Retirement Planning
Generally speaking, retirement income planning involves saving out of and investing current earned income in order to build a pool of capital that can support lifestyle needs when earned income ceases.
Savings can be accumulated in a great variety of programs. There are registered plans such as pension plans or registered retirement savings plans. Under these types of programs, funds are tax deductible on the way in and tax deferred during accumulation, but fully taxable upon withdrawal. There is also the tax-free savings account (TFSA) where funds are not tax deductible on the way in, investment income accumulates tax-free and funds are not taxed upon withdrawal.
Alternatively, money can be accumulated in an exempt life insurance policy, which combines insurance coverage with a savings element. Premiums are not tax deductible on the way in, and the growth within the policy is tax-deferred during accumulation, but may be taxable upon withdrawal.
Of course, money can also be accumulated on a nonregistered basis. In this case, there is no tax relief on deposits, there is annual taxation of investment income, and funds may be only partially taxable upon withdrawal (for example, depending on the accrued capital gain within the fund or other investment).
Retirement planning can be based on a target retirement income which drives out an annual savings goal based on the expected rate of return and the number of years leading up to retirement. Alternatively, retirement planning can be based on a target amount of savings which drives out a potential retirement income amount based on similar assumptions.
Example
In order to keep an example simple, the following analysis assumes that retirement savings were accumulated in a Registered Retirement Savings Plan. Note that other forms of savings will, in all likelihood, also be used and a comparable analysis can be accomplished using similar projections. Also note that various complicating factors must be taken into account for any retirement needs analysis; although some have been noted below, a more fulsome analysis is always required.
A. Target Income
Jack would like a pre-tax retirement income of $50,000 per annum. He can determine the lump sum required at the point of retirement by making an assumption about the number of years he will live in retirement, and the amount of inflation protection he would like in his retirement income. In order to analyze the target sum, the input variables that have to be assumed are:
(1) target amount of income;
(2) number of years the income is needed;
(3) an investment rate of return; and,
(4) an inflation rate
| 4% assumed rate of return 20 years of retirement no inflation protection |
4% assumed rate of return 25 years of retirement no inflation protection |
|---|---|
| $706,700 SAVINGS GOAL | $812,400 SAVINGS GOAL |
| 4% assumed rate of return 20 years of retirement 1% inflation protection |
4% assumed rate of return 25 years of retirement 1% inflation protection |
| $768,100 SAVINGS GOAL | $899,500 SAVINGS GOAL |
The above chart only varied two of the possible four variables (number of years of retirement and inflation), yet produced four very different answers.
The key to planning is to focus on the range and which end of the range should be targeted.
B. Target Savings Goal
If Jack decides that $800,000 is his goal in terms of an accumulation target, then he would need to know how much to set aside annually. Similar to the example above, in order to analyze the required annual savings target, the input variables that have to be assumed are:
(1) the starting amount already accumulated;
(2) number of years until retirement;
(3) an investment rate of return; and,
(4) an inflation rate.
4% assumed rate of return 18 years to retirement no inflation adjustment4% assumed rate of return 18 years to retirement2% inflation adjustment
| 4% assumed rate of return 18 years to retirement no inflation adjustment |
4% assumed rate of return 22 years to retirement no inflation adjustment |
|---|---|
| $30,000 ANNUAL SAVINGS TARGET | $22,500 ANNUAL SAVINGS TARGET |
| 4% assumed rate of return 18 years to retirement 2% inflation adjustment |
4% assumed rate of return 22 years to retirement 2% inflation adjustment |
| $25,800 ANNUAL SAVINGS TARGET | $18,700 ANNUAL SAVINGS TARGET |
Again, the chart produced four different answers that create a range for planning and setting realistic savings targets. The annual savings target could be increased every year (indexed) based on an individual’s increases in earned income. Also, if the intention is to save through an RRSP, the annual RRSP contribution limits will need to be taken into account. If saving is outside a tax-deferred vehicle, then annual taxation will need to be factored into the analysis.
Financial planning is not about seeking the answer within a financial calculator, but rather a process of setting targets, creating plans and constantly reviewing to ensure overall direction is correct. Plans will need to be changed and adjusted for a great number of variables, but those who take the time to plan will be much further ahead financially and emotionally for the exercise.
E.O. & E.
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Copywrite ISSN 0382-7038
Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.
