Saturday, June 30, 2012

Maximum RRSP contributions



Question:

The program does not seem to increase RRSP contribution to the maximum allowed in coming years, even though the Government has announced increased limits.

Answer:

The RRSP maximum annual contributions for future years are in the program.

You need two conditions to hit the annual maximum: high income and high annual savings. If both of these are met, then the maximum will apply.

In order to see RRSP contributions during the first year of your plan, ensure you put the applicable amount for the current year RRSP deduction limit on the 'RRSP Deductions' tab of 'Registered Investments'.

Retirement Income Objective



Question:

I have inserted a retirement expense objective of $33K. The client is 63 years old and retired with only an RRSP portfolio to draw from.

For some reason, in the first year only, the objective is doubled to $66K and thus there is a large withdrawal from the registered portfolio.

How do I fix this issue?

Answer:

The first year of retirement may be only for a few months. So the objective would reflect employment income up to the month of retirement, and a portion of the $33,000 for the month remaining in the year. Also, when the retirement year is in the future, the objective of $33,000 is in terms of "today's dollars", which means it will be indexed between the current and retirement year.

Planning Your Life


You want to live a long and fulfilling retirement? You'll need sufficient funds to do all you want to do for the early years, and pay for medical care not covered by provincial health insurance in the later years.

If you still have a number of years before you plan to retire, you should evaluate where you are with your retirement savings and set the financial goals you need to meet to afford to retire comfortably.

But the first step for planning the rest of your life is knowing where you are today.

An inventory of your money

Many people don’t have a clear idea of how much money they actually have. Finding out how much you can have for retirement starts with adding up the value of all your current assets.

Assets are cash, investments, such as RRSPs, locked-in accounts and investment accounts. Also include the value of real estate property such as your home and cottage. Other assets include the cash value of life insurance.

Then include your liabilities such as mortgage balance, line of credit and loans. Get accurate numbers by referring to account statements. If you can't locate a recent statement, contact the financial institution or access your account online. The bank holding the mortgage can provide the amount of your mortgage balance. Be realistic about how much of your home equity might be worth.

Count only money earmarked for retirement. You should exclude emergency funds and money set aside for your children's education.

Knowing how much you have today, you can now estimate how much you can expect to have at retirement.

Diversify your investment and spread your risk

With your money inventory at hand, determine your asset allocation by adding the current value of each type of investments in basic categories. Here are common asset classes for Canadians:

  • Cash, GICs, money markets
  • Bonds and fixed income investments and funds
  • Canadian stocks and mutual funds
  • U.S. stocks and mutual funds
  • International stocks and mutual funds.

Compare the current allocation of your assets to the investor profile that matches your risk tolerance and the time horizon of your investments. If you don't know, complete an investor profile questionnaire from a reputable Website (including this site).

You can expect different rates of return to apply to each of the different types of savings.
This is why you asset allocation decisions are so important. Higher expected returns mean more risk and more volatility. More risk means a greater chance of achieving low or negative investment returns.

Your risk of loss is reduced by investing in a variety of asset classes and individual investments. The ultimate diversification strategy for equities is an index fund, which is a fund that invests in the same securities and in the same proportion as the stocks of a market index, such as the TSX Composite.

On the other hand, inadequate diversification by having too much money in one or a few types of investment is rarely a good idea. One bad outcome can devastate your portfolio.

How much you'll need for each phase of retirement

All the money we are trying to save up is for one purpose: having sufficient funds to stop working and living off our assets. You can expect that you and your spouse's retirement will last a long time. The longer you have to plan for, the more uncertainty there is.

If you figure out what it takes, you can then start figuring out how to get there. You need to determine what will be your expenses during retirement. Your expenses will change over time because of inflation and because of life pattern.

Early on, you'll spend more on traveling, hobbies, and lifetime dreams. As you age, it is likely that more of your budget will go toward medical expenses.

Start with day one for your retirement budget.

You can think of retirement consisting of three periods. The first part is the active period: travel, sports, hobbies, and the good life. This could be between age 65 and 75.

The second period is the sedentary period: less travel, more time around the house and around town. This would typically be between age 75 and 85. If you're reasonably healthy, your expenses will actually go down.

In the third period you will need more services, particularly for assisted living and health care expenses. Expenses will typically be higher during this time.

You don't know exactly how and when you will go from the first to the second to the third period, but it is reasonable to assign 10 years for each period as a starting point.

The variation in the expenses for each period depends on the difference in the lifestyle you're hoping to live.

Another aspect to consider is the split between essential and discretionary expenses, and the expenses
you need to cover as a couple and if only one spouse is alive.

