind of practice your investment advisor runs.  Instead of just asking “how much” the fees are, perhaps examine the types of fees you are paying, why you are paying those fees, and what incentive it gives to the recipient of those fees.

Trading Commissions

By far, the most common method of compensating advisors is still commissions.  However, all commissions are not created equal.  There are basically three types of commissions:

  • Brokerage commissions: when trading securities, a fee is charged based on the size and type of trade.  Some brokers will pre-arrange a fee schedule for their clients that provide a certain number of transactions for a fixed cost.
  • “Spreads” on Bonds:  Many investors are unaware that there is a commission paid on a bond.  That commission is called the spread, and it is the difference between the actual rate being paid on a bond, and the rate at which it is sold to you.  For most bonds the spread is between 10 and 25 basis points (0.10% and 0.25%).
  • Mutual Fund “Front End” commissions: when an advisor recommends a fund, the client is charged a percentage of their investment in order to purchase units in the fund recommended.

In all cases, the commission here is a fee paid as a result of a transaction.  Make sure that, when you are working with an advisor, you are comfortable with what those commissions mean.  The commission regimes mean that the advisor gets paid when you act on their advice.  Thus, it is reasonable to say that their bias will be to implement a portfolio solution that prefers action.  If you are an active investor, then this will compensate an advisor who continues to bring quality investment ideas to you.  However, if you are an inactive or conservative investor, you may feel that you are pressured to take action that you do not feel is in line with the objectives of your portfolio.

Deferred Sales Charges

Mutual Fund “Back-end” commissions are a contentious topic among investment professionals and the investment public.  These “deferred sales charge” occur when a client purchases a new fund within a mutual fund company.  The advisor is paid a commission by the fund company, but the client is required to remain with that fund family for a certain period of time to account for those fees being paid, usually 3 of 6 years.  After the first year, those funds pay a trailing commission to the advisor of roughly 25 to 50 basis points.

The upside is that there is no immediate cost to the client.  In addition, the commissions paid are usually either 2.5% or 5.0%, and this allows advisors to receive compensation from smaller accounts, and enables them to spend the appropriate time with those smaller clients to deliver proper advice.

The downside, however, is that the bias for a practice run with this compensation scheme means that the advisor is paid to meet and satisfy new clients rather than existing clients.  If an advisor is being paid 5% on a new client and 0.50% on their existing clients, the attention of their practice is likely biased towards the initial portfolio set-up, and not necessarily the ongoing management of your account.  If your advisor recommends the use of these charges, ensure that you are comfortable that you will continue to receive the same quality of advice into the future.  In addition, your advisor should not be asking you to re-invest in deferred sales charges again once the deferred sales charge period is over.

No Load

No load compensation schedules are generally by advisors working with mutual funds, and are intended to mimic the type of compensation schedule that investment managers receive (see below).  The no load schedule means that the advisor receives their compensation as a percentage of the assets they have under management.  This means that their bias is towards maintaining the assets they already have, as there is no extra incentive for them to attract new clients, and there is nothing stopping them from leaving if they are unhappy with their service.  These are a form of servicing commissions, as above, but are the only form of fees these advisors receive for clients invested in these funds.  Thus, their bias will be towards more inactive clients.

Servicing Commissions

Servicing commissions are fees that are paid by fund companies (generally) to advisors for maintaining the accounts that they have.  Servicing commissions vary depending on whether the advisor has recommended a front end load, no-load, or deferred sales charge fee options for their clients.  Reasonably, these are the fees that the advisor receives for maintaining your account over the long term.

Investment Counsel Fees

A direct relationship to a discretionary portfolio manager usually means a fee schedule much like the “no-load” schedule described above.  These fees are usually lower, as a result of the size and structure of accounts being managed.  In addition, it is generally accepted that these fees are tax deductible for non-registered accounts (although taxpayers are advised to consult their tax professional to ensure this is the case for them).  The fees paid to these managers can also be mixed with an incentive fee of some sort, such as a share in a percentage of profits.  This is more commonly found in managers with higher risk or specialty mandates.  There are a variety of “retail” solutions like this that are available to clients through advisors that mimic this relationship.  Two of note are offered by SEI and Franklin Templeton.

