Planning Your Retirement Income
Posted 06 Jun 2014 by Rick Irwin, CFP, CLU
Whether retirement is imminent, or still many years away, it's never too early to sit down and start mapping out a retirement income blueprint. Part of this exercise involves pulling together all of your available future income streams from various pensions and determining what these would produce on their own. If you are fortunate enough to have a work pension, is the future income variable and therefore based on the sum of deposits into the plan and the performance of the markets (Defined Contribution) or is it a fixed formula based on best career average earnings and years of service (Defined Benefit)? More and more Defined Benefit plans are the exclusive realm of government as increasing numbers of private employers are choosing to shift the responsibility for providing a set level of retirement income to the markets, and thereby off-load risk onto the employees.
Even if it is a Defined Benefit plan, you need to access what the indexing (annual inflation adjustment) is. Some plans have full “indexing”, to the CPI (Consumer Price Index) which is the most common gauge of the increase of cost of living and the determinant by how much government benefits, like OAS and CPP, are increased. It is becoming more common, however, for plans to have partial, or limited indexing. Examples would be only 50 percent of CPI, or CPI increases up to a maximum of 2 percent. This erosion of purchasing power may not be a huge factor in the early years but over time it can really eat into your income and should be factored into the equation when determining inflation-adjusted retirement income.
Another factor is whether the inflation adjustment is discretionary, which it is for many plans; contingent on the funding status of the plan. The recent long stretch of flat stock market returns, combined with extremely low interest rates on bonds, have left many plans in such an under-funded status that future indexing is questionable.
Its also important to know if, and how, your plan "integrates" with government benefits like CPP and OAS. Defined benefit plans typically pay a "bridge benefit" to carry the pensioner to age 65, when normal CPP starts. The bridge benefit is equal to the amount that CPP will pay at age 65. When normal (unreduced) CPP starts at age 65, the bridge benefit falls off and the pension income should be more or less the same before and after. But if you chose early CPP, when the integration happens your combined pension will be lower. It's also important to consider the new rules around CPP and OAS and how this may impact your future entitlements.
Of the items discussed above, other than the timing of when to take CPP, you have little control about these inputs to your retirement income. The other two inputs are more within your control; how much investments play into the equation and what sort of lifestyle you envision in retirement.
Typical retirement planning calls for setting a goal of being able to replace 70 percent of your current income. The idea here is that with source deductions being considerably lower (CPP, EI, pension and RSP contributions now removed from the equation) and possible lower tax rates on a portion of the income due to pension income splitting, for many people a 70 percent replacement ratio may put them at or close to what they were netting pre-retirement. This is only a rule of thumb however and does not take into account desired retirement lifestyle, which is entirely individual. Some retirees are content to stay close to home, gardening and golfing and living modestly while others may have a bucket list of exotic travel destinations to cross off. While the 70 percent rule of thumb might make perfect sense for many retirees, its not necessarily the right benchmark for everyone and a far better starting point for this exercise is to envision would your retirement lifestyle will look like and what that will cost, in today's dollars and work backwards from there.
As you can by now hopefully appreciate, there are a lot of moving parts in this equation. Once you have thrown in all the known inputs into the mix (fixed income pensions) and made an estimate for desired income in today's dollars, the next step is to add in the current value of your investments, expected future contributions pre retirement, and a conservative rate of return both pre and post retirement.
There are other factors that might materially impact the bottom line, such as selling the family home and down-sizing, the sale of a business or an expected inheritance. Generally these can be factored in but maybe are not wise to include in the core plan. Some times you just down-size the square footage of your home, for example, not the price tag. Or business conditions might change and your business may sell for less than you anticipate. Or extended health expenses may drain down an expected inheritance. An alternate plan could be drafted should these additional infusions of retirement income come to be, but they should not be part of the income engine that will drive core retirement income needs.
Hopefully this article summarizes some of the main variables that go into the retirement income planning exercise. There may be a little homework on your part to pull all the missing pieces together but once you do I’d be more than happy to sit down and start working on some numbers!