bout de papier, Vol. 4, No. 4 (1986) — Winter 1986 // Hiver 1986, pp. 55–56
E., many of us, the most significant assets we will have as we approach our retirement years will be the equity that has built up in our principal residence and the capital and benefits that we have accumulated or that have accrued under our individual Registered Retirement Savings Plan (RRSP) or employer-sponsored Registered Pension Plan (RPP).
There is a great deal of confusion, uncertainty and frustration among many individuals when it comes to understanding how they might best meet their goal of providing an adequate, inflation-proof income at age 60 or whenever they retire.
We will deal briefly here with some of the proposed changes in pension legislation and with the role of the RRSP and its potential advantages.
The RPP is the vehicle used by most employees and employers to provide for future retirement income needs. There are two basic pension plan designs utilized in Canada today. The Money Purchase Pension Plan allows the employee and employer to contribute specific amounts, normally stated as a percentage of the employee’s income. The current maximum deductible contribution is $3,500 each per year, for a total contribution of $7,000.
A Defined Benefit Pension Plan is the type employed by most large employers in Canada today. As with the Money Purchase Pension Plan, the maximum employee contribution is limited to $3,500 per year. However, the employer contribution is not restricted to $3,500, but is the amount in addition to the employee’s contributions required to fund the pension benefit that has been promised under the Defined Benefit program. It is estimated that the annual combined contributions of the employee and employer to fund the maximum pension benefit of $60,025 over a 35-year period would be $15,500.
The table on page 56 is an extract from the May, 1985 Budget papers which shows the contribution limits available in 1985 under an RRSP, Money Purchase Pension Plan and a Defined Benefit Pension Plan, and the estimated annual pensions that could be accumulated over a 35-year period. As you can see, under the pre-1986 legislation those participating in a Defined Benefit Registered Pension program were in a much superior position to those employing an RRSP or participating in a Money Purchase Plan.
As a result of these findings, significant pension changes have been introduced to more effectively equate the opportunities available to all individuals seeking to accumulate capital for retirement regardless of the retirement vehicle they employ.
The next table summarizes proposed changes in contribution limits that are due between 1986 to 1990. You will note that both the RRSP and the Money Purchase Pension Plan are to have their annual contribution limits raised systematically over the next five years. In 1990 the annual contributions will be more closely related to the limits in place for Defined Benefit Plans at that time. The contributions for an RRSP or Money Purchase Pension Plan are limited in 1986 to the lesser of 18 per cent of earned income of the maximums noted.
It is proposed that the annual contribution limits under the Registered Retirement Savings Plan and the Money Purchase Plan from 1990 onwards by indexed to the increase in the Average Industrial Wage (AIW). With the Defined Benefit Pensions Plans, the current maximum pension benefit of $60,025 annually will, as well, be indexed to the increase in the AIW.
Along with the changes in the contribution limits, there were a number of other amendments introduced which could have a significant impact on retirement strategies.
One question that many employers will have to deal with is whether they should continue to structure their RPP on a Defined Benefit basis. For many younger and middle-aged employees, the opportunity for tax deferral under a Money Purchase Pension Plan or an RRSP may exceed that available under a Defined Benefit program. For those employees in their ’50’s and ’60’s, the Defined Benefit route may continue to offer the most attractive alternative.
For other reasons, there may be employees who choose to opt out of the employer pension plan (if permitted) and establish their own RRSP. The employer, if agreeable, could redirect their previous pension contributions to the employee as income which would then be deducted from income by the employee when contributed to an RRSP. The use of an RRSP allows individuals to directly control the investment strategies of their retirement pools; it also offers greater flexibility in terms of the options available upon plan maturity.
For example, under an RPP the only option available to an employee at retire. ment is a single or joint life annuity with varying guarantee periods. It would be possible for an individual to defer receiving income from an RRSP until the end of the year in which he or she turned age 71. At that point the RRSP funds could be converted into a joint or single life annuity, a term-certain annuity to age 90, or cashed out, with the funds brought into income and fully taxed in the year of receipt.
Alternatively, assets could be transferred to a Registered Retirement Income Fund (RRIF) and paid out in accordance with a predetermined formula through to age 90. This last option may be utilized combination with the purchase of a life annuity to provide the required balance between the guaranteed income provided by an annuity, and the opportunity for control of capital and improved investment performance potentially available under an RRIF.
