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’.
