Change occurs gradually, unless poked by some trig- gering event. In Canada, the pension regime has evolved slowly but surely since Old Age Security (OAS) was introduced in 1952. Major milestones along the way include the introduction of registered retirement sav- ings plans (RRSP) in 1957 and the registered retirement income fund (RRIF) in 1978, the creation of the Canada Pension Plan (CPP)/Quebec Pension Plan (QPP) in 1966, and the Guaranteed Income Supplement (GIS) one year later. The major change in recent years was the overhaul of CPP’s/QPP’s funding formula in 1996 and the creation of the Canadian Pension Plan Investment Board (CPPIB) in 1998.
Now, in 2010, governments may be poised for another significant change to Canada’s pension system " change triggered in large part by the 2008 financial downturn, which savaged the retirement savings of a generation about to retire (figure 1).
The ensuing ”œpanic” may have subsided now that the recession has been declared over and investment markets have begun to revive, but the warning bells are still ring- ing. There may be vulnerabilities in our current system and, if so, it is right for governments to consider ways to address them.
The underlying question, of course, is whether Canadians are saving enough for retirement " whether they will have saved enough to have the income they need to fund the lifestyle they desire during retirement.
Canadians are saving considerably less than they were. As we emerged from recession in 1982, the savings rate climbed to more than 20 percent. It has been dropping ever since. In 2005, Canadians set aside just 1.2 percent of per- sonal income for a rainy day. (The savings rate has since rebounded to 4.8 percent in 2008, demonstrating that, in times of economic uncertainty, people tend to save more; see figure 2.)
Is this enough?
Members of Canada’s baby-boom generation who begin turning 65 next year may have cause for con- cern. Canadians are living longer, healthier lives " which means they will need more to sustain them in a long and active retirement. For every couple hitting retirement age this year, it is likely that one of them will live to see his or her 90th birthday.
Today’s boomers have other reasons to worry.
Only about 38 percent of Canadians are covered by a registered pension plan (RPP). While many of these are defined benefit (DB) plans that provide guaranteed income for life, defined contribution (DC) plans, which are becoming the norm, put an extra burden on individuals not only to fund their retirement savings adequately, but to manage those savings effectively, as well " an issue highlighted by last year’s market crash.
The financial costs of care-giving are rising rapidly, which means there will likely be a need for addi- tional savings in future " not only for the boomers themselves, but for their parents, who are also living longer. The financial needs of this so-called sandwich genera- tion would appear to be greater than any other generation before.
The lifestyle expectations of today’s retirees are also likely to be more costly than any previ- ous generation " throwing into question traditional rules of thumb about what proportion of their income requirements today will need to be replaced in retirement.
And, while it may not worry them, boomers are carrying more household debt than any genera- tion before them. Their parents strove to enter retirement free of debt, but today’s pre-retirees do not seem fazed by the prospect of having a mortgage. Household debt-to-income levels have hit a record high of about 145 percent.
To be clear, Canada’s seniors are not headed for the poor house. The Organization for Economic Cooperation and Development (OECD) said Canadian seniors were number three in the world with regard to their income prospects in retire- ment " less than 5 percent of Canada’s seniors were living below the poverty line in the OECD’s 2009 study, one of the lowest rates in the devel- oped world.
Likewise, the federal-provincial task force on pension reform, headed by Jack Mintz, did a careful investiga- tion of Canada’s pension regime and concluded late last year that a major overhaul may not be necessary " the system is working just fine. Even the government of British Columbia, one of the strongest advocates of bringing in a new supplemental pension plan, has suggested taking more time to craft an effective, national plan to help those who are not saving enough for a decent retirement.
If there is not a crisis, however, there is still room for improvement, and it would be unfortunate to allow the developing momentum for change to falter because the perceived urgency has diminished. Maybe the system as a whole isn’t broken, but parts of it still need to be modified. Are there things we can reasonably do now that will improve the lot of those about to retire over the next five to ten years " and be good solutions for everyone else after that?
For these pre-retirees, the big ques- tion is this: What proportion of today’s income will they need once they hit retirement?
As a rule of thumb, most financial planners use 70 percent as the target income replacement ratio " if you earn $70,000 per year in your working years, you will need about $50,000 to maintain your lifestyle in retirement. This presumes that people who are no longer working spend less on such things as business clothing, commut- ing, fast food and prepared meals. Some academics argue that a 60 per- cent income replacement ratio is ade- quate for most people " and for higher income earners, some say the replacement ratio could be as little as 50 percent.
While these rules of thumb may have worked in prior years, it remains to be seen whether they will still be valid in future " especially given the boomer generation’s lifestyle expectations and the unpredictable course of future health care costs. (If nothing else, it is clear that a ”œone-size-fits-all” approach to retire- ment planning is overly simplistic.)