Your Objectives

Perhaps the best advice ever spoken on this topic was delivered by Upton Sinclair when he uttered the following: “It is difficult to get a man to understand something when his job depends on not understanding it.”  More specifically, if your objectives do not fall in line with the method in which your advisor receives fees, it will be difficult for you both to see eye to eye on an investment strategy.  While the fee discussion tends to raise the blood pressure of both clients and advisors alike (for different reasons), it is a discussion that should be had.

Regardless of the fee schedule, good quality advisors are likely going to give good quality advice to their clients, regardless of the fee schedule.   However, even good quality advisors are running a business, and the business decisions that they have made about their practice are going to impact how they deliver their advice in the future.

As far as I can tell, there has already been much written about fees, and a recent report suggests that Canada’s mutual fund industry may have the highest fees in the world, on average.  So what is an investor to do when faced with the costs of investing?

The Child Care Expense Derby

find out who should really claim child care expenses on their tax returns

Can't decide who should claim the child care expenses at tax time?

My wife and I earn similar (but variable) incomes, and so each year we engage in what we call the “Child Care Expense Derby.”  We have the government to thank for that.  Every year I am a bit suprised by who it goes to (“and the winner is…”), but I am glad for the opportunity to get some tax back for the money we put into child care.  I always like to go to some handy tax calculators to figure out where I stand before tax time to see if I can predict the winner.  Here are two: my website (not very complicated), and TaxTips.Ca (more complicated).

The reason for the derby is this – we are never exactly sure which income will be the lowest until we get our employers’ T4’s, and then the spouse with the lowest income is the one who receives the benefit of the child care tax deduction.  Also, thew winner of the Child Care Expense Derby will be the spouse who contributes less to their RRSP.  The child care expenses can cause a big swing: tax rules allow expenses to be deducted in the following amounts:

  • a maximum of $7,000 per year for each other eligible child who is under 7 years of age at the end of the year; and
  • a maximum of $4,000 per year for each other eligible child (between the ages of 7 and 16).

This means that a family of three children under the age of 7 has deductions of up to $21,000 – nice work.  You could notice significant savings on your taxes, approximately a $7,000 tax savings for the average Canadian, who earns income at approximately a 30% tax rate.  The eligible child care is defined by CRA as on their website follows:

  • an eligible child care provider;
  • a day nursery school or day-care centre;
  • a day camp or day sports school;
  • a boarding school or camp (including a sports school where lodging is involved); and
  • an educational institution for the purpose of providing child care services.

Note that this is not an exhaustive list expenses, and other expenses, such as advertising for a care worker, or agency fees to find a care worker are also included.

The downside here is for a family that only has one income, or when the incomes are far apart (i.e. one high income and one low income), the deduction may not be as great that two mid- or high-income earners.  But it is still powerful.  Imagine a family with one income of $75,000 and one income of $45,000.  (Let’s say there are two children under 7, so $14,000 of eligible expenses).  The lower income spouse at $45,000 would reduce their taxable income by $14,000, using the childcare expenses as a deduction against income.  This would be a tax savings of approximately $3,300 for the year.

You should also note that this deduction gives you the exact same tax relief  as an RRSP deduction, so if you have to make the choice between who does what, don’t let the lower income spouse do any RRSP deduction until the higher income spouse has maximized their RRSP contribution.  This will ensure that the higher income spouse gets more deductions against their income, and that the lower income spouse does not put RRSP contributions in at an exceedingly low rate.  Some planning should help you avoid this.

This should help when it comes to deciding what to do about care for your kids, to help and reconcile the finances at the end of the year, and to generate some other tax benefits while you are at it.

Debt and the RRSP contribution – Worth it?