Inflation is a major factor in determining how much money you will need in retirement since even a modest inflation rate adds up to a big difference over time. Medical costs have risen faster than inflation over the last 20 years, and this trend is expected to continue indefinitely. Provincial health care does not cover everything. For most, drugs and many hospital services, including long-term care must come out of our own pocket.

Do not forget about vision and dental care, which are not covered and will be a continued expense for the rest of your life.

Where and how will you live?

Your future housing needs must be a top priority. You must have an idea of how this will play out, because expenses related to housing is an important component of the budget. If your mortgage is paid off, you still have to pay for heating, utilities, property tax, and maintenance and repairs.
Eventually, your house will no longer be adequate: too many rooms, too many stairs and too much maintenance. You will have to consider other types of housing. Retirement living facilities, designed for reasonably healthy older people, often commands high rental costs. Where more assistance is required, costs can be prohibitive.

This is where long-term care insurance can make sense. It can protect your assets by paying for medical care in a nursing home

Premiums vary by the features you choose, such as the amount of daily benefit paid and inflation protection. If you're considering a policy, get advice from a professional, because long-term care insurance is complex and each product is different in their coverage.

Friday, June 22, 2012

Five More Retirement Planning Pitfalls!


Looking to improve our odds

Last time, we looked at five major retirement planning pitfalls and pointed out ways to improve odds of achieving financial security.

We complete our list with five more in this post.

6. Early death of a spouse

There are two cases to plan for: you die first and your spouse dies before you. Thinking that that the typically older male will pass away before a younger female spouse is only one possible scenario.

You have to look at the consequences of the early death for each spouse. How will be each do, considering the many years the survivor may live?

If the surviving spouse's budget reduces substantially,  with the combined assets remaining untouched, then it will have little effect on financial security.

A decrease in income from reduced survivor pensions or lifetime pensions ceasing at death may require a reduction in expenses.

Here are a few ways to protect each other:

  • Estimate what expenses will decrease after death, such as food costs. As a rue of thumb, the surviving spouse may be able to maintain her standard of living on about 80% of what was required when both were alive.
  • Ensure each spouse has the appropriate type and amount of life insurance. You can set up a policy to pay the face amount on either, the first, or the last death.
  • Select a "joint and last survivor" pension option if you have a defined benefit pension plan with your employer.
  • Consider purchasing a joint annuity with a portion of your retirement savings.
  • Determine which income sources will be lost or reduced (such as CPP) when a spouse dies, and how any shortfall can be met going forward if required.

7. Long-term care

This is a topic we don't like to think about.

We tend to think we'll never need long-term care (LTC). Few can afford to self-insure and fewer buy long-term care insurance coverage.

A few things to consider when planning for this possibility:

  • LTC insurance is quickly evolving, so keep abreast of what is available, review coverage and premiums of each carrier.
  • Premiums increase rapidly with age, so consider it as soon as possible while premiums are still affordable.
  • Think of the financial impact for your spouse and for your estate goals if you do require long-term care.
  • Review what your provincial health care covers in these situations, and whether the level and quality of care is sufficient for your needs.

8. Saying no to annuities

We just love receiving a cheque each month for life.

However in practice, few set up their retirement to eliminate the possibility of running out of money.

In essence, we are trying to self-insure against long life and this is very difficult to do.

Having lifetime income that doesn’t depend on the vagaries of the capital markets greatly reduces the chance of having to reduce your standard of living in retirement.

Consider investing part or all of your savings in an annuity. If your sources of lifetime income (Government plus annuity) cover your essential expenses, you've eliminated the financial consequences of living longer than you ever thought.

Remember that as interest rates go up, annuity premiums go down. This is because premiums are determined based on funds earning fixed income rates of return.

Here are a few ideas to deal with the (desirable) prospect of living a long life:

  • Work as long as you can, even on a part-time or contractual basis to reduce the period of time you'll need to rely solely on retirement savings.
  • If you have a defined benefit pension plan, do not take a lump sum option when retiring or leaving your employment; only consider it if you are a long way from retirement.
  • If you have a defined contribution pension plan or group RRSP, consider using these funds to purchase an annuity when you reach your retirement age.
  • Ensure you have enough guaranteed income to meet your budget for essential expenses.
  • Get professional advice to decide how to allocate your assets between portfolio investments and an annuity.
  • If you have a spouse, consider a joint and last survivor annuity, so both of you can benefit from the lifetime income it provides.
  • Consider staggering your annuity purchases over time to take advantage of lower premiums as you become older, and reduced premiums if interest rates rise.
  • Determine the amount and payment terms for you and your spouse for each source of retirement savings. This includes CPP, OAS, a defined benefit pension and annuities.

