Retirees have become reliant on their employer-sponsored pension plans, Old Age Security and Canada Pension Plan for a comfortable retirement.
But when these pensions are threatened in any way, it can have a significant impact on your retirement.
These plans are changing - and not necessarily for the better.
Recent reports indicate many companies in Canada are having real problems with their defined-benefit plans and funding benefits. With interest rates at extremely low levels and equity markets uncertain, it has put many employers in a material pension shortfall position.
To address these problems, companies are looking at how the pension is structured and making decisions that do not favour the employees. Employers are also looking to reduce benefits, such as health and dental care, as a way for companies to save costs.
The biggest change for some companies is changing defined-benefit plans to defined-contribution plans.
Defined benefit plan
With a defined benefit plan, the employer is committed to providing a specified retirement benefit. The "benefit" is established by a formula, which normally takes into account the employee's years of service, average salary and some percentage amount (usually between one to two per cent). The key point is that the employer bears the risk of pension fund performance. Another key point is that employees are able to calculate their benefit with more certainty than a defined contribution plan.
Defined contribution plan
The "contributions" made into this type of pension plan are established by a formula or contract. Many defined-contribution plans require the employer and/or employee to contribute a percentage of an employee's salary each month into the pension fund. The employer does not make a promise with respect to the amount of retirement benefits. This leaves the employee to bear the risk of pension-fund performance in a defined contribution plan.
Between the two types, the defined benefit plan is normally viewed as the better type of plan for employees. As noted, the employer bears the risk with defined-benefit plans. Employees have more certainty with a defined-benefit plan. Unfortunately, most companies are choosing the defined contribution plan to avoid having unfunded liabilities and shortfalls as a result of low interest rates and market conditions. With the defined-contribution plan, employees are generally given a choice among different types of investments (conservative, balanced or aggressive). It is up to the employee to select their own investments (from the group plan offering), even if they have no knowledge in the area.
In planning for the most likely outcome, it appears pension plans will offer less for retirees in the future.
As pensions deteriorate, it is even more important to look at other ways to supplement your income at retirement.
Registered Retirement Savings Plans should be used by all individuals without an employer-sponsored pension plan.
Even if you are a member of a pension plan, an RRSP may be an effective way to build additional savings and gain investment knowledge.
With defined-contribution plans, many employees are required to transfer the funds to a locked-in RRSP upon retirement. If you have both a defined contribution pension plan and an RRSP, we recommend that you periodically look at these accounts on a combined basis to review your total asset mix (the percentage in cash, fixed income and equities). This is a wise exercise because it helps in the investment selection for both the pension plan and your RRSP. As an example, you may choose to have the defined-benefit pension plan invested 100 per cent in fixed income, and rely on your other accounts to provide the emergency cash reserve and equity exposure.
Tax Free Savings Accounts are a great way to build savings on a tax-free basis. How you invest within the TFSA is really dependent on your goal. It is important to note that the funds in your TFSA do not have to stay in a bank account, as the name somewhat suggests.
What is your current goal for the TFSA account? How does it fit into your overall retirement plan? Is the purpose of this account to act as an emergency cash reserve currently?
At some point, these accounts are going to be significantly larger, exceeding most recommended emergency cash amounts. The TFSA investment approach should be consistent with your objectives and risk tolerance. If the funds are not required immediately, then we encourage clients to have a combination of growth and income.
Purchasing a blue-chip equity with a good dividend (four per cent or higher) can provide both growth and income over time. If income is not needed today then it can be reinvested until you need it at retirement.
Non-Registered Accounts are as important as RRSP accounts at retirement.
When we talk about nonregistered accounts, we are referring to both investment and bank accounts. Both hold after-tax dollars that can be accessed with no tax consequence.
When I prepare a financial/retirement plan, one of the important areas I look at is the ratio of non-registered to registered funds.
Having funds in a non-registered account at retirement does provide more flexibility. If all funds are within an RRSP or RRIF, it becomes more challenging to come up with funds for emergencies.
Retirees who have built up savings within RRSPs, TFSAs and non-registered accounts will be better prepared to deal with further changes to pensions. Regular contributions and savings into these three types of accounts over time will put more certainty on being prepared for retirement.
Relying solely on your pensions and the government for a comfortable retirement could set you up for disappointment.
Kevin Greenard CA FMA CFP CIM is an associate portfolio manager with The Greenard Group at ScotiaMcLeod in Victoria. His column appears every second week. Call 250-389-2138.