How much should you be contributing to your RRSP? Start with a basic plan
Studies have revealed that most people do not have a financial plan and most do not maximize RRSP contributions. Without a plan it may be difficult to determine when you may retire comfortably.
It also may be difficult to determine how much you should be contributing to an RRSP. There are many different types of financial planning reports with different degrees of information that advisors may provide, but financial planning does not have to be complicated and time consuming. From our experience, investors primarily want to know if they are going in the right direction to reach their goals. The missing piece to the puzzle for most people is determining how much they should be contributing monthly to their RRSP to meet their retirement goals.
The first question we ask our clients who are wondering if they are on track is, how much monthly income (in today’s dollars) do you feel you need to live on? This is a very important question and you are the best person to answer this.
Several financial planning articles try to give guidance as to what this amount should be. We have read some articles that suggest 50 per cent of your pre-retirement income, while other articles suggest 150 per cent. This is a huge range leaving many people confused.
Rather than focusing on your current income or using a percentage of pre-retirement income, we recommend giving careful thought to what your plans are for retirement and what this might cost in today’s dollars. Giving your advisor this number will speed up the process considerably.
Certain types of income are indexed to keep up with inflation. Typical types of monthly income that are currently indexed are Canada Pension Plan (CPP) and Old Age Security (OAS). If you are unsure of the amount you may be eligible to receive for CPP, you may request a statement online through the Human Resource Development Canada website (www.hrsdc.gc.ca/en/isp/cpp/soc/proceed.shtml).
Individuals with a defined benefit plan may also find that their pension is indexed. Pension administrators should periodically send out pension calculations to their active members. You should also be able to request this information from the administrator. Other types of income may not be indexed, such as annuities (although they can be). You should provide your financial planner details regarding your expected sources of income.
The last question you will have to answer is when would you like to retire? Once you have gathered the above information your advisor should be able to give a rough calculation on whether you can retire without selling significant assets such as your personal residence.
Every financial plan or concept will have various assumptions embedded in the calculations. One assumption is the expected rate of return your assets will achieve during your lifetime. Life expectancy itself is another assumption. Future tax rates and actual retirement age are other assumptions used in calculations.
Here’s an example of how a small change in an assumption may have a significant impact.
■ Mr. Sanderson is 50 and has compiled some information for us. Based on the information provided today we have projected that, at age 65, his future monthly after-tax income will be approximately $2,058 from Canada Pension Plan, Old Age Security and independent pension plan. He feels that he needs $4,000 monthly after-tax at retirement to cover expenses representing a shortfall of $1,942.
This shortfall represents $23,304 annually in today’s dollars ($1,942 multiplied by 12). With a three per cent rate of inflation the future annual amount would be approximately $36,307 when Mr. Sanderson is 65 years old. Mr. Sanderson has an RRSP with a current value of $149,000. The missing piece that Mr. Sanderson would like to know is how much he requires in his RRSP at age 65. Or more specifically, what is the monthly amount he would need to contribute to meet his retirement goals. Mr. Sanderson mentioned that his health is good and would like us to use a life expectancy of 88 years. He also would like us to do two calculations, one assuming a very conservative rate of return of six per cent and another assuming a seven per cent rate of return. Mr. Sanderson has an average tax rate of 25 per cent.
Six Per Cent: Mr. Sanderson would have to accumulate approximately $829,000 in his RRSP by age 65. He would need to make initial monthly contributions of $1,363.78 into his RRSP beginning in 2008. The cost of this contribution is only $1,023 per month because of the RRSP tax deduction. Every year Mr. Sanderson would have to increase his monthly contributions by the rate of inflation (three per cent).
Seven Per Cent: Mr. Sanderson would have to accumulate approximately $755,000 in his RRSP by age 65. He would need to make monthly contributions of $912.64 into his RRSP beginning in 2008. The cost of this contribution is only $684 per month because of the RRSP tax deduction. Every year Mr. Sanderson would have to increase his monthly contributions by the rate of inflation (three per cent).
The above highlights how a single percentage point can make a huge difference. The required monthly savings is $1,364 if his RRSP returns six per cent versus only $913 if his RRSP returns seven per cent. The other assumptions noted above may also have a significant impact. Be careful when looking at financial material or plans that have unrealistic long term return expectations. The above also highlights that it can be difficult for investors to reach their retirement goals if they are too conservative.
The above illustration provided Mr. Sanderson a quick snapshot to see if he was on the right track. A change in the assumptions may have a significant impact on whether retirement goals are met. The above calculation does not replace a comprehensive financial plan that may include non-registered investments, real estate holdings, mortgages, debt and other factors specific to each person’s situation.