Just graduated? Time to start your retirement plan (really)
By Jennifer Empey, CFP® 19 May 2022 8 min read
When contemplating what your future holds, it’s certain your retirement will be vastly different from that of your parents. You need to plan for a future that is uniquely your own. And that starts with you and your earning power. In this article, we’ll explore how to use your earnings to grow your savings over time, and, through the science of compounding, make your retirement nest egg grow.
Starting out on the right path
To make sure you set out on the right path when planning for retirement, we need to address a few misconceptions about retirement planning that can lead you astray, before you even start.
Myth #1 Retirement by age 55 is totally reasonable and realistic
The notion of retiring by age 55 is based on a marketing and brand construct created by a life insurance company in 1984. In reality, a full retirement at that age may be difficult to achieve without other sacrifices. Consider this—if you start a full time career at age 24 you will have worked 31 years by age 55. Given increasing life expectancies, if you live to age 90 your retirement savings has to last 35 years—four years longer than you actually worked! Accumulating sufficient savings to achieve retirement at age 55 requires a supreme level of savings discipline throughout those 31 working years, and may require the exclusion or deferral of other life goals.
With discipline however, retirement prior to the current conventional age of 65 might just be doable.
Myth #2 The rule of thumb that you will need 65 to 75% of your pre-retirement earnings to cover the costs of your retirement lifestyle.
Planning to have only 65 to 75% of what you earn today may actually lead to a shortfall in retirement as the other rule of thumb that does hold true is that the more you make the more you spend!
More importantly, you won't spend in a consistent pattern throughout your retirement. You may need more in the early years when you have greater capacity for leisure and travel, and many need occasional lump sums for large ticket items, like a vehicle replacement, or a home repair.
In our previous article How to harness your earning power for future savings, we set the foundation of budgeting needs versus wants (both current and future) and outlined some recommendations for targeted savings towards mid- and long-range goals as well as an emergency fund.
Here we provide tips on how to save for the retirement you want (even if you don't quite know what that looks like yet).
How to pay your (future) self first
Let’s work through some numbers. Setting aside the world of Bitcoin and Ethereum for the moment, we’ll work through a conventional retirement savings strategy using Registered Retirement Savings Plans (RRSPs). Tax-Free Savings Accounts (TFSAs) have their place in your overall savings strategy but RRSPs have some unique tax advantages worth exploring.
RRSPs are a cornerstone of many Canadians’ retirement savings. In summary, an RRSP is:
- A tax-advantaged savings account. RRSP contributions create tax deductions, investment income earned within RRSP accounts compounds on a tax-deferred basis and withdrawals are generally included in taxable income.
- To maximize the benefit of this account, it’s recommended RRSP holders contribute during their high-income-earning years, maximizing the benefit of the tax deduction. This is followed by withdrawing funds when the holder is retired and likely at a lower tax rate.
- Your RRSP contribution room is determined by:
- x multiplying your previous year’s earned income by 18% (up to the allowable maximum for the tax year),
- - less any pension adjustments
- + plus any unused contribution amounts from previous years.
In our previous budgeting article, we discussed an average new grad salary of $55,000. Continuing with this number, let’s calculate their RRSP room. A new grad who earned approximately $55,000 in 2021, and does not participate in an employer-sponsored pension plan, can contribute $9,900 to their RRSP in 2022. Whether contributing the full amount of your available RRSP contribution room is the right amount requires a little more analysis.
Want to retire early? Be aggressive with your savings
For an age 60 retirement, you will likely need to save 15% of your gross (pre-tax) income yearly if you start at age 25, and your savings must increase as your income increases. If you start your retirement savings later in life you will have to increase the percentage of your income you set aside for retirement even more, as you have a shorter period in which to accumulate funds. For instance, if you wait to start saving for retirement until age 30 but still want to retire at 60, you now need to save 18.5% of your gross income every year.
Unlike the rest of your budget where you spend after-tax dollars, an RRSP contribution should be budgeted before tax. Referring back to our example graduate, their net income annually (after-tax, Canada Pension Plan contributions and Employment Insurance premiums) is approximately $42,000 before accounting for the impact of an RRSP contribution.1
When our graduate contributes 15% of their $55,000 salary to an RRSP ($8,250) they get an RRSP contribution receipt which they can use to claim a deduction against their taxable income. This reduces their taxable income to $46,750 and reduces their income taxes by approximately $2,300. So, the actual after-tax cost of the contribution is no longer $8,250; it’s actually $5,950.
