There are many risks that Canadians face when planning for retirement, both during their pre-retirement and post-retirement years. The federal government's recent flip-flop in tax reform for small business owners is a classic example of this. Governments profess to help citizens in planning for their golden years, but ill-conceived income distribution philosophies and tax policies can actually do harm to Canadians during their pre-retirement savings stage and to their post-retirement available spending.
As a result, financial planners and financial advisors must be aware of the effects of unpredictable government policy and calculate and mitigate the consequences of this important variable when helping their clients plan for retirement.
The Society of Actuaries has published many research reports over the past 10 years around these risks for both Americans and Canadians. These risks can be categorized into public policy risk through direct government policies for taxation and entitlements, and the indirect effect of government fiscal and monetary policies on inflation, interest rates and stock markets.
Here's a more detailed look at these risks and potential mitigation strategies for lowering the level of these risks for retirees:
- Public Policy Risk. These include future increases in taxes (income, property and consumption) as well as limits and clawbacks on government-controlled retirement plans and entitlements. Some recent examples of these risks include the reduction of the TFSA's annual contribution limit and the Canadian Revenue Agency's limits on the accumulated values and trading activities within TFSAs.
When planning for the future, it's worth considering the following possible public policy risks that could affect your clients' ability to save for retirement and the money they have available to spend in retirement: Will income tax rates rise with current government deficit spending? Will property taxes rise along with house values? Will the HST rate stay at 5%? Will a future government once again raise the CPP entitlement age?
Some simple solutions are to balance contributions between tax-deferred vehicles, such as RRSPs, tax-free vehicles, such as TFSAs, and paying down the mortgage on an existing principal residence or purchasing a principal residence vs renting. In this exercise, you're hedging current tax rates against future ones to balance the risk. Proper income planning is also needed by considering these risks to ensure the retiree's liquidity during retirement for higher taxes, lower social security entitlements or future income means testing. Income planning should also determine if the future retiree should work an additional number of years to counterbalance an unexpected entitlement change by future governments.
- Inflation Risk. Although consumer inflation is currently low as per the consumer price index (CPI), real consumer inflation numbers (those that are not officially recorded by the CPI, which include mortgage principal, costs of land, renovations, condo and lot fees, indirect taxes, transaction fees for primary residences, and hidden price increases by reducing package sizes of consumer goods) are on the rise. An increase in the current federal government's spending may help inflation make a comeback. Obviously, inflation is a concern, as it will erode the spending power of a future retiree's accumulated savings.
The solution is to balance inflation risks with investment risks to counteract inflation. Generally, the appreciation of common stocks has outpaced consumer prices over the long run; thus, stocks are used in a portfolio during the pre-retirement accumulation phase. However, these historically high returns cannot be guaranteed during the post-retirement period. So, to counteract this risk during clients' post-retirement years, there are inflation-indexed bonds and annuities now available. Finally, one of the best inflation hedges are investments in resources and other commodities that often rise in value during periods of long-term inflation; however, the values of these investments may fluctuate widely in the short run, so that limits this strategy in post-retirement.
- Interest Rate Risk. Lower interest rates tend to reduce retirement income in several ways. Notably, more must be saved to accumulate an adequate retirement fund; income generation during retirement is less due to low returns on income products; and payout annuities yield less income when long-term interest rates are low at the time of purchase. In managing this risk, it's important not to overestimate that interest rates will return to pre-conceived "normal" higher levels in selecting the interest rate assumption in a retirement plan. Moreover, investing in long-term bonds, mortgages or dividend-paying stocks will offer protection against lower interest rates, although their value will fluctuate.
- Stock Market Risk. Changes in government policy can have a direct impact on the business climate and the resulting stock market outlook. Incorrect allocation and diversification among investment classes and individual securities during policy changes can lead to stock market losses that can take years for clients' portfolios to recover. International stocks should also be considered, especially when domestic government policy may harm local stock markets.
The change of government and resulting policy changes always need to be considered in the development of a retirement plan — and monitored to update the plan. Understanding how government policy can affect your clients' retirement through the interplay of these various retirement risks is paramount to formulating the "right" balance in their retirement strategy. The current Canadian government policy changes bring these issues into the spotlight.