As we covered earlier in this series, the single biggest mistake when saving—for retirement or anything else—is not saving at all. If you spend everything you earn, by definition you have no surplus and won’t even get a start on saving for retirement or any shorter-term savings goal.
The second biggest mistake is failing to take advantage of government programs designed to encourage retirement saving and that provide the incentive of a tax break. If you’re in an employer pension plan, you’re partially covered off automatically, and that’s also the case with the Canada Pension Plan; the CPP is likely to be expanded now that Justin Trudeau’s Liberal party is in power.
But it would be a mistake to rely on those two plans exclusively when Ottawa also provides tax breaks to save in RRSPs and – since 2009 – Tax-Free Savings Accounts (TFSAs).
Depending on your tax bracket, one of these may be preferable to the other, although ideally both should be maximized. Generally, low-income earners just starting out and low-income near-retirees with few other income sources will be better off with TFSAs. If you’re in the top tax brackets, the upfront tax deduction of RRSPs is more compelling.
But remember that eventually, the wealth accumulated in these plans must be drawn down in retirement. TFSAs and RRSPs have a radically different tax treatment at that stage: the sweetness of the upfront RRSP tax break is offset by the sour taste of forced taxable annual withdrawals once an RRSP becomes a RRIF (after age 71).
By contrast, the TFSA offers no upfront tax deduction (hence it’s often underestimated by young workers) but the beauty is that in retirement it will create no tax liability whatsoever. That means it also will ensure that you won’t lose money to the dreaded clawback of Old Age Security benefits, which should begin as early as 65 for all Canadians, in light of the Liberal majority government. Ditto for the Guaranteed Income Supplement or GIS.
Sadly it appears the $10,000 annual TFSA contribution limit introduced the past summer when the Conservatives still ruled will be slashed back to $5,500 in the New Year. But that just means what room we are permitted becomes that much more precious and should be maximized as soon as possible. Remember, you don’t need new money to contribute to a TFSA: you can “transfer-in-kind” securities from taxable plans, although doing so may incur one-time capital gains tax hits.
Doug Dahmer, president of Emeritus Retirement Solutions, says one of the biggest and most common mistakes is the failure to recognize that the success strategies investors relied on during their accumulation years “actually turn on their head and bite them when the flow of funds reverses from saving to spending in your retirement draw-down years.”
Dahmer quips that while dollar cost averaging works well in the wealth accumulation years it can morph into “dollar cost ravaging” in the decumulation years. “The goal of tax deferral that was central to use of pensions, RRSPs and TFSAs in your early years of saving can create dangerous tax traps once it comes to trying to draw income from these vehicles.”
The problem is that, ironically, time has changed from friend to enemy: the volatility that in the accumulation years provided an opportunity to lower your cost base and enhance rates of return instead causes portfolios to deplete faster than anticipated. This is the dreaded “Retirement Risk Zone” popularized by finance professor and author Moshe Milevsky: retirees are most at risk in the five years preceding and the five years following their chosen retirement date.
Dahmer also thinks it may be a mistake to hold the belief held by older generations that they will be able to protect their principal and live solely off the interest or dividend income generated by their capital. “While many people have fallen asleep as it relates to the impact of inflation, the reality is the cost of funding retirement has gone through the roof. In a world of 2.5% yields I need a portfolio of $2,400,000 to deliver a before-tax income of $60,000 per year.”
Compare to previous generations, when 10% interest rates meant they needed only $600,000 to generate the same amount of annual income ($60,000).
A related mistake is underestimating life expectancy. It’s quite possible that you may need to fund an extra decade or even two decades of life, meaning that nest egg with limited returns must work even harder.
Thankfully those extra decades are being added to the years between traditional retirement and true old age; the so-called “Go Go” years. But Dahmer cautions those are the same years that require greater cash flow to fund desired activities.
Sadly, all this means investors must be prepared to draw down on principal, which in turn requires superior investment talents and greater discipline than may be possessed by traditional investment advisors oriented to wealth accumulation.
All the more reason to lament the passing of the old-fashioned Defined Benefit pension plans: “Most Baby Boomers are just now waking up to the reality that with the demise of the defined benefit pension plan—a whole bunch of risks and responsibilities have been quietly transferred to them—responsibilities previously handled by talented and disciplined pension plan managers.”
Go back to:
Part 1: The biggest mistakes you make with your savings »
Part 2: The biggest mistakes you make when paying down debt »
Part 3: The biggest mistakes you make when selling your home »
Part 4: The biggest mistakes you make when investing »
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Jonathan Chevreau founded the Financial Independence Hub and can be reached at [email protected].