Canada’s retirement income system can seem very complex and overwhelming to many Canadians, so we want to break down this system into more manageable and easier-to-understand parts.
Today’s post will help you understand the three pillars of Canada’s Retirement Income System, and offer up some considerations for each pillar to help you with your retirement plan.
Three pillars of Canada’s Retirement Income System
At Cashflows & Portfolios, we recognize that saving for retirement might be one of the last things on your mind. You might already have so many other priorities for your money right now, like paying off your student loans, killing consumer and credit card debt, or paying off your mortgage.
However, having some savings, at any age, is important.
Make sure you check out one of our popular posts about Savings by Age – to see if you’re saving enough and why.
Many financial experts will share that millennials will generally need more retirement dollars than their parents, and previous generations before them. There are a few factors for this:
- Potential longevity in retirement.
- Expensive house prices and higher housing-related costs, relative to any wage increases.
- Lower expected market returns in retirement associated with wealth preservation*.
*Of course, the financial future is always very cloudy!
So, while we recognize you might have many other competing financial priorities, we believe you do need to start saving for retirement – ideally – as early as possible and as young as possible. Every bit helps. This way, your personal savings and investments can be used with any universal publicly-funded plans (administered by the government) along with any mandatory earnings‑related programs – to fund your retirement.
Together, the sum of the following make up what is considered the three pillars of Canada’s Retirement Income System:
- Universal benefits: Old Age Security (OAS) and Guaranteed Income Supplement (GIS)
- Earnings-related programs: Canada Pension Plan (CPP)/Quebec Pension Plan (QPP)
- Voluntary savings: which can include employment pension plans (such as defined benefit and defined contribution pension plans), as well as individual retirement savings accounts (focusing on the RRSP and TFSA, although you can certainly invest in a taxable account as well).
Understanding the power and limitations of each pillar is important since you may be able to leverage all three pillars to some degree to fund your retirement. No singular pillar may be enough.
Pillar 1 – Universal benefits OAS and GIS
The first pillar provides benefits based on age and years of residence in Canada. It includes the Old Age Security (Old Age Security) pension, the Guaranteed Income Supplement (GIS), the Allowance and the Age Credit. Rightly so, universal benefits are considered the foundation of Canada’s Retirement Income System.
This pillar helps ensure retirees/seniors in Canada can afford the basic necessities of life such as food and shelter. This first pillar is financed primarily through general tax revenues. Meaning, you do not make contributions to these universal plans – they are funded by taxpayers.
Old Age Security (OAS)
OAS is a taxable monthly payment available to seniors who are aged 65 and older and who meet the eligibility requirements. Here are some other quick facts about OAS:
- There is no requirement to stop working in order to receive OAS.
- To get benefits, you must have lived in Canada for 10 years after age 18. To get full benefits, you must have lived in Canada for at least 40 years after age 18. Those who can’t meet the 40-year residency requirement get a pro-rated benefit.
- OAS is paid to individuals and does not depend on participation in paid employment nor on the income of a spouse or partner.
- OAS is clawed back from individuals whose income exceeds certain thresholds. Like the rest of our progressive tax system, clawback incomes are adjusted each year for inflation.
- OAS is funded from general tax revenues, it is not a contributory plan like CPP is.
- In fact, Old Age Security is the Government of Canada’s largest pension program.
- Benefits are also indexed for inflation, based on price increases. While CPP benefits are indexed annually, OAS benefits are indexed quarterly.
Generally speaking, OAS was designed to fund only a small portion of retiree’s income needs.
In fact, the first “old-age pension” was enacted by the federal parliament in 1927. The plan paid up to $20 per month at the time.
While times have certainly changed and the income stream expected from OAS for most Canadians is much higher now, the fact is, OAS still only typically funds a very small portion of your retirement income needs. So, while we believe it’s very important as a taxpayer to access these government benefits you’ve paid over the years, just know that any OAS monthly payment will be likely a drop in the bucket to fund all your retirement income needs.
Guaranteed Income Supplement (GIS)
History tells us that GIS is not as old as the dawn of the OAS benefit, but it remains an important income source for many low-income seniors.
What is GIS?
Guaranteed Income Supplement (GIS) is a monthly payment – if you qualify. The great news is, this benefit is not taxable but at the same time, we believe this benefit is also not desirable – it is based on low-income and available only to low-income Old Age Security (OAS) pensioners.
You can get GIS if:
- you are 65 or older
- you live in Canada
- you get the Old Age Security (OAS) pension, and
- your income is low whether you are single, widowed, or divorced.
Given the monthly payment is subject to change and the income threshold may also be subject to change, we’ve made a direct link to this Government of Canada page so you can see exactly what GIS benefits might currently be.
GIS is a benefit in addition to regular Old Age Security benefits.
To be eligible for the GIS, you must first meet the eligibility requirements for the OAS pension. Also, the combined income of you and your spouse or common-law partner, cannot exceed a specific amount determined by the federal government.
