The importance of creating cash flow in retirement
You’ve likely saved for many years and invested your money carefully. But when the money has to start flowing in the reverse direction – when your portfolio has to start paying you – suddenly you’re faced with a whole new set of challenging choices.
No matter what the approach, it always comes down to the same question: how much income can I expect each year? And the closer you get to actually retiring, the more you start to care about the accuracy of that estimate. After all, you’re going to be retired for quite a while.
Forty years ago, someone retiring at age 65 could expect to live roughly 13 years in retirement. Now, if you’re healthy, you can expect to live another 20 years, and both you and a few of your friends could live for another 30 years or more.1
What you need in retirement, then, is regular, reliable cash flow. Each month you’ll have expenses, and you’ll need a steady stream of cash coming in to meet those costs. Depending on how you plan for retirement, that money will likely come from multiple sources, all working to offset the effects of key retirement issues such as inflation, longevity and taxes.
Identifying sources of guaranteed income
Ideally, you’ll want day-to-day expenses – such as housing, food, utilities and taxes – to be mostly covered by lifetime guaranteed income sources. Government benefits in Canada, like the Canada/Quebec Pension Plan and Old Age Security (OAS), are a secure source of retirement income that will last your lifetime, and are indexed for inflation to match the rising cost of living. But these payments are likely to replace only about a third of the average Canadian’s pre-retirement income, which is currently about $53,000.2
Guaranteed company pensions are becoming a thing of the past, but if you are entitled to one, be sure you understand what you can expect down the road. Defined benefit plans promise to pay out a regular income calculated according to a formula involving your years of service and your earnings, so you’ll know exactly how much you’ll receive upon retirement. Many also provide some degree of inflation protection.
With defined contribution plans and group Registered Retirement Savings Plans (RRSPs), however, the size of the pension you’ll receive depends on the amount of money accumulated through the contributions you and your employer made and the earnings in the plan. As a result, your eventual cash flow in retirement will be much more difficult to estimate.
Creating a retirement paycheque
Truth is, without defined benefit pensions, Canadians are increasingly on their own when it comes to creating income in retirement. If, like many people, you’ve accumulated most of your retirement savings inside RRSPs, you must convert them to a Registered Retirement Income Fund (RRIF) by the end of the calendar year in which you turn age 71. You are required to make a minimum withdrawal from a RRIF each year, and this allows you to systematically draw income from your savings. Withdrawals from your RRIF are taxable when you receive them, but investments inside the RRIF continue to grow tax-deferred. RRIFs offer the same investment options as RRSPs.
The mandatory RRIF withdrawal amount is based on your age and a percentage of your RRIF’s value. The minimum RRIF payout percentage gradually increases as you get older. There’s no maximum withdrawal limit, however, so you can vary your retirement cash flow depending on your lifestyle needs.
Increasingly, retirees are also looking to TFSAs to create cash flow in retirement. Unlike RRSPs, there’s no age limit at which TFSA assets must be withdrawn. Plus, investments made in your TFSA account are tax-free, meaning that you pay no income tax on the returns your savings generate through retirement, or on withdrawals from the TFSA.
For non-registered assets, establishing a systematic withdrawal plan is likely the preferred way to access your savings. In this case, units of your investment portfolio are sold on a regular basis to provide the retirement income you need. Generally, units are distributed in proportion to what you own, to help keep your overall asset mix in balance and manage risk.
Using an instrument such as Fidelity Tax-Smart Withdrawal Program® (T-SWP®) can help defer tax on non-registered investment withdrawals. T-SWP doesn’t require selling units of an investment every month to generate cash flow; instead, the monthly cash flow payments are mostly made up of return of capital (ROC). ROC is not regarded as taxable income when you receive it. Michelle Munro, Fidelity’s Director of Tax and Retirement Research, says that “most people aren’t aware of this tax-efficient withdrawal program for mutual funds.”
Another feature may be particularly appealing to those investors who want to lower their tax bills in retirement: in addition to providing an excellent source of cash during your retirement, TFSA withdrawals and T-SWP ROC payments won’t affect your eligibility for government benefits like OAS.
It’s what you keep that matters
While tax-planning opportunities like this may have been somewhat limited during your working years, they’re going to be a key element of your retirement income planning. Remember, if you can’t count on a company pension, you’ll likely be generating much of your cash flow from personal savings and distributions from various investments – all of which are taxed at different rates.
For instance, the income from your non-registered investments may be characterized as interest, dividends, capital gains or ROC distributions, depending on how you invest. This right combination here can have a significant impact on the after-tax dollars that you have to spend in retirement. Getting it right can be complicated: Michelle Munro notes that “an advisor can help you build and sustain a tax-efficient cash-flow plan to ensure you enjoy the retirement you have been working towards.”