This article on retirement savings was written by David Aston, originally published in the Summer 2012 issue of Money Sense magazine.
The 7 new retirement strategies
Canadians can no longer rely on pensions, government benefits and bull markets to carry them through their golden years. Here’s how to make the new retirement work for you.
There was a time when many Canadians retired right at age 65—whether they wanted to or not. It was a full-stop kind of retirement: you worked for the same company for most of your career, they threw you a party on your last day, and the next morning you woke up to a life of hobbies and doting on grandkids. Government benefits and traditional employer pensions kicked in immediately and they were often sufficient to take care of you, even if you had no other savings.
That traditional notion of retirement is pretty much dead. Today most Canadians are able to say goodbye to a full-time career sometime during their early 60s, but the new retirement comes in many forms. It might include golf, travel and volunteering, but it’s also likely to involve contract or part-time work, too. More and more, the goal of retirement is really about achieving financial independence—or to use the word coined by MoneySense editor Jonathan Chevreau, “findependence.” That’s the point in life where your career and lifestyle choices are no longer driven by financial necessity, and it may occur decades before traditional retirement.
The challenge, however, is that the responsibility is more on your shoulders than it was in the paternalistic past. Defined benefit pension plans are dying out, except in the public sector. And the government is starting to scale back seniors’ benefits such as Old Age Security, which will eventually start at age 67 instead of 65. Increasingly, your retirement income depends on how much you save and how you manage your own money. Unfortunately, just while this is happening, your nest egg has no doubt been afflicted by low interest rates and uncertain stock markets. All this makes the new retirement more precarious.
In what follows, we describe seven strategies that will speed you towards financial independence, preferably while you’re still young enough to enjoy it. You’ll also meet seven Canadians who are living out their lifelong dreams and reinventing the traditional notion of what it means to be retired.
Reinvent your job
Before you even think about giving up your full-time job, you need to figure out where your retirement income will come from. Your goals and circumstances are unique, but a couple enjoying a middle class retirement (or slightly better) should expect to spend $40,000 to $70,000 before taxes, in today’s dollars. Singles can expect to spend $28,000 to $49,000. If you retire at 65 with annual government benefits of $15,000 per person, you’ll need to make up the remainder with personal savings of $250,000 to $1 million for couples, or $325,000 to $850,000 for singles. If you retire earlier than 65, you’ll need a bit more.
If you don’t have enough money to retire, then you’ll need to make some tough choices. You can cut back your planned retirement spending, or find a way to save more. But these days, many Canadians are choosing to work longer. The average retirement age is 62, but that’s changing. “We see average retirement ages marching up, and we will get to 65,” says Malcolm Hamilton, partner at Mercer. “At some point we’ll likely go right through it.”
Working longer doesn’t have to mean holding your nose to the grindstone at something you despise. Older workers have an array of part-time, contract and temporary jobs available. How easy it is to find those jobs—and how much you’re paid—depends on your skills and the demand in your local market. You may have to accept less than what you earned at the peak of your career, but even a modest retirement wage can have a substantial financial impact.
If you don’t like the idea of working longer, you’ll need to ramp up your savings. That takes discipline, but even if you’ve saved little by your late 40s or early 50s, you have enormous potential to save if your mortgage is gone and your children are financially self-sufficient. The idea is to redirect into savings the money that used to go to your mortgage and kids. If you’re in that situation with an average paying job or better, you can probably save more than 30% of your income (counting RRSP refunds) if you set your mind to it. Do this steadily for a few years and it can add up to a tidy sum that may allow you to work only if you want to.
Protect your savings
Thirty years ago, retirees could put their savings in government bonds and earn 10% to 15% interest. Today 10-year Government of Canada bonds are yielding about 2%—you would be lucky to keep up with inflation, let alone earn a healthy income. Still, you need to keep a good portion of your portfolio in low-risk investments so you won’t be devastated if stocks get walloped. “You want to make sure you get your principal back on the fixed-income side,” says Hank Cunningham, fixed-income strategist at Odlum Brown Limited and author of In Your Best Interest, a guide to Canadian bonds. “Take risks with your capital on the equity side.”
Plain old GICs are among the best low-risk investments, but you have to shop around for the best rates. As we went to press, top yields for a handful of five-year GICs were around 3%, compared with less than 1.5% on federal bonds of the same maturity. GICs may even pay slightly more than investment-grade corporate bonds with terms of two to five years, Cunningham says, which is contrary to the usual pattern. The highest-yielding GICs are offered by small financial institutions you may never have heard of. You can also find higher-yielding GICs through an adviser or by going to the institution directly. Just make sure you stay within deposit insurance limits: usually $100,000 per institution.
If you use investment-grade corporate bonds, you might be able to boost yields a little by going longer term, since GICs don’t usually go out longer than five years. However, that makes your portfolio more vulnerable to rising interest rates (bond prices fall when rates rise, and the longer the maturity, the greater the decline). For a simple one-stop solution, consider the iShares DEX All Corporate Bond Index Fund (TSX: XCB), currently yielding just over 3%.
