RRSPs are a great mechanism for retirement savings but if you contribute the maximum allowed each year for your entire working life, will you have enough to retire?
If you’re not using all up of your RRSP contribution room every year, you should start doing that as soon as you can. You don’t need a nicer home, you need to be able to pay the bills when you are unable to work.
(Note: It's important to think of it as unable to work not unwilling to work because while you may be willing to work until you die, you never know when you won't be able to physically do it any more.)
For anyone who hasn’t yet looked into retirement savings or is not Canadian, here’s what RRSPs are: you can stick a certain percentage of your income into an investment account each year. You get a refund on all the tax you paid on whatever amount you put into that investment account. Then your investment grows, and when you need it, you can take money out of the investment account, shove it into your normal bank account, and pay normal income tax on it. It has tax taken out just as if you were being paid by a job.
What I’m curious about is that percentage. The tax men say you can put away 18% of your income up to about $26,000 per year into a RRSP for your retirement.
I was wondering if that limit is high enough. That is, if you use that limit every year and don’t save anything else, then will you have all the retirement savings you’ll need.
How much would you retire with?
Let’s say you work for 40 years. From age 25 to 65. Let’s also say you make the average wage in Canada, which is almost $50,000. We’ll use $50,000 for easy math.
18% of $50,000 = $9,000.
So you can shove nine grand into your retirement account each year. Over 40 years, that’s $360,000. Plugging those numbers into FireCalc, and you could take a retirement salary of somewhere around $10-15,000 depending on how the market goes. Not enough.
It’s also completely irrelevant because I didn’t include interest. Unless you put your money into a non-interest RRSP, you’d get more than $360,000.
At a 5% annual return, for example, you’d have $1.14 Million. That should let you take a retirement salary of $40-50,000. Add your government pension of roughly $13,000 and it looks like your retirement would be just fine. Peachy, even. At the same salary you’ll have more money to spend because you won’t be saving for retirement anymore. That’s an extra $9,000 / year you’re not putting away. So the same $50,000 salary will feel a lot looser in retirement.
So it looks like the government’s finance guys know what they’re doing.
Or do they?
How many 25-year-olds do you know max our their RRSP contributions? I would say none, because any of them who are doing that probably don’t have any friends.
I didn't think about retirement at 25. I was 25! I could barely open a milk carton.
A more likely scenario is that you start saving for retirement when you start getting scared of dying. Even if you want to save in your mid-20s, there are those pesky student loans to pay off and not to mention the never-ending onslaught of marketing and social pressure making us waste our money.
I say if you’re debt-free and maxing RRSP contributions by 35, you’re ahead of the curve. Fortunately that RRSP room for all those wasted years carries over so all you really lose is the compound interest effect.
Unfortunately, it's a big impact.
Let’s say you start putting away money for your RRSPs at 35, and use your 45 years of RRSP room evenly over 35 years. Same $360,000 going into your investment account, but over 10 fewer years because life is difficult.
Using the same 5%, you end up with about $630,000.
That’s a retirement salary of $30-40,000. You’re going to need that government pension in this case. You’ll probably still be fine on this salary, but it will be tight.
Unfortunately, it’s far more complicated
That 5% could land anywhere
I've been factoring out inflation, but it can be a major factor. The 5% I use is a more normal 7% return accounting for 2% inflation. But there's no promise that your investments will return that much. You could get a 7% annual return no problem. You could also lose 25% of your entire investment account in a single year, like many people did in 2007-2008.
The only way to reduce the risk is to over-contribute. You’d want a retirement fund that’s over and above what you’d need. Better to leave the rest to your children than have to rely on your children.
Yet another reason to avoid paying high investment fees.
So for a 40-year working life, I’m not sure the RRSP limit is high enough. It’s a tricky line though because if you raise the RRSP limit, you reduce government tax income from high-income earners who could shove more of their money in there. And someone earning $50,000 a year is unlikely to be able to save more than $9,000 per year anyway.
I think this is some of the reason they created the TFSA in 2009. But I never thought of that as a long-term retirement thing. More a save-up-for-a-car-or-vacation-or-house-repairs thing.
After looking into this, there’s definitely an issue here. The system is not set up for a person making the average wage to retire with confidence. And it certainly ignores common behaviour, which is perhaps the bigger issue. Shouldn’t the system be set up for the way we actually think and behave, not the way we want to?
So two things:
First, max out those RRSPs as soon as you start working and every year afterwards. Make it priority #1.
And second, the tax and retirement system is too complicated. I get that the lawmakers and economists and even some normal folk understand it, but I think we can do a lot better on the UX of taxation and savings.
Or maybe we don't need to care. Basic income is coming to solve these (and so many other) issues. We just may be dead before it comes.