If you have a defined contribution pension, when you retire you must convert it into either an annuity or a Life Income Fund. If you have an RRSP you must convert it to an annuity or a RRIF. What is best for you? This post and spreadsheet will help you evaluate your options.
Do you take the annuity’s fixed lifetime yearly payments? Do you take a RRIF or LIF with the same payments and accept when the capital is gone? Do you take the RRIF or LIF minimum payments and accept that there is a cash flow loss compared to an annuity? Do you know how much of a return on the RRIF or LIF you need to match the annuity and are you willing to take the risk?
You can get answers to most of these questions by using the spreadsheet provided in this post. It lets you change yearly withdrawal amount, interest rate, withdrawal options and inflation rates. It charts how capital is depleted and if the annuity has a cash flow advantage.
You can also use the spreadsheet for non-registered investments (such as cash, term, stocks, bonds) to decide if an annuity is to your advantage when evaluating the best way to ensure a steady income. The same arguments apply, you just do not have the constraints of a RRIF or LIF as discussed below. (You only have to select, in line #3, the RRIF option and, in line #4, the “Closest Possible” option. If the Min limit appears, adjust the Target withdrawal of line #10 to remove it.)
How to Decide between an Annuity and a RRIF or LIF
As you will see in the example below and when you use the spreadsheet provided, the decision basically comes down to whether
1) you want a constant stream of monthly payments for life from an annuity and no capital when you die (but possibly guaranteed payments for a fixed period, depending on the annuity type) or,
2) you are willing to accept a potentially more volatile stream of payments and the need to manage the RRIF Registered Retirement Income Fund) or LIF (Life Income Fund) investments to obtain the rate of return desired without depleting the capital too soon. However, once the RRIF or LIF capital is gone, the monthly payments stop, even if you are still alive.
Using the examples discussed below, a few criteria are provided later that can be used to decide if a RRIF or LIF is a good option for you compared to an annuity.
Annuity Compared to a RRIF or LIF
An annuity is an agreement with a financial institution for them to provide you with monthly payments based on capital that you provide. They make their calculations based on which type of annuity you choose, your and/or your spouse’s age and their expected rate of return on the capital. Based on the annuity type, they will provide monthly payments until death and for a set number of years depending on the type you have selected. A good description of the types of annuities is given by Canada Life on their Annuities page.
A RRIF or LIF is different in that you or your estate gets to keep whatever capital is left, if any, after death, but you must manage the investments. Note that the minimum (and maximum for a LIF) withdrawals can have a major impact on how long the RRIF or LIF will provide monthly payments (and the amounts) and the amount of capital left. The maximum LIF withdrawal rates change each year and by province. Keep in mind that because of the minimum withdrawal rates, both the RRIF and LIF are designed to reduce the capital to zero at about age 90.
Buying an Annuity
If your Defined Contribution pension accumulated amount or the capital value of your LIRA or the value of your RRIF when it is time to convert, what could you expect from an annuity? While you will need to deal directly with the insurance companies of your choice to get competitive rates, there is a very good reference to get you started. It is a Globe and Mail page that provides monthly payments that selected insurance companies offer for annuities. Just click on the entry that fits your circumstances when you expect to do the conversion. The data given on the spreadsheet uses the above website’s page.
You can also use RBC Insurance’s Payout Annuity Calculator.
There are many articles on buying an annuity and when it is appropriate. (For example, this one from MoneySense.) Also, Beef up retirement cash flow by J. Chevreau, Dec 14, 2017 and A guide to having retirement income for life by J. Chevreau, Feb 15, 2018.
If you are using fixed rate term investments for your registered (RRSPs) and non registered investments (GICs), you will probably have used the laddering approach to ensuring that you are getting the best interest rates over the long-term. In this strategy, you renew you about one-fifth of your investments every 5 years at the going rate. In this way, you do not have everything locked in whatever was available at the time.
You can apply the same laddering strategy to taking out an annuity. It has been suggested by some authors (see above), that you space out taking annuities every 5 years or longer to get higher annuity payments as you get older, rather than taking one annuity. This also gives you access to your capital for a longer time.
Company Pension Plans
Over the past few years, more and more companies have stopped offering Defined Benefit (DB) pensions where you receive a life-time pension based on the number of years worked, the average salary over a period of years and a percentage. In some cases, there was no employee contributions to these pension plans. The employer managed the plan and took the risk to ensure that it was viable. Such company failures as Nortel’s bankruptcy shows that pensioners’ future payments are at risk.