Another idea is to create a corporate bond ladder, which smooths out the effect of changing interest rates. While you can build a ladder of individual bonds, you can diversify further by using RBC’s family of target-maturity corporate bond ETFs. Each of the eight funds holds a portfolio of bonds that mature in a specific year, from 2013 to 2020 (the ticker symbols are RQA to RQH). By purchasing equal amounts of these ETFs, you’ll have one-eighth of your investment mature each year, and you can then reinvest that money at current rates.
Boost your income with dividends
While fixed-income investments can protect your savings, you’re not likely to grow your wealth with GICs and bonds. To stay ahead of inflation, you’ll need to keep a significant part of your portfolio in equities, and focusing on dividend-paying stocks may provide the right balance of risk and reward. “The best way for people to get a decent return these days is to have a good portion of that return come from reliable dividends versus less reliable capital gains,” says Bob Gorman, market strategist at TD Waterhouse. “This is going to be the era of the dividend growth stock.”
Picking the right dividend stocks is key. Avoid companies with the highest yields, because that may indicate the dividend is likely to be cut, and the stock price will suffer as a result. Instead, choose reliable dividend-payers that can maintain those dividends even in bad times, while also growing them consistently over time. Look for well-managed, profitable companies in stable industries with good balance sheets and modest growth. They should also pay out only a reasonable proportion of profits.
Income investors will appreciate that many such stocks generate higher yields than 10-year government bonds, the reverse of historical norms. These steady-eddy stocks may lag during booms, but often outperform in bad years. And dividends paid by Canadian companies are taxed at lower rates than interest when held in non-registered accounts. But because Canada’s market is so concentrated, it can be hard to diversify your holdings across a variety of industries, so you may want to consider foreign dividend-payers, too, especially in an RRSP or RRIF. Real estate investment trusts (REITs) can provide further diversification and steady income, although they don’t have the same tax advantages as dividend stocks.
The easiest way to build a portfolio of dividend stocks is with ETFs. For Canadian dividends, MoneySense columnist Dan Bortolotti recommends a combination of the iShares Dow Jones Canada Select Dividend Index Fund (XDV) and the iShares S&P/TSX Canadian Dividend Aristocrats Index Fund (CDZ). For U.S. dividend ETFs, consider the Vanguard Dividend Appreciation ETF (NYSE: VIG). If you prefer buying individual stocks, check out Stocks that pay you back from our April 2012 issue.
But for all the benefits of dividend stocks, you can get too much of a good thing. While the right mix of stocks and fixed income in your portfolio is highly personal, Gorman suggests retirees and near-retirees consider 55% to 60% in dividend-paying equities and the rest in fixed income.
Cash in on your home
Many people approaching retirement have good reason to complain about the investment climate they’ve endured over the last dozen years. But there is one area where they can’t bemoan their bad luck—at least not if they own a house. Real estate in Canada has enjoyed an enormous boom in recent years, and that’s allowed many long-time homeowners to build significant wealth without really trying. That can give you more options in retirement.
If you own an expensive home, you could add to your cash savings by downsizing or relocating. To give an exceptional example, Tony Ioannou, associate broker with Dexter Associates Realty, says some Vancouver homeowners are selling modest-sized homes in the west end, buying two-bedroom condos nearby, and winding up with $500,000 in their pocket. It’s more common for homeowners in other parts of Canada to net $100,000 or $200,000 after costs.
Consider the experience of Phil and Brenda Lewis. The retired couple in their 60s wanted to sell their semi-detached Toronto house and move to Halifax to be closer to their son and his family. The Lewises (whose names we changed) weren’t in dire need of extra cash, but they saw a chance to take advantage of Toronto’s hot housing market to top up their nest egg. So they sold their semi for $780,000 this spring and bought a renovated detached Halifax house in a desirable neighbourhood near the ocean for $620,000. They netted more than $100,000 after costs, while retaining home equity they hope will at least hold its value. “We could have bought a less expensive home in Halifax that gave us less equity and more money,” says Phil. “Instead we chose to buy the home we wanted, which gave us more equity and $100,000.”
The equity in your home can also provide a back-up plan if you run low on savings. If you stay put, you can cover essential expenses by borrowing against it with a reverse mortgage or home equity line of credit—albeit only as a last resort. Later in life, if you move into a retirement or nursing home, the proceeds from selling your house can defray those costs for years. Even if you never draw on your home equity, it can provide a great legacy for your kids.
Think differently about debt
When Catherine Christie split from her husband two years ago at age 61, she wanted to buy a house with her half of the proceeds from their marital home. Christie (whose name we’ve changed) fell in love with a nicely renovated three-bedroom house with a beautiful garden in Toronto’s east end that cost $460,000. However, she was $160,000 short and uncomfortable borrowing so much at that stage of life.
Carrying debt into retirement was once considered dangerous and irresponsible. But today’s low interest rates have changed the game—as long as you borrow smart. “If people want to give you money for free, take advantage of it,” says economist Jeff Rubin, author of The End of Growth. “Just make sure you’re able to finance at much higher rates than you’re financing now,” he advises. You can do that by making sure your debt payments are much lower than your capacity to cover them.
