TFSAs reduce retirement income risk

Retirement is idealized in advertisements as a time of comfort and leisure.

That’s because it’s when the physical and psychological stresses of work life are laid aside, and replaced by an enriched personal life underpinned by financial security.

You’ve all seen the pictures of fit, smiling senior couples strolling along beaches and gazing at sunsets. I can’t speculate on personal enrichment (since it’s something very much in the eye of the beholder), but I do know that the financial aspect of retirement cannot be taken for granted.

Like any other stage of life, retirement has key financial risks. In 2011, Fidelity Investments Canada published a report entitled “After the Global Financial Crisis: The Five Key Risks to Retirement Income.” Thanks to that report, we know investors should be aware of:

• longevity;
• inflation;
• asset allocation;
• withdrawal rates; and
• health care costs.

Though retirement-age clients have to manage these risks under any circumstances, the reports says the financial crisis and recession of 2008-2009 filled investors with uncertainty for the future and the halting economic recovery we’ve seen since continues to undermine confidence.

As an advisor, there’s much you can do to rebuild confidence. You can start by helping clients develop written retirement plans.

In this article, however, I want to talk about how TFSAs can be used to mitigate the five key risks of retirement. Although individuals are limited to annual TFSA contributions of $5,500, these accounts have some clear advantages when it comes to building longer-term income security.

Living long, and prospering

The evidence is clear that many people need more retirement savings. In 2011, the median retirement age in Canada was 63.2 for men and 61.4 for women, said StatsCan data, compared to 61.3 and 59.9, in 1997. Now, people expect to be retired around age 66.

That’s because they need more funds, especially given the fact life expectancies are increasing. Someone retiring today could well spend as much time at leisure as he or she did at work.

But the prospect of living 30 or more years after retirement increases the risk that individuals will outlive their savings, so potential longevity must be factored into retirement planning.

The role TFSAs can play in this respect becomes evident when you compare them to the principal savings alternatives, non-registered accounts and RRSPs.

Let’s start by comparing a TFSA with a non-registered savings account. Contributions to both are made with after-tax dollars, and both accounts offer similar scope for diverse investments. But while the TFSA will generate tax-free earnings on investments, the non-registered account’s returns will be taxed. Clearly then, reinvested TFSA earnings will be greater than the after-tax non-registered account earnings. And given the impact of compounding over the years, TFSAs will eventually produce higher account balances for your clients.

Your clients can also benefit from the TFSA’s capital gain advantage. When investment assets in non-registered accounts are sold, they can easily trigger capital gains. Half of the capital gain from any sale will then be included in an individual’s taxable income. Capital gains from TFSAs are not included in taxable income, nor do withdrawals from TFSAs incur any tax. From a tax perspective and longer term values then, TFSAs have clear advantages over non-registered accounts.

TFSAs can also have advantages over RRSPs. While contributions to TFSAs are made with after-tax dollars, RRSP contributions are made with pre-tax dollars because they reduce taxable income. Any earnings on investments within a TFSA will be tax free. But while earnings within an RRSP will grow on a tax free basis, they will eventually be taxed as ordinary income when the plan is drawn down.

As a rule of thumb, a TFSA will be preferable for a client whose current tax rate is lower than the expected tax rate in retirement. An RRSP will be the better choice if your client’s current tax rate is higher than the expected tax rate in retirement.

Reducing inflation’s bite

Inflation – the sustained rise in the general level of prices for goods and services – was identified in Fidelity’s 2010 Retirement Survey as the number one financial concern retirees and non-retirees have about retirement.

Their concern is justified; even though we have had about two decades of modest inflation (with increases of less than 2% a year), a continuation of price increases of even this amount could erode the purchasing power of an individual’s retirement income by some 40% over a 25-year period. A higher rate of inflation would have far more damaging effects.

Logically, your clients should ensure that their investments are in the best paying and most tax-efficient accounts possible. TFSAs are tax efficient since the earnings and the withdrawals are tax free and can therefore mitigate inflation risk.

Gaining tax free diversification

It goes without saying that your clients have to pay attention to asset allocation, to select investments that balance appetite for risk with long-term income requirements. Whatever the mix of equities, bonds and short term investments (cash) in a portfolio, it should be productive in generating returns and built to last. Investors must also concern themselves with after-tax rates of return because it’s the after-tax yield that determines how much money they’ll have in their pockets.

The tax rates on different types of investments are also important. An investment with a low rate of return may be competitive with an investment carrying a higher rate of return if the latter is taxed at a higher rate. In Canada, capital gains generally receive the most preferential tax treatment, followed by eligible dividends and then non-eligible dividends. The least tax efficient income is interest income which is taxed as ordinary income.

TFSAs come into the picture here because their tax free status allows investors to hold tax inefficient investments in them in order to maximize after-tax yield. Advisors can help clients not only by reviewing their overall asset allocation but also by encouraging them to consider the after-tax yields of investments and then making sure the tax inefficient ones are held in TFSAs. That way, clients will keep more of their money.

Reducing the pain of withdrawals

The annual rate of withdrawal determines how long a retirement portfolio will last, and even small changes in the rate can have dramatic consequences. In one simulation of a balanced North American portfolio that we ran (in 2011), the funds lasted 25 years at a 4% withdrawal rate. At 5%, duration dropped to 19 years, and at 8%, the portfolio was exhausted after 11 years, not good for someone hankering to be a centenarian. The challenge for retirees is setting a withdrawal rate (and periodically adjusting it) to provide a reasonable standard of living without running down their savings too soon.

TFSAs can help by minimizing withdrawal rates while maintaining standard of living. Like everyone else, retirees pay tax on their income, in their case on entitlements, pension income (including RRIF withdrawals) and investment income. By reducing their tax bill, they may be able to reduce their withdrawal rates from their retirement portfolio, or maintain the same withdrawal rates while enjoying a higher standard of living.

A TFSA can do this in two ways. One, investments inside a TFSA grow tax free, so the investment income they generate isn’t subject to tax. Two, TFSA withdrawals are tax free, unlike withdrawals from RRIFs which are included in taxable income.

A hedge against healthcare emergencies

The same 2010 Fidelity Retirement Survey listed health care expenses as one of retirees’ top concerns. And their uncertainty isn’t helped by the ongoing strains on the public healthcare system. Partly it’s a question of information. People need to understand what is and isn’t covered by government programs. For example, many types of prescription drugs and basic hospital services are covered while newer drugs and services or quality of care options such as rehabilitation, upgraded accommodation in nursing homes or certain therapeutic devices are not.

Your clients are not going to be able to fully anticipate their future healthcare needs, but they should know how TFSAs could eventually help. Withdrawals can be made at any time for any purpose, including unanticipated healthcare expenses without incurring unexpected tax bills.

A versatile financial tool

The basic risks of retirement aren’t going away. If anything, they are becoming more acute as the global economy attempts to recover from the 2008-2009 recession. Indeed, there’s more onus than ever on individual investors to assess their risks and commit retirement plans to paper.

In this regard, TFSAs are not a cure all but they can be very useful. These accounts have been available for 5 years, providing Canadians with $25,500 of accumulated contribution room. Annual contribution room of $5,500 for every Canadian over the age of 18 may not seem extraordinary, but their potential for growth is considerable. And as these accounts grow, they will become an integral part of any investor’s retirement planning arsenal. Their tax advantages in coping with a variety of risks are simply too potent for your clients to ignore.