Instead, the Defined Contribution (DC) pension has become increasingly prevalent. In this case, the employee and employer each make a contribution to a plan managed by a third party. Often, the employee has a choice of investments that have different risks and potential returns (typically, mutual funds, stocks and bonds). Just like a Registered Retirement Savings Plan (RRSP), the employee contributions to this Registered Pension Plan (RPP) are tax deductible, assets grow tax free and when the pension is taken, all of the income is taxed. The amount of the pension is determined by the capital in the employee’s plan at retirement. The risk is now with the employee and the employer is not involved in the long-term management of the plan.
For DB plans, the employer either arranges for an annuity or provides it themselves. For DC plans, it is up to the employee to transfer the capital to an annuity or a Life Income Fund (LIF).
Many companies are also offering employees the ability to purchase an RRSP with matching contributions. Contribution to these Group RRSPs are also tax deductible and the assets grow tax free. While they look the same as a Defined Contribution pension plan, a RRSP created this way is governed by tax law and not by pension law as is the DC.
Conversion of a RRSP to a RRIF
A Registered Retirement Income Fund (RRIF) is required when you have funds in an RRSP (Registered Retirement Savings Plan and before you reach 71 years of age. The plan’s funds must be converted to a RRIF or an Annuity or else the plan’s funds are included as income in the year.
To recover the tax refunds that you received when you or your employer provided funds into the RRSP during your working years, the Government of Canada requires a minimum withdrawal from the RRIF each year. This withdrawal is calculated at the beginning of each year and normally reduces the capital remaining in the RRIF. The amount left at any age depends on the interest rate.
This withdrawal is fully taxed as income. The minimum RRIF withdrawal applies for your entire life and is calculated each year on the value of your RRIF on December 31 of the previous year.
Locked-In Retirement Account (LIRA)
An additional complexity to deal with is what happens when a person leaves a company that has a DC pension plan or when the company fails. The commuted value of your portion of the plan is provided for you to invest in a Locked-In Retirement Account (LIRA). Most investments permitted in other retirement plans (such as a Registered Retirement Savings Plan – RRSP) can be used for a LIRA. No additional contributions and no withdrawals are permitted. Only when the LIRA is converted to an annuity or LIF before age 71, can withdrawals be made, and only under specific circumstances.
There are a number of complexities with LIRAs which you should understand or have professional help. For example, the following links may be of use as background information: retirehappy.ca – Unlocking pension money: Getting money out of a LIRAs; taxtips.ca – Unlocking Your Locked-In Pension Accounts; financialcrooks.ca – What Is a Locked In Retirement Account and How Do I Get One?. While these deal with unlocking, they also cover the differences between provinces. Make sure you know which province has jurisdiction over your LIRA.
Life Income Fund (LIF)
A LIF is similar to a Registered Retirement Income Fund (RRIF) in that most investments permitted in a RRIF can be used in a LIF and that there are many financial institutions that can issue a LIF. As with an RRSP, withdrawals are fully taxed, and any growth in the fund is not taxed. The minimum withdrawal rates are the same. However, a LIF has a maximum annual withdrawal limit, which is discussed later.
A good source for questions that you may have regarding a LIF in Ontario is provided by the Financial Services Commission of Ontario’s FAQs on New Life Income Funds.
This post and the spreadsheet hopefully assist you in deciding if an annuity is appropriate for your circumstances compared to rolling over your DC pension into Life Income Fund (LIF) or your RRSP into a RIFF. Use this as background information only. You should seek professional advice before making a decision.
The RRIF and LIF Withdrawal Rates
The RRIF minimum withdrawal rates are set by the Government of Canada and were changed in 2015. The LIF rates are the same. These rates are age dependent so that each year you have an increased rate. Here are two links to view these rates: RRIF minimum withdrawal rate (item 3 in their list) and RRIF Minimum Payout – 2015 Rates.
The LIF also has a maximum withdrawal rates which changes each year as well as being age dependent. The formula used has been difficult to track down, but the methodology and the 2016 rates are presented on a webpage by the Government of Canada, Office of the Superintendent of Financial Institutions (Life Income Fund FAQs, question 1, item 2). It uses the previous year’s November 30th CANSIM rate. (These can be found at the Statistics Canada website for CANSIM B14013. Enter B14013 into the search, click on the v122487 series and then select the dates to include November of the last year and then the Retrieve now button. For Nov. 2015 it was 2.17%.)
It appears that each province that has LIFs has its own maximum withdrawal rates, which are close to, but not the same as the Federal ones above. For example, the Financial Services Commission of Ontario’s L200-415 pdf has higher values for all ages. A useful link that has all provinces is the Kudsia Leith Sanchez website at klsfinancial.ca, which is used for the 2018 rates shown on the spreadsheet. For subsequent years, at the beginning of the year, go to any of the above references and copy and paste the year’s values into the spreadsheet, if they have changed.
