There's smart saving for retirement, and there's blind saving.
Blind saving is where you contribute money to a registered retirement savings plan, tax-free savings accounts or company pension and hope for the best. Things may work out, especially if you're maxing out on all three. But new data on pension outcomes in retirement suggest some people could be disappointed with where they end up.
This is why it's not enough to just put money away for retirement. You also have to find out what kind of income your current savings regimen will buy when you retire. Be a smart saver by using an online tool such as the federal government's Canadian Retirement Income Calculator or getting some analysis from a fee-only financial planner.
Even people with pension plans need to undertake this exercise, notably defined contribution pensions. Unlike defined benefit plans, DC plans don't guarantee you a set payout every month for life after you retire. Instead, your retirement income is based on several factors: How much you saved (and what your employer kicked in) while working, the returns this money generates when invested both pre- and postretirement, and the amount you withdraw every year in retirement.
Now you see why DB plans are better than DC plans, and why employers are increasingly dumping them in favour of DC. The employer takes on all the risk and responsibilities with a DB plan, whereas it's all on employees to make a DC plan successful.
DC pensions became popular in the mid-1990s, which means it's only now that people are retiring with a significant part of their incomes coming from these plans. "There's all of a sudden a lot more attention being paid," said Janice Holman, a principal at the consulting and actuarial firm Eckler. "Baby boomers are all of a sudden going to be coming through. A lot of them lost their DB plans somewhere in their career, and have been earning under a DC."
Eckler has been looking at how DC plans perform using what it calls its Capital Accumulation Plan Income Tracker. It's designed to estimate a typical DC plan member's replacement ratio, or the percentage of working income that would be replaced in retirement. The tracker's data begin in late 2006 and have shown almost continual deterioration since then, largely because of low interest rates and the effects of the last stock market crash.
For example, someone whose gross earnings were equivalent to $100,000 in Eckler's base year of 2013 would have had a very solid replacement ratio of 72 per cent back in late 2006. As of mid-2014, the ratio had fallen to an adequate but much reduced 51 per cent.
Eckler's assumptions in these numbers:
- Maximum Canada Pension Plan and Old Age Security benefits are included.
- Employee and employer both contributed 5 per cent of gross pay to the pension.
- A 25-year contribution period, from age 40 to 65.
- Invested in low-cost index-tracking funds with 60 per cent in stocks and 40 per cent in bonds.
The tracker does not factor in personal savings – they would obviously improve your retirement outlook.
One further assumption is that people take the contents of their DC plan at age 65 and buy a basic annuity. Few people would actually do this, but it's nevertheless a clean way to compare how much income for life a person's DC pension savings could buy at different points in time.
DC plans typically give employees some discretion on how much of their salaries to contribute, and many do not choose the maximum. In our $100,000 example, someone who contributes 2.5 per cent with a matching amount from her or his employer would have had a dismal replacement ratio of 35 per cent at mid-year, down from an already weak 46 per cent back in late 2006.
Ms. Holman attributes the declines documented by the tracker to the 2008 market crash and persistently low interest rates. Low rates are actually double trouble in that they depress both investment returns and the return people get from annuities.
Lots of investment advisers and investors believe they can do better than annuities by investing in stocks, bonds, exchange-traded funds and mutual funds. Ms. Holman is skeptical.
"People say I can earn 6 per cent, at least, with my broker or adviser. But it's 6 per cent minus your management expense ratio of 2.5 per cent, which only gives you a 3.5-per-cent return." She said that's in line with what annuities offer today, with virtually zero risk.
Annuities aren't really the issue here. Use them, or don't. But do make an effort to not save blindly for retirement.
Globe app users click here for chart showing how far a pension goes