Both the employer and the employees fund these plans. The
employee’s contribution is fixed at a certain percentage of the
employment income. However, the employer carries the burden of
funding the plan adequately, so that the future liability related
to the employee’s pension is met. In this sense, these plans are
excellent from the employees’ point of view (you know what you are
contributing and you also know what you are getting). However,
these plans place an additional financial burden on the employers
and for this reason, many employers choose to move away from such
plans. Also, in the recent times it is becoming increasingly
difficult to visualize a scenario where an employee will stay for
twenty or more years with one single employer. In order to enjoy
the full benefits of such plans, a long length of service is very
Defined Contribution Plans:
In these plans both employer and employees contribute at a
predetermined rate (usually a percentage of employment income).
The employee is offered a range of investments within which both
the employer and employee contributions may be invested. Usually
the employee has the responsibility of making the investment
decision. Naturally the pension income that may be derived from
these investments will depend on the size of contributions,
investment rate achieved and time period. In other words, in these
plans you know what you are putting in (defined contribution)
but you don’t know for sure what you are going to get. Naturally
such plans suit the employers since now they don’t have to promise
you a future pension. For the employees, these plans bring the
element of uncertainty in their retirement plans. Well, that’s
Registered Retirement Savings Plans (RRSP): As the name
suggests this is essentially a retirement savings plan (RSP) that
has been registered. Generally speaking, you can choose whatever
investment meets your investment & savings criteria as your RSP
i.e. every year you could set aside $X in an investment of your
choice and think of it as your retirement fund. Naturally you
would be funding such an account with your after-tax dollars and
furthermore, every year you would be taxed on any income
(dividend, interest etc.) generated by these investments.
Conversely, when you choose to withdraw these funds your tax
liability would be limited to the capital gains on the
investments. It is in this tax treatment that a RRSP differs from
a conventional RSP.
an RRSP the amount that you contribute
to your RRSP is tax deductible i.e. if you contribute $1,000 to
your RRSP, you can reduce your taxable income by $1,000, which
would reduce your tax liability.
income generated by investments within the plan, are sheltered
from taxes i.e. say in year 2001 your plan generated an interest
income of $1000. While doing your tax return for year 2001, you
will not include this amount in your taxable income. This is ‘tax
free compounding’. a very powerful feature of RRSPs.
maximum amount that you can contribute to your RRSP in a
particular year is (18% of your previous
year’s earned income or $13,500 whichever is lower) minus (Pension
Adjustment. a figure that reflects the value of the benefit
derived during the year from an employer sponsored pension plan)
plus any Unused RRSP contribution room carried forward from
can withdraw these funds any time. However, in the year of
withdrawal the entire withdrawn amount is treated as income and
taxed accordingly. Therefore, barring any unavoidable financial
emergency, you would not draw funds from this plan except during
the retirement stage.
age 69, the entire RRSP has to be rolled over into a Registered
Retirement Income Fund (RRIF) from which you have to take out at
least a certain minimum amount (specified by Canada Customs &
Revenue Agency – CCRA) every year. Though you cannot contribute
any RRSPs to the RRIF plan, the plan still continues to enjoy its
tax-sheltered status. Since RRSP
contributions and withdrawals have tax implications, these plans
have to be registered with the government and supervised by a
Trustee. The trustee essentially ensures that the specific
investments meet the government criteria of eligibility and issues
tax receipts for contributions & withdrawals.
Most financial institutions in Canada offer RRSPs and there is
multitude of eligible investments ranging from Savings a/cs,
Canada Saving Bonds, GICs to mutual funds, stocks, bonds etc.
While RRSPs are generally touted as a great tax-planning vehicle
(which is true), its main strength lies in ‘tax free compounding
generally over a considerable length of time’. For a 40 year old
with life expectancy of, say, 80 years you are looking at 40 years
of tax-free compounding. That’s powerful!
Wuzz up dude ?
So what’s up ? Well,
let’s see. DJ Industrial is down 5% this year. DAX is down 9%,
Nikkei is down 10% and oh yes, good old London is down about 12%.