Although the Guaranteed Income Supplement (GIS) was initially seen as a transitional program to be phased out when the Canada Pension Plan (CPP)/Quebec Pension Plan (QPP) began paying full benefits in 1976, we read that at this time unfortunately a sizable portion of CPP/QPP beneficiaries qualified for less than a maximum pension. Also, with some employer-sponsored pension plans starting to be on the way out, this meant that some low-income seniors were left in poverty. Since the 1970s, GIS remains an important element of our universal publicly-funded retirement benefits.
Read on to learn more about GIS in our detailed post here including what is the maximum income to qualify for GIS.
Pillar 2 – Earnings-related benefits CPP/QPP
With our universal retirement income benefits in place, we can then look at the next pillar – earnings-related programs. More specifically, we mean retirement income benefits from the Canada Pension Plan (CPP)/Quebec Pension Plan (QPP).
These public pensions are funded primarily through mandatory contributions by employers, employees and the self‑employed. Because these benefits are based upon age criteria and the amount contributed over a person’s working career, this second pillar recognizes and supports workers who have spent decades contributing to the economy.
Just like Pillar 1, the government-administered plans in Pillar 2 for CPP/QPP are not designed to be your sole source of income during your retirement. In fact, we would argue that given potential retirement longevity, the demands on your money needed to sustain higher housing-related expenses over time, combined with lower expected market returns in retirement associated with wealth preservation tactics, you will absolutely need to consider supplementing your retirement income through personal savings plans. We’ll cover that information in Pillar 3.
The biggest thing you need to know about CPP is: CPP is a contributory plan. That means your income stream from CPP depends on how much you put into the plan (to a maximum contribution amount) AND how long you’ve contributed to the plan. This makes CPP very different from another government benefit, Old Age Security (OAS). Payments from OAS as you know by now come from general tax revenues.
With very few exceptions, every person over the age of 18 who works in Canada outside of Quebec and earns more than a minimum amount ($3,500 per year, a basic exemption amount) must contribute to the Canada Pension Plan (CPP). Essentially, this contributory program is ensuring you have some sort of a retirement income plan.
If you have an employer, you pay half the required contributions and your employer pays the other half. If you are self-employed, you make the whole contribution.
There is much more to say about CPP/QPP so please read this comprehensive post:
What Age Should You Take CPP?
While the standard age to start collecting CPP benefits is age 65, you can take it earlier. You can also consider delaying CPP. At Cashflows & Portfolios, we often run financial projections for clients considering CPP at age 65 and 70.
- If you take CPP benefits early (from age 60), your CPP payment is reduced by 0.6% for each month (36% reduction if you start CPP at age 60) you receive it before turning 65. If you need income security, maybe this is a wise choice but in most cases we think it makes sense to delay CPP as much as possible.
- If you take CPP benefits later (after age 65), your CPP payment is increased by 0.7% for every month that you delay receiving up to age 70. This means a retiree that waits until age 70 to start CPP will get a 42% benefits bump beyond taking CPP at age 65. That’s significant for retirement income that will pay you until your last breath.
Here is a case study about when to take CPP in retirement based on client information to us.
Pillar 3 – Voluntary Savings
This final pillar lumps together savings for retirement using employer-based plans and/or accounts for individuals. Pillar 3 includes workplace registered pension plans (RPPs), private/personal savings (Registered Retirement Savings Plans (RRSPs), Tax‑Free Savings Accounts (TFSAs)) and taxable (non-registered) investment accounts.
We believe, firmly, that this is the most important pillar and why we dedicate so much content and case studies on our site and running financial projections for clients on these accounts. At the end of the day, nobody cares more about your retirement savings and plan than you do – so save and invest wisely!
Defined Benefit and Defined Contribution Pension Plans
The 101 on any defined benefit (DB) pension plan is that your pension amount is essentially defined.
A common DB pension formula might be:
Annual Pension = 2% * years of service * average of the best 5-year highest income-earning years.
Example: Annual Pension = $60,000 per year = (2% * 30 years worked * $100,000).
The beauty of most DB plans, beyond knowing your retirement income benefit, is many of these pensions offer some inflation protection (i.e., there are indexed fully or partially to inflation) and these plans may also have survivorship benefits for your partner. Make sure you discuss the details of your defined benefit (DB) pension plan from your employer (ie. if you work for the government). These plans can be a very valuable and likely a secure income stream during your retirement.
Defined contribution (DC) pension plans are a bit different – your contribution to the pension is defined but the outcome of what your pension value might be is largely dictated by what you invest in and how well those investments perform over time. While you can likely tailor your investments (a bit more) with any DC plan when compared to a DB plan, you will need to very mindful about your investment goals, risk profile and any financial products offered by the DC pension plan administrator. Remember, at the end of the day – investment fees matter!
