In recent times the importance of retirement planning has been increasing significantly. At some point the steady income individuals earn will ultimately come to an end, and it is crucial to be financially prepared for this time. With the average life expectancy increasing, the requirements for funds post-retirement are vital, and it is important to acknowledge that the Canadian Pension Plan and other government benefits may not be sufficient. In most Muslim countries where developed social programs for seniors is almost non-existent, parents would typically rely on their children to support them in post-retirement years. However, these cultural norms are changing around the world. Due to these shifts in values, it may not be the case anymore where parents can completely rely on their children after retirement so the need to plan ahead is greater than ever for the Muslim community.
One of the major factors that might stray people away from investing for their future is the risk associated with it. There are several different avenues for risk, whether it be exchange rate risk, inflation risk, political risk etc. But one of the risks that are often overlooked is the longevity risk. Longevity risk can be defined as the economic consequences of outliving financial resources. This risk entails of living longer than expected, and hence the capital saved up is insufficient. When a finite amount of capital must provide lifetime income, portfolio management often becomes a tug of war between capital preservation (terminal wealth) and lifetime spending (consumption). The balance between these two factors: terminal wealth and consumption, is crucial when preparing for retirement.
With inflation at a 30 year high, Longevity risk has increased substantially. One simple way to understand this is looking at an informal index invested by The Economist magazine in 1986 called the Big Mac Index. It’s a lighthearted way to measure the purchasing power of money. For example, a Big Mac from McDonald’s cost around $1.89 in 1986, and $5.59 in 2021. This is an increase of over 200% in just 35 years, which equates to an average annual increase of approximately 3.2%. Inflation reduces the purchasing power of money. This concept is known as the time value of money. As time passes, due to inflation the value of the dollar will decrease.
The average increase in price for the Big Mac is a reasonable indicator of the inflation rate. In the last 30 years, inflation has been around 2% to 3%, however in the last year we have seen significant increases in the inflation rate – reaching up to 7.8%, and therefore it is becoming a growing concern in today’s age. Even though this high rate may not sustain in the future, it is safe to assume that we will face on average higher than normal inflation rates. With this changing environment, it is important for us to start preparing for our retirement and battle the effects of higher inflation rates. Tying this back to longevity risk, we see that due to high inflation, our terminal wealth will decrease but is still important to keep that balance between wealth and consumption.
Tools for Retirement
One of the most common retirement tools is the Registered Retirement Savings Plan (RRSP). It is a savings plan, registered with the Canadian government that you can contribute to for retirement purposes. You can contribute to this account while gaining many tax benefits, and when the time comes the account turns into a fund that will provide direct payments once retired. The growth of the RRSP investments is also tax-sheltered, meaning your returns are exempt from any capital gains tax, dividend tax or income tax. However, once you retire, the payments you receive from the fund are taxable, but typically at a lower rate than your working years. Another benefit of an RRSP is that there are Spousal RRSPs also available, which allows for income splitting at retirement. A higher earner (spousal contributor) may contribute to a Spousal RRSP on their spouse’s name (the account holder).
Pension Plans and Defined Benefits Plans
These are both forms of pensions. In principle, a portion of your salary is kept aside throughout your career, and once you retire, you receive an income stream from the money that was saved. These plans can be company-sponsored, where the employer will have a certain formula that will calculate the amount of your guaranteed scheduled payments once retired. Unlike the RRSP, where you can actively manage your retirement funds, these funds require little to no involvement. However, like RRSP, the income you receive once you’ve retired is also taxable. In Defined Benefit Plans there is some flexibility regarding your future payments. In some cases, if you wanted to leave your profession earlier than scheduled, you can opt-out of the pension plan and instead take upon a lump sum amount that would have been given to you later as payments. Taking on the lump sum amount, allows you to take control of your retirement funds in the same way as an RRSP. The most known example of a Pension Plan is the Canadian Pension Plan (CPP). As you must have noticed, on all paychecks a certain amount goes towards our individual CPP, and we are entitled to receive this amount once we’ve retired.
Tax-Free Savings Plan
A Tax-Free Savings Plan can be used to complement pre- and post-retirement years. It is a tax-exempt account, where you can contribute towards and invest without any tax liabilities. Capital gain, dividends and income are not taxable in this account; however, it is important to note that US sources of income are subject to 15% IRS withholding tax. Furthermore, in a TFSA account, withdrawals are not taxed and do not count as taxable income, which is the case in RRSP and Pension plans.
Real Estate and Non-Registered Investment Accounts
Another great tool for retirement is real estate. As you grow older you may start to experience empty nesting, when your children get married and eventually leave the house. With fewer people living in the house, the need for a large home with three to four bedrooms starts to deteriorate and you may want to sell the house. With the proceeds and capital gains from selling real estate, it is common to put this money into a Non-Registered Investment Account and allow your investments to grow. This is an account where you can invest an unlimited amount of money, but all realized gains, dividends and income are taxable.
Investment Tips for Retirement
When planning for retirement many different variables would need to be individually addressed. A very important factor is understanding your time horizon. The time horizon is an investing timeline, in other words, how long you plan to hold an asset before selling it. In terms of retirement, the number of years you expect yourself to work for can be considered as a time horizon. People differ from one another, and some may be willing to work longer than others, and hence it is key to have a unique plan for yourself. Another factor that is worth addressing, is your spending needs post-retirement. Not everyone will have the same spending habits after retirement, so it is necessary to plan for your retirement according to your individual spending needs. With all these factors in place and several others, the portfolio you hold for your retirement funds needs to be appropriately distributed. Whether it be mainly investing in stocks or a less aggressive approach in investing in Sukuks, it is important to find that right balance. A Financial Advisor could be key in finding that right balance when investing for your retirement. Individually planning for retirement can be rather cumbersome, and sometimes the help of a professional may be of great value.