RRSP Meltdown

People who have savings when they retire are faced with tough choices for how to spend their money to get the most out of retirement.  Their instincts to try to preserve their savings often leads them to mistakes such as living too small, overpaying their taxes, and not getting the most they can out of CPP and OAS.

The common investment accounts retirees have are RRSPs, LIRAs, TFSAs, and taxable (non-registered) accounts.  Trying to figure out which accounts to draw from is already a complex problem.  To add more complexity, retirees might have a workplace pension, a possible inheritance, income from part-time work, and face decisions on when to start drawing CPP and OAS.  Fortunately, it’s not important to come up with a perfect plan.  What you need is a good plan that isn’t too far from the best possible.

It’s not possible to go through all combinations of retirement scenarios in a single article.  Instead, I’ll discuss how some good savers go wrong in retirement and some solid strategies to consider for getting a better outcome.  One important strategy is called the RRSP meltdown.

An example of common thinking going into retirement

Meet Jim.  He’s about to retire at 60.  He was never a super-high earner, but his strong saving habits for many years have put him in a good financial position.  He’s got nearly a million dollars invested, most of it in RRSPs.

Jim has always tracked his nest egg closely.  The idea of spending from his savings runs counter to all the habits he used to build that nest egg.  He’d rather find some way to preserve his savings.  This leads him to make the following choices that don’t serve him well.

1. Cut spending

Jim has retirement dreams: mainly travel and a woodworking hobby.  But his nervousness about the prospect of spending from his savings is making him delay booking any travel or buying woodworking equipment.  He doesn’t think of this as cutting spending, but that’s what he’s doing.   

As his retirement begins, Jim is spending much less than he could be spending based on a reasonable retirement projection.  This can be sensible for wealthy people wanting to preserve a legacy, but it’s a problem when retirees cut the fun from their lives out of an emotional need to keep their nest egg growing.

When Jim reaches age 72, he will get a surprise.  His RRSPs will be converted to RRIFs, and the minimum required withdrawals will be larger than what he’s used to spending.  He’ll be upset about the amount of tax he’s paying.  What’s worse is that for 12 years he did little of the travel and woodworking he dreamed about.

2. Seek higher-income investments

Jim “reaches for yield” in the hope of preserving his principal.  There are income funds that promise higher yield, but they often dress up return of capital to look like returns.  Whether Jim goes for high-dividend stocks, covered calls, or income funds, the result is likely to be the same: his principal will dwindle.  He will also be less diversified, meaning that he will be taking on more risk without the expectation of higher return.

3. Take CPP at age 60

To reduce the bleeding from his savings, Jim started his CPP as soon as he could.  His monthly CPP benefits are less than half of what he could have received each month if he had waited until he was 70.

Delaying the start of CPP has the near-term cost of higher spending from savings.  You are essentially buying a larger guaranteed income later in life.  This means lower spending from savings later in life.  For someone of average health like Jim,  the implied price of larger CPP benefits is low, much lower than it would cost to buy a similar annuity.  I say “similar” because you can’t buy an annuity like CPP that is indexed to the Consumer Price Index (CPI); the best you can do is buy an annuity whose payments rise by a fixed percentage each year.

4. Take OAS at 65

If Jim had waited until he was 70 to start OAS, his payments would have been 36% higher.  The implied price of larger OAS payments isn’t as good as it is for CPP, but it’s still cheaper than what it would have cost Jim to buy a similar annuity.

A better plan

It’s impossible to come up with retirement strategies that work for everyone.  There are always cases where a given strategy doesn’t work.  That said, here are some retirement strategies that I use, and that you should at least consider.

1. Know how much you can spend in retirement

Whether you go through a full-blown retirement projection or use some reasonable variant of the 4% guideline, you need to know roughly how much you can safely spend each year at the start of retirement.  You don’t need to be accurate to the penny.  False precision is the enemy of a good plan.

Your plan could be based on constant real spending (rising with inflation), or you could allocate more money for living your dreams in your 60s.  It’s unlikely that your best plan involves scrimping in your 60s to be wealthier in your 70s.

2. Stay diversified in low cost investments

There are many sensible approaches to investing.  Once you’ve chosen an appropriate risk level, it’s important to stay diversified and control costs.  Too many Canadians pay annual fees in the 2% to 2.5% range, and all they get for their money is someone who sells them mutual funds.

Even if you have a financial advisor, it’s important to understand what you’re paying.  Only then can you judge whether you’re getting good value for your money.  Investigate lower cost options such as periodically hiring an advisor by the hour or managing your own investments.

3. Delay CPP

This is where we get to the RRSP meltdown.  Canadians are offered a very good price for delaying the start of CPP to age 70.  That price is paid for with extra spending from savings during your 60s.  This often means spending from RRSPs (or RRIFs), the so-called RRSP meltdown.

In general, Canadians don’t like the idea of delaying the start of CPP.  It’s their money and they want it.  They try not to focus on the fact that monthly payments more than double if they wait the decade from 60 to 70.  Beyond this more than 100% increase, there are also inflation increases.

The main reasons not to delay CPP are if your health is so bad that you’d be willing to spend down all your savings before age 80, or you simply don’t have savings to live on before turning 70.  It’s appropriate to hold back some savings for emergencies or big purchases.  A TFSA is good for this.  If a need for a large amount comes up, a TFSA can cover it without raising your taxes.  If you can’t delay CPP all the way to 70, there’s nothing wrong with delaying it part way through your 60s.

Some people justify taking CPP at 60 saying they want the money while they’re young enough to enjoy it.  The point of an RRSP meltdown isn’t to cut spending.  The goal is to dip into savings in your 60s and spend the larger CPP benefits in your 70s.  In most cases, doing this increases your annual safe spending level throughout your entire retirement.  In my case, the fact that I’m waiting until I’m 70 to start CPP allows me to safely spend more in my 60s.

If you think your investments will outperform the implied returns from delaying CPP, I suggest reading this analysis.  If you have any other reason for wanting to take CPP early, I suggest reading this article.

4. Delay OAS

The case for delaying OAS is less compelling than it is for CPP, but it is still beneficial for some people if they have enough savings to melt down.  There are other complexities, though.  High-income retirees who face OAS clawbacks and low income retirees collecting the GIS need to analyze their situations carefully before deciding when to start OAS.

5. Maintain steady taxable income

A part of melting down an RRSP that can be confusing is that it can make sense even if you don’t need the money to maintain your spending.  For example, I have taxable investment accounts that I spend from, but I still draw from my RRSP each year.  The reason is that I don’t want to waste the low tax rate brackets.

In general, it’s better to delay taxes rather than pay them now.  But the decision is more complex if you’re deciding between paying some taxes now or paying a larger amount in the future.  After I turn 72, I expect the average tax rate on my RRIF withdrawals to be higher than it is on the RRSP withdrawals I’m making now.

My simulations tell me to top up my income to the top of a particular tax bracket.  Every November, I estimate the total income I’ll have for the year (mainly dividends, interest, and capital gains in taxable accounts), and I make an RRSP withdrawal to bring my income up to the top of a particular tax bracket.  The optimal level of taxable income each year depends on your entire financial situation.

The rough goal here is to keep your taxable income steady.  This isn’t the same as keeping your retirement spending steady.  Spending from an RRSP or RRIF creates taxable income, but spending from a TFSA doesn’t, and spending from taxable accounts is somewhere in between.

Conclusion

Retirement spending is a complex area.  Our instincts for how to handle investments and withdrawals in retirement can steer us the wrong way.  There is a set of good strategies to give us a better plan, but they’re not right for everyone.  One strategy that many retirees should consider is the RRSP meltdown.