How much do I need to save for retirement? It’s the most common question asked of financial planners.
Of course, the response depends on how much you’ve already set aside, how much you need to live on now, and how much you want to (or must) spend in those later years. That’s the core of financial planning, and there’s a lot of information to be gathered, decisions and assumptions to be made, and calculations to be applied to come up with viable options and sound recommendations — and even then, there is still some degree of uncertainty.
This doesn’t mean that you don’t go to the effort, particularly if you are the financial planner tasked to make those recommendations. The critical step of any plan though, is putting it in motion.
Heuristics – The appeal of simplicity
In the face of what may feel like a laborious and elusive task, people often prefer to use a heuristic, for example “save 10 per cent of your income.” This is also known as the 10 per cent rule. Because it is so simple, it may very well get things moving, which in fairness, is a victory in itself.
Once good saving habits are established and experience gained, adjustments can be made that cater to changing circumstances.
Even so, 10 per cent is just a nice, round, but otherwise arbitrary figure. The aura that surrounds it should not be confused with the principled due diligence that informs good financial planning.
Do you apply it before or after…?
If we’re not careful, the apparent simplicity can be misleading. How you apply it is equally and arguably more important than the rate you choose in the first place. Too little and there’s not enough when you need it. Too much and the budget stress could be overwhelming, perhaps leading you to abandon the initiative you have taken. Consider these key tax issues:
Is the 10 per cent set before or after income tax?
In other words, are you applying it to gross income or net income? As a rough example (which varies by province), the average tax rate at $100,000 is about 25 per cent.
So, do you target $10,000 based on the gross, or about $7,500 based on the net? That could hinge on the mechanics of how you save.
If you pre-calculated $10,000 then you could pre-authorize a proportionate dollar amount from each paycheque/auto-deposit.
If instead you took 10 per cent off each deposit after it is in your account, it would come out to $7,500.
Are you saving with before-tax or after-tax dollars?
As compared to the first question, which was about the amount to save, this is about deductibility. Put in more familiar terms, you could make a deductible RRSP contribution, or a non-deductible TFSA deposit.
While you can get more into the RRSP to begin, eventually that is taxed on withdrawal before you can spend. TFSAs face no further tax. You’ll need to look at tax rates now (known) and in retirement (assumed) to properly compare. If you’re doing some of each, the arithmetic is more challenging.
Pre- or post-payroll?
If you contribute to a workplace group RRSP, your employer will generally reduce its withholding tax, as it knows of this deduction. When you contribute to your own RRSP, the annual withholding will likely exceed your actual tax due, resulting in you receiving a tax refund. While you don’t have to, reinvesting the refund effectively boosts your savings rate.
Canada Pension Plan?
The CPP is a savings program, with a base premium of 4.95 per cent. It is withheld by your employer, so most people wouldn’t notice or think of it as saving, per se. But depending on your response on the preceding questions, it could be quietly baked into your savings rate. And with premiums increasing to 5.95 per cent over the next few years, and an additional four per cent premium on higher income levels after that, it warrants a closer look to make sure it dovetails with your intentions.
Housing and mortgage?
What does housing have to do with it? Well, equity in a house is a type of saving, usually by first saving a down payment then servicing a mortgage. As an owner, you defray some of your future shelter costs, whereas otherwise you would need more savings to pay future rent. Whether this is before, after, or part of your 10 per cent depends on your circumstances, which is why a holistic financial plan should underlie your efforts.