RRSP loans are generally recommended as a way to “jump-start” your savings, or advertised as a way to create wealth where it did not exist previously (check out this sample Google search I did – most of these entries encourage debt).  There are a number of strong opinions out there that can debunk the myth that borrowing to invest is  good for you.

Borrowing to invest is a tricky straegy at the best of times.  Using debt for investment will increase both the gains and the losses that you receive in the market.  However, using debt can mean that you lose more than you actually have – you have lost someone else’s money.  

Leverage can do more harm than good, and must be done carefully.  If you are going to make the executive decision to use debt to invest in the RRSP, then you should be able to answer yes to one or more of the following questions:

  1. Am I at the highest marginal tax rate? If you are, then you will get the maximum benefit (i.e. tax refund) from your RRSP deduction.  If you deduct at lower tax rates, you will get less in the form of a refund at tax time.
  2. Am I going to be able to pay this off before the next RRSP season?  If you are (or you expect some compensation, a bonus or some inflow of cash that you do not currently have) then go ahead.  If not, you will likely just be in the same boat next year, forced to borrow again, and get into a “vicious” circle of debt again and again.
  3. Am I going to get a cash refund by making the contribution?   If you are, then you can have some confidence that you will soon be able to reduce your debt.  If you are not going to generate a cash refund and instead only reduce your taxes owing, then you will not be able to reduce the balance of your “quick loan” at tax time, and you will be encumbered by a great deal of debt.
  4. Is your other debt generally under control?  If so, then you might consider this as a one-time event.  However, if the reason that you have not made an RRSP contribution in the past is because your cash flow is committed to servicing other debt burdens, then this is definitely a bad idea.  Spend time getting your debt under control, and then revisit your RRSP savings later on.

So, in general, an RRSP loan is not a good idea, unless you are simply using it as a bridge until you get other funds coming in.  Also note that the interest payments on RRSP loans are not tax deductible, so there is no added deduction benefit to the investor.

I would venture to guess that, over the long term, taking a year off your RRSP contribution would serve you far better in the long run.  Perhaps, instead of borrowing to make an RRSP contribution, you start a monthly deposit plan and get ahead of the debt curve.

The Registered Education Savings Plan – A primer

The Registered Education Savings Plan, or RESP, is likely the best opportunity that a parent (or other relative) can establish to contribute to a child’s future education, and to help with the parents’ financial planning into the future.  Here are some things that you should know:

  • Almost anyone can deposit money into an RESP, as long as the parents agree
  • The money deposited into the plan grows tax free
  • The money deposited into the plan gets a government grant
  • You can invest it how you choose, or with the help of a qualified investment professional
  • The funds in the plan can be used for a wide range of post-secondary education, such as university, college, trade school or other programs that may qualify
  • If unused, the a portion of the balance of the RESP may be transferrable back to the parents later in life

So – sounds like a good deal?  It is.  The government established this program to encourage parents to save for their children’s future, and the government grant program (the Children’s Education Savings Grant, or CESG) creates a powerful incentive.  Here are the rules:

  • You can deposit up to $2,500 each year to get the “current year” grant, or 20 cents per dollar, per child.
  • You can deposit a lifetime maximum of $50,000 into the plan, per child.
  • You can receive a maximum of $7,200 of grant, per child, by the year in which they turn 17.
  • Note that there are special rules for beneficiaries (i.e. the kids) on the plan who are 16 or 17 years old, so consult a professional to discuss if your older child qualifies
  • There are added benefits for families with family incomes as described below:
    • incomes of less than approx. $77,000 there is an additional GESG incentive of $50 for the first $500 deposited
    • family incomes less than approx. $38,000 there is an total additional GESG incentive of $100 for the first $500 deposited in addition to qualifying for the Canada Learning Bond, which is $500 in the first year your family qualifies, plus $100 each year after

The math is fairly good for in favour of starting this plan.  If you look at the grant as free money (which is it), you are getting an automatic 20% return on the first $2,500 you put into the plan each year, and that grows tax-free.  In the current market, that seems a fairly strong argument to use this structure to plan for the future!