For a LIF, the difference between the minimum (which you must withdraw) and the maximum (which you cannot exceed) is not very much (the maximum is only about .6 to .8 more than the minimum when the person is in the 70s), so there is not a lot of flexibility to increase or decrease the payments depending on your circumstances.
Because a RRIF or LIF will likely run out of capital (as they are designed to do because of the minimum withdrawal rules), you need to consider seriously if you will be alive when this occurs. If you are, you will may be hard pressed to deal with the loss of the income. With an annuity, you do not have to worry about this as it is guaranteed for your life. Consequently, you need to look at life expectancy and the probability of survival at various ages.
Life expectancy is the average age to which one might be expected to live. Keep in mind that when you see a life expectancy it is a 50% probability of survival. For example, for a male that is 65 years old this year, the life expectancy is age 84. For a female it is 86.9.
Based on your family history, your present heath and other factors, you can assess whether these generalized life expectancies apply to you. Also keep in mind that these are the average for a large population so you may decide that another age applies to you.
Your expected life expectancy, from a specified age, should inform your decision on whether a RRIF or LIF is better for you. Use the spreadsheet provided with the Life Expectancy and Survival Probability post to see the changes in both of these variables for different ages. If you download the spreadsheet and keep it open as you work with the spreadsheet discussed below, you can evaluate the various probabilities.
Range of Returns for RRIF or LIF
Determining the interest or rate of return you might use for the RRIF or LIF to provide the same yearly payment that the Annuity offers is one of the key aspects of the spreadsheet. You can enter different rates to see what effect it has using the chart provided.
However, you must be realistic as to what you can expect and not use too high a rate. For example, the best you can obtain today (Sept. 2018) for a 5-year Guaranteed Investment Certificate (GIC) from a credit union ranges from 3.2% to 3.75%. Here are two links that provide up-to-date GIC rates: GIC rates comparison chart and Guaranteed Investment Certificates – Annual.
The stock market’s long-term return is 8.5% but the volatility is very high. One very good post to read before deciding to commit your “pension” to the stock market is by the Canadian Couch Potato: What are Normal Stock Market Returns? Another is by Retire Happy: What rate of return can you expect from the stock market? In both of these posts the argument is made that year to year returns can range from a negative to a positive double-digit.
Click on Download Spreadsheet and open it so that you can follow along with the example below and then customize it to your circumstances. The spreadsheet which was designed with the Excel application. If you do not have Excel, try the online version which is free, but requires that you create an account and then upload the file. Other applications will probably open the file, but charts do not always work.
When opened for the first time, the spreadsheet has data for the example. As you enter your own data into the outlined cells, some other cells will automatically change and the chart will be updated, as indicated below.
The spreadsheet consists of a section for entering data (in the upper half of the window, numbered 1 to 14), a chart, a table of Limits and Values to the right and tables below the chart that are used for the chart. Only enter data into the cells that are outlined.
Hovering the cursor over any line on the chart will show a comment that describes the Series, the Age and the Value. Alternatively, scroll the window down to see the tables that are used for the chart. They are in bold and a colour code to the chart.
Data entry is divided into 3 areas. Each area and a description of each numbered line is given below.
Values shown in the chart are for the following fictitious example: $250,000 initial capital at age 65, annuity providing $435.22 per month per $100K ($13,056.60 per year) for a couple with joint coverage and a 10-year guarantee, 3.25% interest for the RRIF or LIF, $13,056.60 target withdrawal from the RRIF or LIF to match that provided by the annuity with a .2% inflation for a person living in Ontario (needed for the LIF only). The inflation is kept small rather than 0% so that all the lines on the chart are visible.
The chart will change when values are entered into specific cells as mentioned below. The x-axis (Age) starts at the age your LIF starts and goes to 100. This axis only changes when what you enter into line #1 (Age When LIF Starts) changes. The earliest age is 50.
The chart shows the RRIF or LIF Payments as a solid thick black line. The Target Withdrawal/Year is a dashed green line. It will show through the black line when the payments/withdrawals are the same. The annuity payment is a dashed blue line.
Because one of the features of a RRIF or LIF is that the capital can be turned over to the estate upon death, the dashed purple line, which uses the right vertical axis shows how much capital is left at each Year-End. For the example, capital is gone by age 92 (and so are the payments).