Our home Toronto (TSE300) is down about 15% and finally, to crown
it all, dear ole Bharat (BSE200) is down about 25%! Pardon me for
not mentioning a few exceptions like Mexico, Australia etc. that
have actually posted positive numbers this year. In short,
globally the markets and consequently, the investors have been
‘depressed’ for over a year now. Considering that prior to that we
were having a great Bull market for a very long time, the arrival
of the Bears has ruined the party for a large number of investors.
So when did it all begin? Last summer with the onset of Technology
sector meltdown? Did it have anything to do with the preceding
breathtaking rise in the darling of technology stocks the NASDAQ
composite? You remember someone referring to ‘irrational
exuberance’? Then there was that changing of guards between the
‘old economy’ and the ‘new economy’. The global village tied
together with the internet, linked with super fast communications,
and of course the biotechnology revolution…..all that was going to
change our lives the way we know it.
What does all this do to our financial plans and investment
strategies? Have the market forces undergone a fundamental change
and if so, should we discard our old financial tools and invent
new ones? To understand this let us do a quick recap of what
financial planning is all about. Your Net Worth (assets less
liabilities) represents where you are today, financially speaking.
This is what you have managed to accumulate so far. Let’s call
this point ‘A’. You have some financial goals….retirement,
children’s university education ($10-15k/yr in Canada), reduce
taxes (we are one of the highest taxed countries and we are
working hard to be number one!) etc. Each goal would have a time
frame (retire in 30 years) and a dollar cost ($5000 per month
income at retirement) associated with it. Let’s call one of these
goals as point ‘B’. A financial plan would examine these goals in
light of your current financial situation (Net Worth & Cash Flow)
and suggest workable strategies for achieving those goals. This
effectively is the path that takes you from point ‘A’ to point
‘B’. Some of these paths may involve investing money such that the
future value of these portfolios is sufficient to meet the cost of
the particular goals. For each of these investments the ‘time
frame’ is a critical factor.
Why is ‘time’ a critical factor for investments? Well, time
represents your ‘investment horizon’. Every investment has a time
horizon associated with it. For example, money deposits with banks
etc. guarantee you your principal and may be suitable for
investments with a short time horizon. At the other end of the
investment spectrum we have investments related to stocks (oh
those wonderful tech & biotech stocks) which do not guarantee the
principal but do promise (not legally enforceable, unfortunately)
considerably higher returns on your investment. These investments
are ‘volatile’ meaning that over short periods of time their
prices may fluctuate dramatically. Which means that such
investments may not be suitable for an investor with a short
investment horizon. For example, if you had bought Nortel,
Canada’s pride & jewel, last year at $120 hoping to make a ‘quick
buck’, you would be lucky to get $15 today. In other words you are
out of luck. On the flip side you would have learnt the value of
picking investments consistent with your investment goal.
So what is an investor to do in this stock market? Back to basics.
Fundamentals. Simple as that. Do you have a workable financial
plan? Why are you investing? What is your investment (time)
horizon? Do you have the time and the financial wherewithal to
weather the storm? For short-term goals (buying a car in 6 months)
use simple guaranteed investments. For long term (e.g. retirement
for people south of 60) consider stocks related investments. If
you like a new sector in it’s infancy (biotech?) and you have a
long term horizon (and the appetite) then consider mutual funds
instead of individual stocks. And always ask yourself ‘Am I an
investor or a Speculator?’ If you are an investor odds are you’ll
get through the mess we are in today. If you are a speculator, you
may want to search the net for keyword ‘Prozac’.
Raturi is an Electrical engineer from IIT Delhi. He completed his
MBA from IIM Bangalore with specialization in Finance. After
pursuing Project Management for some time, he moved into the field
of Financial Planning 8 years ago. He now has his own financial
planning practice for individuals & families where, in his words,
he ‘happily dispenses advice, financial & otherwise’. He may be
contacted at firstname.lastname@example.org.