Another attractive aspect of the RRSP is the possibility of income splitting by contributing to a spousal RRSP. The contributing spouse continues to take full tax relief on all contributions but the ultimate pension revenue will be split, reducing the impact of tax. The absolute level of tax savings depends on the marginal tax rate of the spouse. Of course, there are some potential negatives associated with placing funds in the hands of your spouse, particularly if the relationship changes.
Another very valuable planning alternative that’s been introduced with recent proposed changes in our pension vehicles is the fact that you may carry forward unused RRSP deductions from 1987 onward for up to seven years. Many Canadians wrestle with the question as to whether they should pay down non-deductible mortgage debt or make an annual contribution to an RRSP. Under previous legislation, an RRSP contribution had to be made in any given year. With this new carry-forward provision, it may now be more advantageous in certain circumstances for individuals to forego annual RRSP contributions and accelerate the pay down on outstanding mortgages. Having eliminated the non-deductible debt on the home, you could then concentrate your resources on optimizing both current and previously unused RRSP limits.
With the new limits applicable to RRSPs and Money Purchase Pension Plans, it becomes extremely important that the investment performance of the accumulating funds be monitored closely to ensure the optimum return consistent with the level of risk you are prepared to assume. All too frequently, Canadians spend little, if any, time evaluating the investment alternatives for their current year’s contributions and in most instances, simply deposit funds with the most conveniently located institution. Assuming you make an annual RRSP contribution, the single most important factor in determining the ultimate income you will receive at retirement, and therefore, the lifestyle you will enjoy during the last 15 to 20 years of your life, is the return you are able to earn on this capital. Even a two per cent improvement in return over a 20-year period
Annual Contribution Annual Pension
Employer/Employee After 35 Years
$ 5,500 $21,000
Money Purchase RPP $ 7,000 $27,000
Defined Benefit RPP $15,000
TOTAL ANNUAL CONTRIBUTION LIMIT EMPLOYEE/EMPLOYER
Retirement Vehicle 1986 1987 1988 1989 1990
$ 7,500 $ 9,500 $11,500 $13,500 $15,500
Money Purchase
$ 7000 $ 9,500 $11,500 $13,500 $15,500
Defined Benefit RPP $15,500 $15,500 $15,500 $15,500 $15,500
produces a substantial additional amount of capital. You work hard for your money and your money should work as hard for you.
Typically, most Canadians will make their 1986 FFSP contribution during the last week of February. This is done not because the funds were unavailable earlier in the year, but because of habit or because we wait until the deadline. It’s possible to increase the assets you will accumulate in your RRSP by making your annual contribution at the beginning of the year rather than the end. If a 45-year-old did nothing more than that, there would be an additional $68,000 of capital (at eight per cent), or $104,000 (at 10 per cent) upon retirement, if the maximum allowable contribution were made each year.
One point often overlooked is the appropriate beneficiary designation under the alternative retirement vehicles. Those of you with numerous RRSP accounts should write to the holders of your funds to confirm the beneficiary designation on record. If our own experience is accurate, you’ll be shocked to find that in many instances there is no recorded beneficiary designation. Providing your will adequately covers the transfer of registered funds at death, this may not be a costly oversight. On the other hand, if your current will does not specifically deal with this subject, the additional tax burden at your death could be significant.
Don’t wait until you’re 45 to initiate your retirement plan. Take the time now to sit down and identify your expected income needs in today’s dollars at your planned retirement age. Using a simple compound-interest table, inflate these 1986 income needs into the future at a rate of growth consistent with what you expect inflation to be. Keep in mind that inflation is a factor after retirement, as well as before. Identify the various sources of income that you might realistically expect to be available to you. Quantify the income gap and then determine the additional capital you will require to reach your retirement income target. Then, employing an investment rate consistent with your risk level, determine the level of savings that must be put aside each year to fund this capital need
Take control of your future. Act now to ensure that you can attain the goals you’ve set for your retirement years.
View the original scanned pages →
Originally published in bout de papier, Vol. 4, No. 4 (1986) — Winter 1986 // Hiver 1986, pp. 55–56. Read the rest of this issue →
