Income Drop

Last week I was a guest at a happy occasion — Harry Lipton’s 81st birthday party. However, about two days after the party my good friend called and set up an appointment. When Harry arrived I could immediately tell that he was worried — his usual smile was nowhere in sight.

“I’ve been to my bank,” he said. “My income is going to be cut nearly in half. I’m very upset about it.”

“What do you mean?”

“I have about $100,000 in my Registered Retirement Income Fund,” Harry said. “That’s the money I live on — plus my Canada Pension Plan and Old Age Security. The funds in my RRIF have been earning 9% for the past seven years, and that’s allowed me to exist in a rather pleasant way. But I’ve just been informed that those high yielding investments have matured and now I can look forward to earning only about 5%. That’s a huge drop. It means my income will fall by about 45%. I earn about $11,000 a year from my RRIF and if that drops to $6,000 I’ll be in trouble.”

“I understand why you’re worried, Harry,” but because of the way RRIF’s are designed, the downturn in interest rates may not make as much difference as you think. Look at it this way. You’re going to withdraw the principal and income in your plan over the remainder of your life. Right now the principal is $100,000. That’s not going to diminish. It’s only the interest that’s going down.”

“I don’t follow you.”

“Let me give you a simplified, conceptual example of how your RRIF works. Assume you are going to live until age 90 — that’s another 10 years. So you tell your plan administrator that next year you want to withdraw 1/10th of the value in your RRIF. You have $100,000 in the plan today. You earn 5% interest; that brings you to $105,000. You withdraw 1/10th of the plan, that’s $10,500. If you earned 9% interest, you’d withdraw 1/10th of 109,000, and that’s $10,900. Your income has dropped only $400, not 45%, because most of your annual withdrawal is made up of principal not interest. In fact over the course of 10 years earning 5% interest, you’d be able to withdraw about $125,000. If you earned 9%, you’d be able to withdraw about $150,000.”

“Do I run out of money at age 90?”

“Yes. This year, you withdraw 1/10th of the value of the RRIF. Next year, you withdraw 1/9th, and so on. At age 88 you withdraw 1/3rd, at age 89 you withdraw 1/2 and in the last year you withdraw the remainder.”

“What happens if I live past age 90?”

“You will be reduced to living on your CPP and Old Age Security.”

“I’m not too concerned about my income at that age. I don’t think I’ll be a big spender. But I would like to leave something for my children, and I always thought they would get the remainder of my RRIF.”

“RRIF’s were never designed for that, Harry. When you die your kids can inherit the RRIF, but your estate will have to pay tax on it. But I do have another suggestion — life insurance.”

“You must be joking. At my age?”

“It may help you from running out of money in your RRIF. Let’s say you take your $100,000 and buy a life annuity with it. Your annual income for life would be about $16,000. The advantage of buying an annuity is that you get a level payment for your entire life and you are not going to outlive your money. With a RRIF you can outlive your money. Also the way the withdrawal mechanics of a RRIF work, your payments tend to grow as you get older — in order to exhaust your capital. But generally most people need less as they grow older not more.”

“All right, I can see the annuity might make sense. Especially since I’ll get about $160,000 over 10 years which is more than I would have earned with my 5% or even my 9% investment. But how does that help me leave something for my kids?”

“That’s where the life insurance comes in. Your kids can buy a policy on your life. They can pay for it entirely or you can help share in the cost for a few years using your excess payments. When you die, they will inherit $100,000 tax-free.”

“It’s an interesting idea, Hank. But as I get older, the life insurance will get more and more expensive, won’t it?”

“Of course. But as you get older, the annuity becomes cheaper so the annuity and life insurance costs tend to offset themselves. Take some time to think about it and discuss it with your kids. It makes sense for them to be involved in your decision.”

Hank Bulmash is a principal in Bulmash Cullemore chartered accountants of Toronto.