So, make sure you consider low-cost, diversified Exchange Traded Funds (ETFs) as a building block for your wealth-building journey.
- What are indexed ETFs and why do they matter?
- Learn how to build long-term wealth by investing in low-cost ETFs like these ones here.
When you leave your employer, the great news is for a DB or DC plan, you might have the choice to transfer the value of these plans to other registered accounts. These accounts include a Locked-in Retirement Account (LIRA) or a Locked-in Retirement Savings Plan (LRSP). We’ll have more content about these accounts in future posts, including the implications of using them in retirement as part of tax-efficient drawdown planning.
Registered Retirement Savings Plan (RRSP)
First off, RRSPs are outstanding accounts to help you save for your retirement. RRSPs are retirement savings plans offered by financial institutions in which contributions can be used to reduce income tax owing – today. Then, inside the RRSP, any investment income or interest earned in the RRSP is usually exempt from tax as long as the investments/dollars remain in the plan. Contributors only pay tax when funds are withdrawn from the account. This makes the RRSP essentially a tax-deferred way to save for retirement.
There are a few key types of RRSPs you can own:
- Individual RRSP – there is one contributor; all the tax implications reside with the account owner.
- Spousal RRSP – there is also one contributor (a contributing spouse that typically earns a higher income than the other spouse); the higher-income spouse contributes to an RRSP opened in the name of the lower-income spouse. The tax deduction benefits go to the contributor. The tax withdrawal implications are based on the marginal tax rate of the lower-income earner.
- Group RRSP – there are multiple contributors; contributions are made by employees and/or the employer as well. Some employers “match” employee contributions! Employee contributions are usually deducted at the time of payroll via deductions on a pre-tax basis. There are however often set funds or financial products to invest in – you may not as a participant of any Group RRSP have your free choice of what financial products to own. Something to consider…
- Pooled RRSP – this type of RRSP was created to better support self-employed individuals and employees who do not have the luxury of any DB or DC pension plan, nor any Group RRSP.
Make sure you check out our detailed RRSP post: everything there is to know about the RRSP and the current RRSP contribution limit.
Tax-Free Savings Account (TFSA)
Who doesn’t like tax-free money???
That’s what the Tax-Free Savings Account (TFSA) can deliver!
The TFSA came into effect in 2009 and immediately allowed Canadians 18 years of age or older the chance to invest (not just save money) tax-free. The idea behind the TFSA is both simple and magical:
- With after-tax money, you can contribute to the TFSA, and
- Any investment income earned inside the TFSA (capital gains, interest, dividends) is sheltered from taxes. It gets even better! In retirement or even earlier, if you wish, you can withdraw money from your TFSA at any time, tax-free!
While the annual TFSA contribution room may not be as generous for some Canadians as any annual RRSP contribution room – it remains significant for wealth-building purposes.
The most recent annual contribution limit for the TFSA, for 2021, was $6,000. If you have been eligible to contribute since TFSA’s inception (as of January 1, 2009), you will know your total available contribution room is fast approaching 6-figures in the coming years!
In that link above, you’ll find tips on managing the TFSA from carrying forward unused contribution room to how to use this account wisely far beyond any savings account.
Three Pillars of Canada’s Retirement Income System Summary
Canada’s retirement income system, with its three pillars and various programs and accounts within these pillars – is arguably one of the best of its kind. Yes, simplification can of course be gained when it comes to the details within each pillar, and any tax implications associated with the programs and accounts. We have lots of ideas on that and can share more with you over time!
However, the premise of Canada’s Retirement Income System is very sound:
- Establishing and maintaining one foundational pillar / a social safety net for all (universal benefits),
- Another pillar tied to mandatory/forced contributions (via CPP/QPP), and
- A final pillar that focuses on employer-based incentives and/or personal accounts to help fund retirement – has been a resilient, time-tested model that has supported Canadians for years.
It is very likely most Canadians will need a little bit of each pillar to help fund their secure retirement. We already know we’ll use each pillar ourselves…
On our site, we often get questions like “How do I know I’ve saved enough for retirement?” or “How much can I spend in retirement?”. Based on this post about Canada’s Retirement Income System, you can now see there are many combinations and permutations that can deliver retirement income success (or failure) for Canadians. Such questions are difficult to answer without adequate knowledge, experience, let alone without good financial tools.
This is where we can help…
Because of Canada’s robust Retirement Income System, it takes some effort to figure out any personal retirement income puzzle. At Cashflows & Portfolios, we are happy to look at your individual or family needs when it comes to retirement decumulation in a tax-efficient way.
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Knowing the best age to draw down accounts or take government benefits is something we can help you or your family with.
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In the meantime, stay tuned for more free content. We’re happy to publish that too.
Disclaimer: Any information shared on our site (“Cashflows & Portfolios” https://cashflowsandportfolios.com/) or related to our site, is for awareness and illustrative purposes only.