After more than two decades of educating people about their personal finances, there are some glaring, frequent and very expensive mistakes and misconceptions about retirement that are present in every group of employees we’ve ever worked with. There are lots of underdeveloped materials that make these issues even more prolific. Unless an employee financial education program provider is going out of its way to make sure their materials help learners avoid these frequent, it could be a huge problem for everyone.
There are also common biases at play, like present bias, which is the tendency to value things we can have now over things we have to delay for long periods of time. Retirement and present bias are at odds with each other, making it more likely that we procrastinate when it comes to saving for the future.
We’re also prone to herding behaviour, which is where we copy what we think other people are doing with their finances to reduce the effort involved in making our own decisions. We’ve developed these mental shortcuts to save time. That’s fine if we’re trying to find out what spin class other people like, or what brand of shampoo is best for curly hair. But many people make huge financial decisions under the influence of herding behaviour. One example is five-year fixed mortgage rates in Canada. There is no study that proves most people are best served by a five-year fixed-rate mortgage, yet it is the most popular in this country.
Read more about behavioural tendencies that could be setting your employees up for bad retirement surprises.
Let’s take a look at some of the common mistakes and misconceptions about retirement that could be costing your employees.
1. RRSPs are the best choice for retirement 😬
We can’t blame employees for assuming that RRSP accounts are the best choice for retirement savings; it’s literally in the name. But, like many other things, the name can be a little misleading. While it’s true RRSPs can be used to save for retirement, they are not a one-size fits all default solution to funding your employees' golden years.
Employees need access to education and tools to determine if RRSPs are the right fit for their retirement, and how much of their savings should be held in this type of account.
One of the biggest misconceptions around using RRSPs is that they’re the most tax-efficient option, but that may not be true for some. Many people are very motivated by the tax refund when they decide to contribute to their RRSP. That’s another example of present bias. Unfortunately, many people may blow their refund, and only some may put those funds back into savings.
But there is a lot more to it than getting a tax refund upon contribution. Every cent withdrawn from an RRSP (or a RRIF from age 71) is fully taxable as income in the hands of the taxpayer, regardless of retirement status. In theory, people may be in a lower tax bracket in retirement, but we can’t actually know that. We have no idea what taxes will look like 20, 30 or 40 years from now.
Even if a retired person is in a lower tax bracket, let’s say 30%, which is down from the 40% marginal tax rate they had in their last year of full-time work. Technically their tax rate is lower, but this doesn’t mean that losing 30% of every dollar they take from their nest egg is affordable for them. Mathematically, especially if they saved their tax refunds too, this may have been the more tax-efficient option. But that retiree still has to pay 30% tax on every withdrawal, which means they need to save 30% more than their take-home income needs. For some people, the pain of the funds lost to tax in retirement will far outweigh any gains from the tax refunds they received during their working years.
Example: A retiree has saved $400,000 in their RRSP, and they’re told they can safely withdraw up to $1,350/mo. This is great news. But they need the entire $1,350/mo to cover their expenses. They also have a small pension, CPP and OAS, driving their top tax bracket to 30%, so they’ll only get to keep $945 of their $1,350 withdrawal each month. That’s not enough to cover their expenses. Now, they’ll need to withdraw about $1,928 every month from their RRSP to keep $1,350. This increased amount could mean they run out of RRSP savings, and end up in a higher top tax bracket because, instead of withdrawing $16,200 per year ($1,350/mo), they actually need to withdraw $23,000/yr.
Further, since RRSP withdrawals drive up their total income (and potentially their tax bracket), how much net from CPP also be impacted and their OAS could be clawed back. It’s a real balancing act that needs at least annual attention during working years, and most employees don’t have what they need to manage this future risk.
2. TFSAs are for savings 🤦
Here we have another misnomer. Employees may be fooled into thinking that TFSAs are only made for savings; that’s what the name says after all. Many assume savings means cash or a high-interest savings account. But in reality, you can pretty much put anything in a TFSA that you can put in an RRSP. They really should have been called Tax Free Investment Accounts.
To harness the power and maximize the tax savings feature of these accounts, your employees will benefit most when they hold their investments with the highest growth potential.
Another point of confusion for many people is that interest income, like the earned on high-interest savings accounts, is also 100% taxable. So, one would think we should put the asset with the highest tax rate into a tax-free account. Again, there’s a lot more to it than that. Investments that earn dividend or capital gains income will be taxed at a lower rate per dollar earned. But with rare exceptions, the investments that can earn capital gains or dividend income tend to grow far more over the long term than even the highest interest savings account. For instance, if you only earn $300 of interest income from a high-interest savings account vs. $3,000 over the same period from investments that earn capital gains or dividend income, you’re going to save a lot more in taxes on the growth of the investments over the interest income. It’s not just the portion of the growth that’s taxable; it’s how much income there is to tax.
Further, people often think there must be a tricky loophole, and that the withdrawals can’t actually be tax-free. But they really are! No matter how much lower one's tax bracket is in retirement, paying no tax is always going to be even better.
The other thing that unfortunately influences the use, or lack thereof, for TFSAs is the fact that your employees won’t be motivated by a tax refund for deposits because they won’t be getting one. We can’t have our financial cake and eat it too. But the big benefit of these accounts is that a retiree can take withdrawals without paying any tax from their TFSA, and those funds also won’t drive up their tax bracket. With no effect on the tax bracket, or taxable income, TFSAs cannot cause retirees to keep less of their CPP, and their TFSA income does not reduce OAS in any way.
TFSAs should also not be a default choice for employees saving for retirement. There should be absolutely no defaults when it comes to saving for retirement. But they should be considered as part of an overall retirement plan for most Canadians, especially those who will have at least some pension income, in addition to CPP and OAS.
3. It’s not worth contributing to matched group RRSPs 😣
This is probably one of the saddest mistakes we see employees make. While making an RRSP a default choice for all retirement savings isn’t a great idea for most, group RRSPs with employer-matched funds is a different story. This is essentially like getting a raise. These programs are often not utilized to the extent they should be. Some focus on the fact that their take-home pay will be reduced, losing sight of the fact that their total compensation will be increased by the match their employer makes.
Behaviourally, this type of program is also very effective. First, it’s automatic and deducted at source, so the employee tends to forget about it. This helps us get out of our own way. Several studies have proven making the default of your program that employees opt-in automatically (so they have to manually opt-out if they don’t want to participate) actually increases enrollment and, therefore, employee financial well being.
Humans like short cuts, and things that are easy. Sometimes getting us to act in our own best interest is as simple as making us put in the slightest effort to act against our interest. So having to fill out a form and follow up to opt-out of retirement contributions could be just enough to keep us saving.
Check out #6 in this article that includes the potential cost of passing on an employer-matched RRSP program.
CacheFlo is a financial education company that builds eLearning and tools to help financial professionals and individuals make behaviour-based changes, which allow them to get more life from their money. We want to make it easier for people to predict the impact of their financial choices before they make them.
About the Certified Cash Flow Specialist (CCS) program
CCS professionals go through enhanced cash flow-based training to develop the skill set to deliver behaviour-based cash flow advice. They start the financial planning process with a cash flow plan to genuinely help their clients get more life from their money.
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The FCP combines quick and practical lessons with tools, including Winton, which helps people make financial changes they can stick to. Users can apply what they've learned to their financial situation, thus bridging the knowing-doing gap. The goal of the FCP is to help people get more life from their money.