There are two other lines at the bottom of the chart that are called Annuity Advantage. The solid red line is each year’s advantage (Annuity payment less RRIF or LIF payment) compounded using the same interest rate as the RRIF or LIF and then cumulated each year. The dashed magenta line does not include interest. How to use these lines is discussed in one of the examples later.
Summary Table of Limits and Values
In the last four columns to the right of the window is a table of Ages, Limits, Interest rate and Annuity Advantage. The Limit column shows which limit is used for each age on the Chart. It will show either Max (for a LIF) in red, for a Maximum withdrawal, Min for a Minimum withdrawal in yellow, Target is in green for a withdrawal that is the same as the Target Withdrawal/Year (including inflation) or Short (for a RRSP). Adjust the Target amount in line #10 to see what happens to the dashed green Target line, the black Withdrawal line and the Table of Limits entries.
A) Starting Values
Enter the values indicated below and use the drop-down menus as appropriate.
Age When Conversion Starts (#1) – Enter the age when the conversion is to start. It is to be greater than the 50 and less than or equal to 71. Once changed, the solid black Withdrawal and the dashed purple Year-End Capital lines on the Chart will change. While any age can be entered, only ages 50 to 99 will produce a chart.
Select Convert to (#3) – This is initially set to “1) LIF”. If you want to use a RRIF, enter the cell and select it from the small drop-down menu appears to the right of the cell.
Select Withdrawal Choice (#4) – This is set initially to “1) Closest Possible“. It will select a withdrawal that gets as close as possible to the Target Withdrawal/Year of #10 (including inflation) while ensuring that the Minimum (and Maximum for a LIF) withdrawal limits are not violated. When the cursor enters the outlined cell, a small drop-down menu appears to the right of the cell. Try the other 2 choices, “2) Maximum” and “3) Minimum“, and observe the affects on the Chart. Choose the one that best suit your circumstances. For an RRIF, the Maximum is not used and instead is calculated as the “Closest Possible”.
Select Province for LIF (#5) – This is only used for the Maximum for a LIF. It is ignored for a RRIF. This is set initially to “1) AB,NB,NL,IN,SK”. If your province is not one of these, when the cursor enters the outlined cell, a small drop-down menu appears to the right of the cell. Select the other set of provinces (“2) BC,MB,NS,QC”). If your pension is a federal pension, select “3) Federal”. There may be a change to the Chart lines in later years due to the lower maximum withdrawal rates.
B) Conversion to Annuity
Annuity Payment/Month/$100K (#7) – Use the previously mentioned Globe and Mail link to obtain an estimate and enter it here. When conversion time approaches, get a quote from an insurance company and enter the amount. The following is a screenshot of the annuity chosen for this example. If you have another source, or obtain a quote from an insurance company, make sure that you convert the payments to per month per $100K before entering it.
Yearly Annuity for Capital Value (#8) – This is calculated automatically and is the dashed blue Annuity line on the Chart. It is #2/1000 x #7 x 12. Use this value to set #10 (Target Withdrawal/Year) to make a comparison between the RRIF/LIF and Annuity.
Annuity Inflation Percent (#9) – Enter the Inflation rate as a percent that the annuity is to increase each year. The dashed blue Annuity line on the Chart will change. Please enter only positive values as there is no check for a negative. Normally, there is no inflation protection with annuities shown on the Globe and Mail website. If you want inflation protection, contact an insurance company to see if they offer it.
C) Conversion to Life Income Fund (LIF) or Registered Retirement Income Plan (RRIF)
The title will change depending on what is selected in #3 as will the text in each lines below.
Target RRIF/LIF Withdrawal/Year (#10) – This value is preset by using a formula to that of the annuity’s yearly payment of #8 (Yearly Annuity for Capital Value). You can override it by entering whatever value you want to receive from the RRIF or LIF as a yearly amount. If it is too low, the Minimum withdrawal will automatically be used. If it is too high, the Maximum (for LIF) or Closest (for RRIF) withdrawal will automatically be used. Examine the two columns along the right side of the window to see what Limit is used. You should set it to a value close to that of #8 (Yearly Annuity for Capital Value) so you can make a valid comparison. Once changed, the solid black Withdrawal and the dashed purple Year-End Capital lines on the Chart will change as will the Limit column.
RRIF/LIF Interest Rate (#11) – Enter the interest rate you expect to obtain with your RRIF or LIF investments. The lowest rate will probably be a 2% to 3% GIC rate and the highest will probably be a 5% to 8% stock market return. Once entered, the Withdrawal and the Year-End Capital lines will change on the Chart. Notice that for the example which uses 3.25%, the Withdrawal matches the Target Withdrawal (with inflation) until age 91 and then drops off as it uses the Maximum (for LIF) withdrawal limits. Try other Interest Rates to see what happens.