Does saving 15% a year towards retirement really work?
Yes! Here is the math using our new grad earning $55,000 as an example:
So we can see this savings strategy could result in an RRSP balance of over $1,000,000 at the age of 60. Let's now consider the retirement income this RRSP could provide throughout retirement.
Let's put $53,000/year in registered retirement income into perspective. If our grad was able to increase their income 2.4%/year from 25 to 60 their projected income at age 60 would be $129,000. On balance, $53,000 a year in Registered Retirement Income Fund (RRIF) income is only 41% of the last year's employment income. However, this won't be your only source of income at retirement. You may also qualify for government pensions such as Canada Pension Plan (CPP) and Old Age Security (OAS).
As a new graduate, if you earn pensionable employment income or earn net self-employment income in excess of $3,500/year you will pay into the Government of Canada’s CPP program. This program was enhanced in 2019. CPP benefits have begun to grow to replace one-third of the average working earnings received after 2019 versus the one-quarter received under the old program. The maximum limit used to determine your average work earnings will also gradually increase. The current yearly maximum pensionable earnings is $64,900 for 2022.
Unlike CPP, OAS pension amounts are not determined using your employment history. Benefits are determined based on your residency in Canada after age 18.
Maximize your employer benefits
If the prospect of setting aside 15% or more of your gross income appears daunting, there may be good news—in the form of employer-sponsored retirement programs. When looking at potential employers and the total level of compensation you may receive, never discount benefits offered by your prospective employer.
These can include extended health and dental coverage, lifestyle protection (such as life and disability insurance), and most importantly, a group retirement savings program, which may come in the form of the following:
This employer-sponsored retirement savings plan is administered on a group basis and employee contributions and often have a matching component by the employer. Employer contributions are considered a taxable benefit to the employee; but you receive an offsetting RRSP contribution receipt for all employer and employee contributions.
This is a registered plan that allows employers to share part of their corporate profits with their employees. The employer may or may not contribute in years where the corporation earns no profits. Contributions are tax-deductible to the employer and funds grow inside the employees plan on a tax-deferred basis.
Contributions are set at a ”defined amount” such as a % of your salary. Employer contributions are mandatory and employees may or may not be able to contribute as well.
This is unique from the other forms of employer-sponsored plans as the benefits you accrue as an employee are based on a formula that multiplies your earnings with your years of service and a participation factor, expressed as a percentage such as 1% or 2% of salary. This form of retirement plan provides employees with monthly retirement income payable as long as they live versus an accumulated lump sum they can draw upon, as is the case with the three previous types.
This plan is not a registered plan, therefore returns are not sheltered from taxes and employer deposits are considered taxable benefits to the employee. This plan generally allows an employee to purchase shares in their employer and their contributions are often matched by the employer.
Some employers may offer other methods of participating in their profits and usually provide some incentives for doing so.
If you are comparing potential employers, don't just compare wages. Look at the total package. The greater the percentage of your required retirement savings that can be paid by your employer, the less personal cash flow you’ll need to meet your goals.
If you are considering becoming a gig worker, check out Four tips to thrive as a gig worker for valuable advice.
When starting your career after graduation, setting up a budget and sticking to it will allow you to prioritize your financial needs versus wants. During your budgeting process, the most important step you can take is to pay yourself first and make this a priority over all the other potential expenditures you may want to make. The amount you need to pay yourself will be driven by how many years you will need to replace your income when retired. The longer the retirement duration the higher the proportion of your income you need to set aside today. Similarly, the shorter the duration you have to save, the higher proportion of your income you need to save.
Calculations assume an Alberta resident individual with the following tax credits: basic personal amount, Canada employment amount, CPP and EI.
Source: Trading Economics, Canada Average Weekly Earnings YoY, 1992 until 2021; https://tradingeconomics.com/canada/wage-growth
Source: Bank of Canada, Core functions, Monetary policy, Inflation, https://www.bankofcanada.ca/core-functions/monetary-policy/inflation/
Return based on a blended moderate risk portfolio, weighted 60% equities and 40% fixed income,returns based on forward looking returns for asset classes as recommended. FP Canada Projection Assumption Guidelines 2021.
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