Every so often a budget makes historic changes; the March 29, 2012, federal budget or Economic Action Plan 2012 is such a document. It will be remembered for three milestones:
- Moving the age eligibility for Old Age Security (OAS) to age 67 from age 65 starting in 2023,
- Eliminating the penny,
- Celebrating Canada as a world leader. Indeed, today Canada leads the G-7 countries — the U.S., UK, Germany, France, Italy and Japan — in economic growth, and has the distinction of being voted the “#1 Best Country for Business” by Forbes Magazine (2011) among 134 countries.
Certainly, the most important provision from the point of view of tax and financial advisors and their clients is the age eligibility for OAS. This is a “heads up” change for the 45- to 54-year-old crowd and one that is hugely unpopular, judging from the 77% of Knowledge Bureau Report poll respondents who were against the move.
However, if we are to understand the full effects of the changes, there are substantive details to explore, including one provision that starts soon. Effective July 1, 2013, Canadians will be able to participate in a voluntary deferral of the OAS pension for up to five years in order to receive a higher annual pension later. Healthy seniors, therefore, may be able to supplement the returns on their investments by postponing the OAS.
It speaks to the need for a highly skilled retirement income planner well versed in tax efficiencies. The phase-in of the age eligibility of 67 is a good decade away and this allows for a savings period in which to fill the gaps left by the OAS. However, today’s budget forecasts continued low interest rates and increasing inflation for at least half that period. Achieving the shortfall may be difficult, given the investment climate predicted by private sector economists in the budget.
The size and effect of that OAS capital gap will also depend on who you are:
(a) The highest-income earners will not be affected at all. If your income is more than $69,562 in 2012, for example, your OAS is already being clawed back.
(b) Clearly low-income pensioners will suffer the most; for this constituency, an alternative to the OAS and Guaranteed Income Supplement (GIS) will need to be developed. Like the OAS, the eligibility age for the Allowance and the Allowance for the Survivor will also gradually increase, from 60 today to 62 starting in April 2023.
(c) Middle-income earners — those with incomes today that fall under the claw-back threshold of $69,562 — will need to plan now. They may plan to work longer before retiring. If they work until 67, this will give them two additional years to compound savings and earn pension credits. However, if they decide to retire at age 65 or before, they will need to withdraw more money from private savings. Those withdrawals will come at the beginning of the retirement period, which has a big impact on capital accumulations for the entire period.
The budget tells us that those who were born on or after Feb. 1, 1962 will have an age of eligibility of 67. Those who were born between April 1, 1958 and Jan. 31, 1962 will have an age of eligibility between 65 and 67. Someone born in April 1960 will be eligible for OAS/GIS at age 66 and one month, as illustrated below:
Note: mon. = months
Source: Table 4.2 March 29, 2012, Federal Budget
So, how do you fill the gap? Consider the following case: a pre-retiree who will have $500,000 in savings when he retires at age 65 by which time the new rules are fully phased in. He will not receive OAS until age 67. That requires $6,500 more be withdrawn (using today’s dollars and OAS pension levels) in each of first two years of an average 20-year retirement period. Here’s what this means to you:
- If your plan is to live off the return earned on the capital and protect the $500,000 for your heirs, the loss of $6,500 in the first two years of retirement will result in a depletion of capital of about $26,5001 – you’ll only have $473,500 at the end of the 20 years instead of the planned $500,000.
- Alternatively, if you were not withdrawing but rather saving your $6,500 OAS receipts each year in the two-year period and the money was invested at 3% return for 20 years, you would be giving up after-tax growth (taxes at 22%) of $23,767. For a couple, that amounts to $47,534. This is not small change.
The run-up time is also going to be plagued by low interest rates. So, just how much you need to save depends on how much time you have to do so, and the rate of return. The young have it easier: to recover the full $13,000 over a 20-year period and assuming a constant rate of return, compounding and no adjustment for inflation, the chart below speaks for itself.
A Tax-Free Savings Account (TSFA) is the logical place to turn. Astute investors will be developing a completely tax-free pension plan for themselves, propelling their wealth much further than the heavily taxed generations of the 1990s, for example. How much can a TFSA help? This depends on the rate of return in the TFSA.
What do retirement savers today need to know? (A special thank you to Robert Ironside’s finance class at Kwantlen Polytechnic University, Vancouver, B.C., for these calculations). Assume that:
• You are currently 40 years old;
• The average annual inflation rate is 2.5% over the next 25 years;
• The real rate is 3% a year that time frame;
• The nominal rate is 5.5% a year.
a) To replace $6,000 of today’s purchasing power will require $11,124 of income in 25 years;
b) To replace the lost two years of OAS, you will need to save an additional $21,285;
c) The 40-year-old will need to save an extra $416 a year (or $35 a month) for 25 years (based on a nominal yield of 5.5%).
The additional savings will drop as the current age of the future retiree drops. For example, a person who is 20 today will need to save an extra $189 a year to replace the lost OAS of $18,227 a year for two years starting 45 years from today.
However, if economic forecasts are accurate, achieving those required rates of return will not be easy, particularly on interest-bearing investments:
- Interest rates will remain relatively low over the next five years: three-month Treasury bills are expected to pay 0.9% in 2012, 1.3% in 2013 and an average of only 2.3% a year in the period 2014-16. Ten-year government bond will pay only 2.2% in 2012, 2.8% in 2013 and 3.5% on average in that same period.
- Inflation, however will exceed those returns in the near future: consumer price index inflation is expected to be 2.1% in 2012 and 2% in 2013, averaging 2% for the period. GDP inflation is higher: 2.4% in 2012 and 2.0% in 2013 leveling off to 2.1% for the period 2014-16. In other words, real returns, for investors will be nil.
- The growth in the Canadian economy will fall behind that of the U.S.: for the period ending 2016; Canada’s average growth is expected to be 2.3%; for the U.S., the number is 2.6%.
1 Calculation based on return rates of 1% in the first year, 2.5% in the second, 3.5% in the third year and 4% in subsequent years. The original plan for $14,518 withdrawal in the first year increased by 2.7% annually. The original plan results in maintenance of $500,000 investment. By removing $6,500 extra in the first two years to cover missing OAS payments results in a reduction in ending capital to $473,300.
It’s Your Money. Your Life. There many decisions to be made about your retirement savings, no matter what your age, as a result of this historic budget. Looking for rates of return that exceed taxation, fees and inflation will become a more important issue for Canadians as they save for retirement and attempt to accumulate, grow, preserve and transition purchasing power into the future.
Evelyn Jacks, president of Knowledge Bureau, is author of Essential Tax Facts 2012 and co-author of Financial Recovery in a Fragile World. To purchase your books, visit www.knowledgebureau.com/books.asp
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