RRIF/LIF Change in Interest rate/Yr (#12) – Because interest rates are beginning to change after being stable for so long over the past few years, this value is included so that you can adjust the rate over future years. For example, if you think rates will rise by .05% each year, enter this value. This will result is the next year’s interest rate (as shown in the Table along the right of the window) will be 3.30%. If you expect then to go down, use a negative value. Do not choose too large a value and keep an eye on the table.
RRIF/LIF Min & Max Interest rate (#13) – To ensure that the rate that results from entering a value in line #12 are not too high or too low, you can set the Minimum and Maximum permitted. By default, these are set to 2% and 5%. If you want to set specific rates for any age, scroll down and in column G, starting at row 44, find the first cell that does not have a #N/A and enter the value you want. This will override the formula for that cell only. To restore the formula, copy any other cell in the row and paste it into the cell that was changed.
RRIF/LIF Inflation Percent (#14) – Enter the inflation rate you want to be considered for the RRIF or LIF. The Target line will change. A .2% inflation is used for the example so that all lines are visible. The Withdrawal may change depending on what withdrawal choice has been selected.
Conclusion for the Example
The example was for a fictitious person but a number of conclusions can be drawn. Use the points given below to evaluate your own circumstances:
What is the risk in using the RRIF/LIF Investment Interest Rate? – Low, as it is what can be obtained today as a GIC and is at the low end of long-term stock market returns.
Does the RRIF/LIF provide the same yearly income as the Annuity? – Yes, when the Target is set to the Yearly Annuity for Capital Value, including a .2% inflation rate, until it is exhausted. This is from the Withdrawal line of the Chart.
When does the LIF payment/capital go to zero? – At age 92 which is 8 years past the average life expectancy. This is from the Year-End Capital line of the Chart.
What is the probability of being alive when the RRIF/LIF capital = 0? – There is still a 22.8% probability of being alive at 90. This is from the Life Expectancy post given above.
Should the Annuity be used? – It depends on how long you expect to live. If you expect to live past age 92 for the example, the use the annuity. However, if you are a couple, check into what happens if one person dies early (as there is often a 40% reduction). Considering another example where a reasonable stock market rate of 4.25% is used, the capital is gone at age 98.
Example Using GIC Rate and Minimum Withdrawal
If you are going to invest the RRIF or LIF in a low-risk GIC, and only take the minimum payments, is an Annuity a better option? For the same values as the example above, but using Minimum in line #4, the chart is as shown below.
In this case, the Withdrawal line is always below the annuity line. The Annuity Advantage red line crosses the Capital remaining line at age 93 when both are at $62K. This means that even though withdrawals are about $1,000 per year less than the annuity amount, it takes up to age 93 before this advantage matches the capital left. If you die before age 93, you will still have capital that is larger than what you lost if you took the annuity and invested it at the same rate the LIF or RRIF returns. If you can live with the lower income, then this is gives the advantage to the LIF or RRIF and not the annuity for capital remaining on death.
The Advantage-Capital crossover is still at age 93, but the advantage is not only $10K not $62K. This increased withdrawal is now $500 less than the annuity for the first few years and slowly becomes more than the annuity due to the .2% inflation. You still do not have capital after age 94, but you do have around $50K at age 90. This example shows that you can make a LIF or RRIF last for a long time and almost equal an annuity and still keep capital. Again, the loss of $12,500 after age 93 may be a problem, so you have to consider what other income you will have and if you have enough to cover expenses at that age (see Comments below).
A few years ago I developed a lifetime finances planner that helped me and others to deal with these types of situations. The planner can be downloaded and tried (with data entry restrictions) as a demo for 31 days. For details see FinanceBase-Lifetime Finances.
Lifetime Finances uses your assets, income & expenses during your lifetime to project whether you will outlive your money. It can be used at any age and provides a yearly cash flow (income less expenses, including taxes) from now to 45 years after retirement. It is especially useful it you are retired because it helps you decide what you can spend and how long your assets will last and still leave an inheritance, if you want. During retirement it includes such income as CPP, OAS, GIS, pensions, TFSA and RRIF. It also includes setting the transfer of assets on death to the surviving spouse. If desired, changes can be made in any year. You can do what-if analysis and save different scenarios.
Lifetime Finances also contains an Account manager to help keep track of your assets and liabilities and generate reports such as gross and net worth. The Accounts are linked to the planner so that at any time desired any scenario can be retrieved and updated. As your circumstances change, you can use the planner and accounts at any time to check how your financial plans need to change to adapt.