Yet boomers have probably accu- mulated more wealth than any before them, notwithstanding any hit to their investment portfolios and despite their low savings rate of late. The equity in their houses alone represents a signifi- cant nest egg.
It makes sense, therefore, to focus on improving what they can do with what they already have, rather than introducing major design changes to the plan " which may benefit younger people but not have much impact on those about to retire.
Canadians generally rely on three components for assistance with their retirement income: govern- ment pensions, employer pensions and personal savings, commonly known as the three pillars. The first pillar provides direct assistance from government through the CPP/QPP and OAS. The second provides assis- tance from our employers who con- tribute some or all of our company pension contributions. The third provides assistance through tax deferrals when our personal savings are invested in an RRSP (figure 3).
Low-income Canadians may have only government pensions to rely on. The maximum an unmarried 65-year-old will earn from CPP/QPP and OAS is $17,413 for 2010; married individuals will receive $34,800. In addition, it is worth noting that only one-half of all Canadians have an occupational pension plan and up to one-third of Canadians do not con- tribute to an RRSP.
For those who have accumulated retirement assets in DC pension plans and/or RRSPs, their annual retirement income will be a function of how much they have set aside. In essence, the way they pay for retirement involves converting their retirement savings, their investments, into an income stream. And as it stands today, this conversion process is simply not tax efficient " regardless of the conversion option they choose: RRIF or annuity.
If governments are going to review pension adequacy, we believe they should also include a review of the current personal saving regime. With this in mind, we offer five con- crete suggestions for RRSPs and RRIFs that would be of immediate benefit to people entering retirement or recently retired, as well as being help- ful to younger adults as they plan for their own retirements.
The bargain we strike with the government when we set up an RRSP is this: the government permits us to defer income tax on our contribu- tions, allowing the savings to grow within a tax-sheltered plan, in the expectation that the tax will eventu- ally be paid when the savings are withdrawn " probably at a lower marginal tax rate. The conversion age for RRSPs is 71. By the end of the year that plan holders reach their 71st birthday, they must cease contributing to their RRSPs and con- vert them into RRIFs or annuities " the logic being that, having allowed Canadians to defer tax while their retirement sav- ings were accumulating, the government needs to be sure that the money will be withdrawn, allowing it to recoup some of the deferred tax.
There is one exception to this rule. A spouse can continue making contri- butions to a spousal RRSP as long as the younger spouse is under the age of 71. For those without a spouse, this option to extend one’s ability to garner tax-sheltered retirement savings does not exist.
As Canadians live longer and work longer " and save longer " they may feel it is premature for them to cease saving and begin making withdrawals as early as 71. Unnecessary (and unwanted) RRIF payments may even trigger OAS claw back, causing some seniors to forfeit some or all of the gov- ernment benefits they might other- wise have received.
In our view, Canadians should be able to choose when to begin with- drawing money from their RRSPs. This will give them more flexibility and allow them to accumulate more retire- ment savings (in their own plans, or their spouses’). And to be clear, it’s not a question of ”œif” the government will get its deferred taxes, but ”œwhen.” The money will be withdrawn eventually, one way or another, which means the government will still have its opportu- nity to collect tax revenue.
As noted earlier, RRSPs were designed to be tax-deferral plans " a way to convert current income into future income so as to defer taxation from today to some time in the future, usually during retirement.
Under current progressive tax rates, the higher one’s income, the higher one’s marginal tax rate. The underlying assumption regarding RRSPs is that contributions and the income they earn would attract a high- er rate of taxation than the later with- drawals. This assumption may not always be true.
Ideally, individuals begin saving for retirement when they are young " typ- ically at a time when their incomes are lower, and so is their tax rate. By the time they convert their RRSPs, they may be in a higher tax bracket than when the contributions were made.
Withdrawals from RRIFs are taxed as interest/salary income " even if the growth in the plan was derived from a combination of divi- dends and capital gains. Had this growth been achieved outside a regis- tered plan, the income would receive preferred tax treatment resulting in a lower tax rate.
In our view, only RRSP contribu- tions themselves should be taxed as ”œdeferred employment income.” The investment returns (i.e., the growth in the plan) should be taxed at a lower rate that mimics the tax rate that might have been paid if the invest- ments had been held outside a regis- tered plan.
In addition, we note that the loss of the preferred tax status for divi- dend income and capital gains held in an RRSP may skew one’s invest- ment behaviour. The very nature of the tax treatment is an incentive to opt for an abundance of interest-bear- ing securities in one’s RRSP portfolio; at today’s all-time-low interest rates, such investments will grow very slow- ly and one’s retirement savings may not even keep up with inflation on an after-tax basis.