9. Lack of Investing Knowledge

In the last 20 years, there has been a shift in responsibility from Government and corporations to the individual for covering financial needs for retirement. We need to save over our working career and manage our invested funds.

And this requires that we increase our knowledge in this area in order to earn decent returns and avoid common pitfalls.

Here are ways to address our shortcomings in this area:

  • Get a solid understanding of financial products (stocks, bonds, mutual and segregated funds, etc.)
  • Review your asset allocation and rebalance regularly in order to be in line with your target asset mix.
  • Do not listen to forecasters, prophets of doom or irrational optimists. The future is unknown and will unfold differently than their predictions. If they get it right time, it’s more than likely because of luck.
  • Do not attempt to time the market and don't sell when times get tough. You will be missing out when markets rebound.
  • Consider investing in target date funds, which automatically shift the asset allocation to a more conservative portfolio as you get closer to retirement.
  • Invest tax-effectively: it's the after-tax return that counts. Put fixed income investments in your RRSP and equities in a taxable account.
  • Your target asset allocation should be measured against all your assets: registered and non-registered.
  • Seek professional advice if you can't handle your investments.
  • Invest in accordance to your risk tolerance. Do not take more risk than needed.
  • If you'll have more than enough money, you don't have to take undue risk.

10. Getting Poor Advice

It's okay to discuss with friends, family and co-workers who are not financial professionals, but do take any advice from them with caution.

Consider the following when it comes to receiving advice:

  • Get your information from reliable sources: online and offline.
  • A financial professional can assist you to sort out your retirement planning issues and help you formulate your goals and plan to meet them.
  • Ask financial professionals for their credentials, in particular their retirement planning expertise.
  • Ask how your financial professional is compensated, in particular whether compensation varies based on the product you are investing.

We touched briefly on approaches to deal with some of the most important post-retirement risks: longevity, inflation, untimely death of a spouse and long-term care. We will expand on each of these in future posts.

Wednesday, June 13, 2012

Five Retirement Planning Pitfalls


Improving our odds

Financial services companies and Government alike have made major efforts in recent years to educate the public about the need to prepare financially for retirement and motivate them to save.

Nevertheless, despite these major efforts, surveys routinely confirm that a large segment of the population lack retirement planning and investing knowledge.

The baby boomers are the largest generation in history of the western world, and they will be retiring over the next twenty years. They have high life expectancy and high lifestyle expectations, and will face increased health care costs in the midst of disappearing defined benefit pensions and uncertain public pension schemes.

How can we improve our odds of achieving financial security? By avoiding these five common retirement planning pitfalls. In our next post, we'll also explore another set of five pitfalls.

1. Insufficient savings

Most people have no idea how much they'll need for retirement in order to maintain their standard of living.

Here are a few ideas on how to ensure you'll have enough money:

  • If you have a company pension or savings plan, contribute as much as possible to get matching employer contributions.
  • If your employer does not have a retirement plans, maximize your contributions to a registered retirement savings plan and tax-free savings account.
  • Calculate how much you will need using retirement planning software (including ours!)
  • If you cannot achieve this target, look at alternatives, such as working longer or adjusting your retirement lifestyle.
  • Within ten years of retirement, start thinking in precise terms how much you'll need each year by completing a post-retirement budget.
  • Develop a plan to pay off all debt, including your mortgage before you reach your retirement date.
  • Plan your sources of income, such as the Canada (or Québec) Pension Plan, Old Age Security and defined benefit pensions.
  • Monitor your retirement savings to see if you are on track to meet your goal.

2. Unplanned retirement

More often than not, we don't choose our retirement date, it chooses us when we least expect it and are not ready.

This is retirement by default: loss of employment, health issues, disability. The older you work, the more common illness or disability will strike.

You can guard against an unplanned retirement by saving as much as possible from an early age.

To bridge the gap in these early years, get disability insurance with your employer. If not available, get personal disability insurance.

If you are forced to retire early due a job loss, consider part-time or seasonal work to supplement your retirement income until Government benefits become payable in full.

In a more general way, learn about the risks you will face at retirement and the various strategies you can use to protect yourself.

3. Unknown longevity

I hope you live a long life. And more than likely you will. In fact, if you have a spouse, odds are one of you will live 30 years or more after retirement.

This is a very long time to live off your savings, and there is a significant risk you or your spouse will outlive your savings.

You can use a life expectancy calculator to estimate your life expectancy. Some calculators take into account health characteristics to get a more precise number.

Look at the odds of living longer than average and ensure you have the financial resources to meet your expenses for this entire period.

