The cold, hard reality is most people need to save for retirement. Government benefits like Canada Pension Plan (CPP) and Old Age Security (OAS) are generally not enough. Combined CPP and OAS might be as much as $1,500 per month, but most people don’t qualify for the maximum benefit. The average is about $1,100 per month, and I don’t know many people who could live off that—even really frugal people.
According to a study by Deloitte, the savings rate in Canada is 3.51% while the saving rate in the US has climbed to 6.26%. Some have said that savings rates are affected but interest rates. If you think about it, savings rates peaked out back in 1981 at a 17% savings rate. In other words, people were saving 17% of their income. This coindentally happened where interest rates were also at their peak. Do we need interest rates to go higher to get people to save more?
How much should people save?
Although interest rates are low, that does affect people’s need to save for the future. But how much do people really need to save? One very common benchmark for savings is 10% of your gross income. Although this figure has been used for a long, long time, I first read about it 20 years ago when I read my first personal finance book, The Wealthy Barber by David Chilton.
Another benchmark in Canada is so save 18% of your gross income. This figure stems from the RRSP rules. In order to maximize your RRSP contributions you need to put away 18% of your gross income. Although rules are slightly more complicated than that, it can be a good (but not easy) target for savings.
Where can you save for retirement?
In Canada, there are a few common ways to save for retirement on your own:
Registered Retirement Savings Plans are very well know in Canada as an account that every Canadian can use to save for retirement. RRSPs are appealing because of two key tax benefits. First you get a tax deduction when you put the money into the RRSP and then you get the benefit of tax deferred growth. The learn more about RRSPs, visit my RRSP online guide.
2. Tax Free Savings Accounts
TFSAs have only been around since 2009 and the interest in these financial accounts is growing. Despite the merits of TFSAs and their growing popularity, TFSAs will not replace RRSPs for saving for retirement. When it comes to debating TFSAs vs RRSPs, both have merits. Instead of choosing one or the other, maybe it makes sense to do both. I love the TFSA but as I see it, the biggest problem is that many people do not have the discipline to leave the money there for retirement. It’s so easy to access this money and while that has advantages, it may not be ideal to save for retirement.
Prior to the introduction of the TFSA, your really had the choice of putting money into a RRSP or investing it outside of RRSPs (non-registered). The TFSA has really made the non-RRSP less attractive except that the TFSA limits prevent people from putting all their money into the TFSA.
Workplace savings plans are usually the best place to save for retirement. In fact, a 2011 survey by Fidelity Investments suggests that more than half (55%) of current participants say they would not be saving for retirement if their employer did not offer a savings program. The study also found that 19% of these participants have no retirement savings at all outside of their employer’s plan.
1. Group RRSPs
Group RRSPs are one of the most common workplace plans. They are very similar to individual RRSPs, except they are administered on a group basis by the employer. Employees make contributions to the Group RRSP directly from their paycheque, and the tax savings from the contribution can be applied immediately. Some employers even match a percentage of the employee’s contribution.
2. Pension Plans
Pension plans are are the foundation of retirement planning. Unfortunately not every one is part of a pension. They are only offered through your work. There are two basic types of pensions – Defined Benefit Plans and Defined Contribution Plans.
- Defined Benefit (DB) Pension Plans pay employees a future retirement benefit that is known in advance, based on a formula that incorporates years of service, salary and a pension factor. In most cases, the contributions to the plan are shared by both the employee and the employer. These contribution amounts can change depending on whether the plan is sufficiently funded to meet its future obligations.DB pension plans really reward long-term employees. People who retire with a defined benefit pension tend to have more stable, guaranteed income in retirement. Unfortunately, outside of the public sector there are fewer and fewer DB pension plans today, because they are costly to administer and the funding liability is shared by the employer.
- Defined Contribution (DC) Pension Plans are becoming much more common than DB pensions because they are less costly and there is no funding liability on the employer. Under a DC plan, the future benefit is unknown: it depends on how much money is put into the plan and the rate of return earned on the investments—which means that employees bear the market risk.What is “defined” in this plan is the amount of the contributions, usually expressed as a percentage of income. For example, an employee might contribute 5% and the employer will match that contribution for a total of 10%.
3. Deferred Profit-Sharing Plans
DPSPs are similar to DC pension plans, whereby an employer distributes a portion of pre-tax profits to selected employees. However, unlike a pension plan, employees do not contribute to the DPSP. DPSPs have become increasing popular in regions where pension plans have moved to immediate vesting because DPSPs still allow employers to put vesting periods on employer contributions
4. Pooled Registered Pension Plans
PRPPs are the new kids on the block when it comes to workplace savings programs. The federal government introduced PRPPs in 2011 to address the concern that millions of Canadians do not have a workplace pension plan. PRPPs are a type of defined contribution pension plan designed to help smaller businesses and self-employed entrepreneurs save for retirement. The idea is that smaller employers can pool resources with other businesses to enjoy a cost-effective pension plan that is easily administered.
Which account is the best?
Just like I always say, the simple answer is “It depends”. I’ve always said planning is personal and the best way to save for retirement really depends on your personal circumstances. Here are some general rules of thumb to help you out:
- Defined benefit pensions lead to more security in retirement because of the guaranteed lifetime income.
- People who contribute to pensions through work generally have an advantage over those that don’t because of the ‘free money’ from the employer and also the forced discipline of saving emposed on the employee
- The principles of cashflow are universal
- Outside of pensions, start with the RRSP first. Use my ONE FORMULA approach to determining if RRSPs make sense
- Success comes from being a disciplined saver. Do you have the savings gene? Developing the savings habit early can be one of the best financial habits you will ever develop.
- The principles of saving for retirement are truly simple, not easy.