Currently, on death, the balance of the plan would be included in that year’s income of the deceased, and only the net after-tax amount is passed on. The balance of an RRSP or RRIF is transferred tax-free to a spouse or common-law partner (or, under certain circumstances, and with con- ditions, to a dependent/disabled child or grandchild). In effect, the law per- mits the tax to be deferred a while longer, until the survivor withdraws the funds or dies. No provisions exist, however, for a tax-deferred rollover to anyone else.
Under current rules, there is no incentive to use the inheritance (or whatever is left of it after taxes) to contribute to an RRSP. In our view, if there are balances in RRSPs or RRIFs when individuals die, these amounts should be allowed to be rolled over tax-free into the next generation’s RRSP or RRIF. If RRSPs or RRIFs could pass untaxed, this would be encour- agement to keep the funds in a retire- ment plan. As it stands, the majority of beneficiaries tend to spend their inheritances rather than re-invest (figure 4, table 1).
Ideally, this rollover should be available on top of any unused RRSP room " but even allowing it to be used to top up a plan to its current limit would be an improvement. Based on cur- rent trends, it is projected that unused RRSP contributions will exceed $1 trillion by 2018. The parents of many boomers are still alive and much has been written about the magnitude of the so-called inter-generational wealth transfer. Such a policy change could therefore be of benefit to many Canadians approaching retirement age. And, as with the earlier argu- ment regarding age restrictions, such a move would not deprive the Treasury of its tax revenue; it would merely defer it a while longer.
If there were real concerns that this would stretch out the tax defer- ral too long " from one generation to the next ad infinitum " the gov- ernment could create a new regis- tered vehicle to receive the proceeds, which must then be paid over a pre- scribed period.
In addition, we believe that bal- ances in RRSPs or RRIFs should be allowed to roll over tax-free into a registered disability savings plan (RDSP). The government took an important step when it created the RDSP in 2008, and we applaud them for it. Canadians with disabilities can face extraordinary expenses and may be limited in their ability to earn enough to support themselves.
Allowing individuals to bequeath their RRSP or RRIF balances to an RDSP would offer one more way to help people with disabilities live more independent lives.
There are prescribed rates at which funds must be withdrawn from a RRIF. In the first year, 7.38 percent of the balance is withdrawn, in the second year, 7.48 percent of the remaining balance, and so on until age 94, when the withdrawal is capped at 20 percent of the remaining (and presumably declining) balance.
As is the case with the age restriction, this rule forces individu- als to make withdrawals from their RRIF whether they need the income or not " for instance, those who continue working into their seven- ties. They lose their flexibility to do what they want with their personal savings and, more specifically, which of their assets to draw down first.
In addition, the current pre- scribed withdrawal rates may deplete the RRIF too quickly. It is highly unlikely in today’s investment world that investment returns will keep pace with the withdrawals. It is nor- mal to expect that individuals will begin drawing on their principal as their retirement progresses, but they are more likely to outlive their invest- ments if forced to make large with- drawals early on.
For these reasons, we believe the government has an opportunity to extend the life of a RRIF by lowering the rate at which funds must be with- drawn.
Finally, we question whether the annual contribution limit is reason- able under current circumstances. As it stands, Canadians can contribute up to 18 percent of earned income up to $122,222, that is, to a maximum of $22,000 for 2010. Unused amounts can be carried forward. However, if the investments in your RRSP don’t per- form as well as expected, there are no provisions " as there would be for the administrator of a DB plan " to make additional contributions to ensure your retirement is funded to the desired level.
For those earning more than this year’s maximum, they could argue that they are being forced to under- save for retirement " or, at least, are not being given the same advantages of using RRSPs to save for retirement.
The rules also favour households. For example, a couple earning a total of $150,000 ($75,000 each) would be permitted to con- tribute a total of $27,000 to their RRSPs, while the single taxpayer earning the same amount " $150,000 " would be permitted to contribute only $22,000.
In our view, contribution limits should be broadened to be more com- parable to DB pensions and to offer ample opportunity for all Canadians to save equally for retirement.
While others are focusing on broader pension plan reforms, we believe the personal saving compo- nent cannot be ignored. We believe that the three pillars on which we rely for retirement income are sound. Major surgery is not required, but like the boomers themselves, Canada’s pension system is reaching an age where elective surgery may improve its health and make retirement more pleasant. In the longer term, the approach we propose " which is based on the principle that individuals should have the flexibility to manage their retirement savings in the most tax-efficient manner, according to their individual circumstances " will make for a healthier pension regime.