If your resources are insufficient, scale back your retirement lifestyle in the early years.

4. Where is the money?

You must know what your sources of lifetime income are and where the money will come from to fill any gap relative to your budget. And you must be careful not to overestimate and be realistic -- especially when it comes to rates of returns you hope to earn in the future.

Make a list of retirement income sources. The most common retirement income sources include:

  • Canada Pension Plan (CPP),
  • Québec Pension Plan (QPP),
  • Old Age Security (OAS),
  • Supplements for low income seniors: Guaranteed Income Supplement (GIS) and provincial programs,
  • Company pensions
  • Savings plans,
  • Annuities,
  • RRSPs and Registered retirement income funds,
  • Locked-in Retirement Accounts (LIRAs) and Life income funds,
  • Tax-free savings account (TFSA),
  • Taxable investment accounts, and
  • Real estate (a home, cottage or investment property).

If you continue working on a part-time or contractual basis. include the income for the time you expect to continue work.

Keep your records handy and update them regularly. Track your account balances and estimate your investment return.

Estimate how much income each investment account you intend to withdraw from will provide.

Think about what you plan to do with your home equity and learn how home equity can be used as a source of retirement income: downsizing, selling, line of credit or reverse mortgage.

5. Erosion of income by inflation

Inflation has been modest in the last 20 years. But even at 2%, it chips away at your purchasing power over time.

You must plan not for a fixed lifetime income, but one that increases each year by the rate of inflation.

If you plan for an annual "pay" increase of , say, 2.5%, you likely won't suffer a reduction in your standard of living down the road.

Remember that your retirement budget will evolve over time: initially you will experience higher living expenses while most active, followed by a period of more sedentary lifestyle, then possibly increasing again late in life as long-term care becomes a necessity.

Determine whether income is inflation-indexed for each source of lifetime income. All Government sources are fully indexed to inflation: CPP, OAS, GIS and provincial supplements for low income seniors. Company defined benefit pensions are usually not indexed, unless you are in public service.

Since you must plan for an increasing stream of income over time, you should start with a lower initial amount that will increase each year.

Understand the impact of inflation over a long period: even at a modest 2.5% annual rate of inflation, your goods and services will be over 60% more expensive after 20 years. Retirees may experience higher inflation than the general population because health care costs have been increasing at a much faster pace than other goods, and this trend is expected to continue indefinitely.

Ensure your investments are ones that keep up with inflation, such as real return bond funds or real return exchange-traded funds, and keeping an exposure to equities, which in theory are a hedge against inflation.

Investment Property



Question:

On taxes: how does the software handle capital gains on other property. I have added a property, that is not my principal residence, but I do not see any related taxes in the year of disposition.

Answer:

1. Select the percentage that will be used as a source of retirement income in 'Other Assets'

2. In 'Sources of Income', select 'Other Property' as a source of retirement income.

If you use 100%, the tax should show in the year of disposition. If you select less than 100%, a proportionate tax is allocated to non-registered investments and shown in 'Accumulations', and the remainder is accounted for in the last column called 'Other Assets'.

Friday, June 1, 2012

Approaches to Managing Risk


Assessing Risk

"Fish see the bait, but not the hook; men see the profit, but not the peril." -- Chinese Proverb

Risk Analysis starts by identifying threats and then estimating the likelihood that those threats may occur.

A risk can be assessed by evaluating at the potential severity of the loss and the probability of occurrence.

Perhaps the most widely accepted formula for risk quantification is:

Risk = Rate of occurrence X impact of the event

For example, suppose you flip a coin and if you get 'heads' you have to pay me $100. Your risk value is:

50% (Probability of Event) x $100 (Cost of Event) = $50 (Risk Value)

Three Approaches

Three approaches can be used to assess post-retirement risks:

  • Finding the expected loss based on the odds for the occurrence,
  • Gauging the impact of an occurrence with stress testing, or
  • Evaluating the impact of a risk to a moderate change in outcome using sensitivity testing.

The nature of each risk determines which approach is most appropriate to quantify the exposure.

How to manage risks

Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories:

  • Avoidance (eliminate)
  • Reduction (mitigate or control)
  • Transfer (outsource or insure)
  • Retention (accept and budget)

The selection of the approach or combination of approaches depends on the nature of the risk under review.

All risks that are not avoided or transferred are retained by default. Some approaches to managing risk fall into multiple categories.

Risk Avoidance (elimination of risk)

Risk avoidance is completely avoiding a situation that poses a potential risk. While attractive, this is not always practical. By avoiding risk we forfeit potential gains, for example by avoiding investment in equities.

