If you don’t have a Defined Benefit Pension from your employer, and you want to supplement whatever Old Age Security and the Canada Pension Plan will provide (which likely won’t exceed $20,000 a year in today’s dollars), then you’ll want to build up a nest egg of your own.
These nest eggs might come in the form of a Defined Contribution Pension Plan, a group RRSP, an individual/spousal RRSP, a TFSA or other forms of non-registered savings. Most retirees have accumulated a lump sum in one or more of these accounts that is now available as an income-producing asset upon retirement.
So, what to do with it?
There are essentially two alternatives to choose from when deciding how to convert a lump sum amount to an income-producing stream of payments. The first is the Registered Retirement Income Fund (RRIF); the second is the Annuity. [There is a third, the Life Income Fund (LIF) which is similar to a RRIF but only accepts money from locked-in retirement accounts. I won’t review those today.]
The RRIF is a popular choice for many because it works like a reverse RRSP. When you decide to ‘collapse’ your RRSP (which you MUST do in the year you reach 71), you can convert the entire proceeds to a RRIF. In the year you reach 72 you MUST withdraw a certain percentage of the value of the RRIF as fully taxable income.
Some people ask ‘Why do I have to pay tax on all of the RRIF value; isn’t some of it tax-paid capital that I contributed to it as an RRSP?’ The answer is yes and no. While the money contributed to an RRSP is after-tax capital, the tax deduction you got for contributions actually makes the RRSP work more like a tax-deferred vehicle. The government will give you a refund based on your working marginal tax rate, and then tax the RRIF as income based on your retirement tax rate (beneficial for most). Plus, the growth within the RRSP (and RRIF) grows tax-free – another great benefit.
In the year you turn 72 you must withdraw a minimum of 5.4% of your January 1 RRIF balance as taxable income. There is no maximum withdrawal rate. And while the money can be invested however you want inside the RRIF (again, like the RRSP), you must continue to withdraw higher percentages each year until death.
Many Canadians prefer the flexibility of the RRIF: They can invest their retirement assets how they want, and they can withdraw any amount over the minimum each year. The RRIF also gives retirees the comfort that whatever balance is left in their RRIF when they die (after the full remaining amount is taxed as income in the year of death) is passed down to beneficiaries. If there is a surviving spouse, the RRIF can be transferred to them tax-free.
On the other hand, Annuities are quite a different option for the retiree. When a retiree purchases an Annuity, they are essentially giving up control of their principal in return for a guaranteed monthly payout, which is typically until death. This means that the retiree does not need to worry about how to invest their nest egg, they needn’t worry that they will ‘run out of money’ and they can count on a guaranteed income for life. The biggest pitfall is that the Annuity is worth nothing upon death – so there is typically nothing for beneficiaries to receive.
There are many different shapes and colours of Annuities. Some offer guaranteed payout periods of say, 10 years. So even if you died the year after you purchased an Annuity the payouts would continue to your beneficiary for those nine additional years. Some are joint-life annuities, so payouts continue until the ‘last to die’ of the spouse/common-law partner. You can purchase an indexed Annuity, where the payouts increase by an inflation factor. So there is an Annuity that fits just about everyone’s needs.
And they are taxed similarly to RRIFs. If you purchase an Annuity with registered funds (like with the proceeds of your RRSP), then each monthly payment will be fully taxed as income. If you purchase an Annuity with non-registered funds, then only the interest will be taxed each year.
The option that is right for you will depend on many factors. It depends on your adversity to risk, your money personality, current interest rates (which will dictate the guaranteed value of Annuity payments), whether you want to control how money is invested and whether you want to leave money to your beneficiaries. It also depends on how big your nest egg is.
And for those who can’t decide, you’ve got the option to do both. There is something comforting about having a guaranteed flow of income each month, while also controlling another nest egg more directly, some of which will pass down. The right money professional can help you make the right choice, and make sure your hard-earned money is doing all it can for you during your retirement years.