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FINANCIAL PLANNING

Ashok Raturi* is an Electrical engineer from IIT Delhi. He completed his MBA from IIM Bangalore with specialization in Finance.


Retirement in Canada

In Canada, traditionally, 65 years has been considered as the normal retirement age.  This is the age when some government benefits kick in [Read More]

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Wuzz up dude ?

So what’s up ? Well, let’s see. DJ Industrial is down... DAX is down ...Nikkei is down...and oh yes, good ole  London is down about ... Our home Toronto (TSE300) is down about ... and finally, to crown it all, dear ole Bharat (BSE200) is down! [Read More]

 

Retirement in Canada
 

In Canada, traditionally, 65 years has been considered as the normal retirement age.  This is the age when some government benefits kick in; tax treatment becomes slightly different etc. However, from financial planning perspective, ‘retirement’ is really a stage in life when one has accumulated financial assets sufficient (and more) to provide for future life style income needs. At that point in time one may choose to retire to a rocking chair or pursue favourite alternative career, hobby etc. Thus, conceivably, one could retire at 50 or still not be retired at 70.

 

So what are the sources of retirement income in Canada? Well, some of the sources are:

1. Employer sponsored pension plans

2. Registered Retirement Savings plans (RRSP)

3. Non-registered savings

4. Canada Pension Plan (CPP)

5. Old Age Security (OAS)

6. Government Income supplements for individuals/couples with low incomes

 

Let’s take the ‘employer sponsored pension plans’ first. Generally these plans come in two flavours.

 

Defined Benefit Plans: Your pension at retirement is based on a pre-determined formula (defined benefit), which is basically like this:

 

Annual Retirement Pension=Years of service x Employment income at retirement x Pension factor, X 

 

X is a percentage, generally, in the range 1 to 2%. So if you work for a company for 20 years and your employment income at the time of retirement is, say, $60,000/yr, then assuming X to be 2%, your annual pension (at age 65) would be:

Annual pension at 65    =20 x 60000 x 2/100

                                    =$24,000/yr

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 important.

 

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 life!

 

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.

 

In 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.

 

The 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.

 

The 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 previous years.

 

You 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.

 

At 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’.


*Ashok 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 ashok@rifp.net.