Risk Reduction (mitigating risk)

With this approach, we try to reduce the extent or possibility of a loss. This can be done by increasing precautions or limiting the amount of a risky activity.

For example, reducing the allocation of your investments to equities reduces the magnitude of a catastrophic loss from a market crash. Diversification of assets is another form of risk reduction, because the various asset classes are never perfectly correlated and are sometimes even negatively correlated.

Risk Transfer (insuring against risk)

This approach means insuring the risk, for example buying life insurance or an annuity. The risk is transferred to a third-party, usually an insurance company.

The risk is still there, that is the adverse event can still occur, but you will not suffer any monetary consequences from it. Early death of a spouse is compensated with the face amount of the insurance policy. Income will continue as long as you live when you purchase a life annuity, so your longevity risk is removed.

Risk transfer using insurance is risk sharing. In exchange of paying their premiums, all insured pool their resources and share the risk. Statistically, only a small number of individuals will experience an early death for example, while the others continue paying their premiums.

Risk Retention (accepting risk)

Risk retention means accepting the risk. Even if the risk is mitigated, if it is not avoided or transferred, it is retained. Retention is effective for small risks that do not pose any significant financial threat. Retention is unavoidable in certain circumstances: an individual may not be able to afford or obtain health insurance.

In other situations, you may decide to accept a risk because the cost of eliminating it is too high. Your only option is then to reduce the risk by introducing safety measures.

Risk management process

Risk management is not something you do once. It is crucial to constantly review and monitor risks and revise your plan when circumstances change. It is also important to ensure that the approaches you have put in place to deal with the consequences of an event are still effective.

Monitoring ensures risks have been identified and assessed and that you have the appropriate controls in place. You can document all this in a risk management plan, setting out your risk tolerance and selected approaches to risk management.

The process of risk management results in improved decision-making, planning and prioritization and an optimal allocation of your resources. It allows you to anticipate what can go wrong and minimize or prevent serious financial loss.

In short, it can significantly improve your odds of avoiding ruin or a financial disaster.

Evaluating and ranking risks

It is worthwhile to rank the risks once you have identified them. This can be achieved by considering the consequence and likelihood of each risk. Prioritizing risks allows you to focus on the most important risks.

Ranking lets you quickly identify which risks you need to focus on.

Using one of the approaches to quantify risk, we can get a risk rating representing the significance and likelihood of the risk occurring. Each risk can be rated on a scale from 0% to 100%. If a risk is rated 100%, it means that it is completely managed. If it is a significantly lower percentage, you can then decide what type of controls should be implemented to mitigate or eliminate the risk.

Risk management plan

You can put systems and controls in place to deal with the consequences of an event that has the most serious consequences. This involves defining an approach to manage the risk and have an escalation process that you can follow if the event occurs.

There's no point in spending more to eliminate a risk than the cost of the event if it occurs. It may be better to accept the risk than it is to use excessive resources to eliminate it.

When you decide -- or have no choice but to accept a risk, develop a plan to minimize its effects should it happen. A good contingency plan will allow you to take action immediately.

Review

Once you've carried out a risk analysis and managed the most important risks appropriately, conduct regular reviews. This is because the costs and impacts of some risks may change, other risks may become obsolete, and new risks may appear.

A prevention plan defines the activities that need to take place periodically to monitor or mitigate the risks you've identified.

Be flexible

With all this sophisticated mechanisms in place, it is important not to lose sight of the need to be flexible when faced with emerging events that change your circumstances and expose you to a dire situation.

There is always more than one way to skin a cat, so keep yourself open to multiple options and forge ahead with your life.

Defined benefit pensions



Question:

1. My spouse, age 59, will retire in June of this year (at age 60) with an unreduced defined benefit pension (Government of Canada). Where does this pension amount go?

2. The pension does not show up in "Income & Cash flow forecast" until age 65. Why not from age 60?

3. Why do RRIF withdrawals show up prior to age 71 when minimum withdrawals is selected?

4. How do I enter the age of entitlement for an unreduced pension?

Answer:

1. If you know the pension amount, enter it as a 'prior defined benefit' pension in 'Company Pensions'.

2. Ensure you select 'company pensions' in 'Sources of Income'. Also, select age 60 for the age of pension commencement.

3. The latest age and minimum will apply only if other funds or income are sufficient to meet the retirement income objective. Otherwise, funds are drawn from a RRIF when they are required.

4. You select the age at which the pension will be paid on the last tab of 'Defined Benefit', and the program will apply the early retirement reduction rule and unreduced pension age rules specified in the 'Early retirement' tab.

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