After looking at the numbers, Christie decided that her home purchase made sense after all. Her mortgage payments would be only $600 a month, easily covered by the public service pension she gets when she retires. And the house had a renovated basement that could be rented out for more than that—with some of the mortgage interest tax-deductible.
You can take advantage of today’s low rates to position yourself for your later years. Many Canadians will soon renew mortgages with five-year terms from 2007 and 2008, when interest rates were one or two percentage points higher than today. On a $200,000 mortgage that’s about $2,000 to $4,000 in annual savings you can use to make extra mortgage payments or, if necessary, pay off other debts. If you have high-interest credit card debt that you can’t seem to pay off, you might consider tapping your home equity for a consolidation loan at much lower rates.
Just remember that your main goal is getting rid of that consumer debt, not just making it more manageable. Debt can be seductive, but as you approach retirement it’s critical to only borrow for productive purposes like buying a home or other appreciating asset. Low rates can make the difference for an otherwise unaffordable expenditure, but they won’t turn bad debt into good debt.
Wait before you buy an annuity
Many retirees like the idea of annuities, which provide guaranteed income for life in exchange for a lump-sum payment. In the past, people often purchased annuities as soon as they retired in order to replace their employment income, especially if they had no pension. That may not be such a good idea any longer.
Annuity payout rates are affected by interest rates, and current payouts are dismally low. That doesn’t mean you should shun these investments altogether—it just means it pays to wait. There’s always a trade-off when you delay buying an annuity. You’ll receive payments for a shorter period, and you’ll need another income source to bridge the gap. But those payments will be larger, so you’ll also have a higher stream of reliable cash flow to protect you if you live well into your 90s.
Many experts say the current sweet spot for annuities these days is about age 70. Moshe Milevsky, finance professor at York University’s Schulich School of Business, suggests easing in over five years starting at that age. For example, if you want to annuitize $500,000, you might purchase a $100,000 annuity each year. Financial planner Jim Otar (retirementoptimizer.com) suggests doing so over three years. This gradual approach makes you less dependent on payout rates at any particular moment. If your finances are tight and you feel the need for assured income, starting to convert at 65 might make sense, but you must be willing to put up with the low payouts.
Annuities suit many middle-class seniors but aren’t for everyone. They can be complex and come in multiple forms, so you will need to do your homework carefully before buying. How much savings you ultimately convert to annuities is up to you. Some retirees like to have a combination of annuities and government benefits cover basic spending. That way, if your investment portfolio suffers a big setback, your basic lifestyle is still assured.
Reduce your tax bill
Before 2009, RRSPs were really the only way for Canadians to shelter their retirement savings from taxes. But the introduction of the Tax-Free Savings Account (TFSA) has added another option. Unfortunately, the rules are complex and it’s not easy figuring out how to combine these two tax-sheltered investment accounts for maximum advantage.
If you’re saving for retirement with limited funds, whether you sock money away in your RRSP or TFSA depends on your tax bracket now compared with when you withdraw the funds. If you have a high income today, it makes most sense to use RRSPs first, since you get a juicy tax refund and you’ll eventually pay less when you withdraw money at a lower tax bracket. If your income is low today and you expect your tax bracket to be higher in retirement, then you’re better off with TFSAs, because your RRSP refund won’t be as large and you’ll avoid a larger tax hit down the road.
Problem is, it’s hard to know what tax bracket you’ll wind up in. But retirees typically live on 50% to 60% of the income they had in their peak working years, so RRSPs should be the first choice for those with average salaries or better. If your income in retirement will be about the same, a tie should go in favour of the TFSA because it’s more flexible. If you need the money for an emergency you can withdraw TFSA money without tax consequences, whereas RRSP withdrawals might cause you to pay hefty taxes if you’re still working. TFSAs are also better if you expect to end up with sufficiently low income in retirement to be eligible for the Guaranteed Income Supplement (GIS). Withdrawals from an RRSP reduce GIS payouts, whereas TFSA drawdowns do not.
Later on, you will need to figure out how to withdraw the money without paying too much tax. If you have substantial RRSPs and non-registered accounts, it’s even more complicated. The best strategy is to take a balanced approach to withdrawing money from both sources. (For more on finding the optimal solution, see How to tap your RRSP from our September/October 2011 issue.) That’s because of our progressive tax system, where higher incomes get taxed at much higher levels. Seniors who defer RRSP withdrawals in their 60s are often forced to make large withdrawals after age 71, when they’re required to convert RRSP money to a RRIF or an annuity. That can often push them into a higher tax bracket. “We try to smooth out the withdrawal pattern and make it work efficiently from a tax point of view,” says Daryl Diamond, financial planner with Diamond Retirement Planning in Winnipeg and author of Your Retirement Income Blueprint.
The path to financial independence isn’t always easy. You’re bound to suffer unlucky setbacks—although hopefully you’ll get some lucky breaks, too. “We try to give ourselves lots of options as we approach the age where we stop working, either by choice or because we’re required to,” says Malcolm Hamilton. “That’s about all we can ask for.” If you set reasonable goals now and make adjustments to stay on track, it will give you more freedom to choose later on. Then chances are you’ll achieve your own version of the new retirement that suits you best.
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