Retirement Planning Can Be So Complex People Avoid It Altogether. Here’s How To Avoid That Trap.

The article “Retirement Planning Can Be So Complex People Avoid It Altogether. Here’s How To Avoid That Trap.” was originally published on Financial Post on August 24, 2020.

There are ways it can be simplified

Saving for retirement can be a daunting task. For some people, it is difficult enough to cover their living expenses, let alone put aside money for retirement. For others, the challenges include not only figuring out how much to save, but also, which accounts to contribute to, and which investments to buy. Retirement planning has become more difficult over time, but there are ways it can be simplified.

In the past, more workers were covered by registered pension plans. 46 per cent of workers had an RPP in 1977 compared to only 37 per cent in 2017. Retirement also used to be shorter — retirement age has decreased over the same period by about two years while life expectancy has increased by about eight years.

The appeal of a defined-benefit pension plan is simple. Participation is often automatic. There are no investment decisions to make. There are annual estimates of a plan member’s future retirement income. DB pension plans reduce the planning required to retire.

Only about one quarter of Canadian workers have defined-benefit pensions. That means most people must accumulate and calculate their retirement income on their own. The difference between good and bad retirement planning choices may be less about delaying the gratification of spending today to save for tomorrow, and more about the complexity of making retirement planning decisions in the first place.

A 2019 study called “How Much to Save? Decision Costs and Retirement Plan Participation” (Goldin, Homonoff, Patterson, Skimmyhorn) looked at the retirement planning decisions of a pension plan for 300,000 active duty U.S. Army service members. One of the key findings was that if the decision to participate in a pension plan required too much thought, people may not contribute at all.

The Army offers a retirement plan to all employees. New employees receive information about the plan when hired. Some new employees in the study were also sent information by email about how to enrol in the plan and encouraged to join. Others received the same pension email, but with a highlighted rate (i.e. one per cent, two per cent … eight per cent) for suggested contributions. Another group did not receive an email about the plan encouraging them to join, nor highlighting a suggested contribution rate.

The results showed that the employees who received an email encouraging them to join the plan increased their participation rate by 15 per cent compared to those who did not receive an email. The employees whose email also highlighted a suggested contribution rate had a 26 per cent higher participation rate than the baseline.

According to the authors, “The difference in the estimated effects between the two types of emails suggests that at least part of the overall observed effect stems from highlighting a specific contribution rate rather than simply encouraging enrolment.”

The study also found that the same increase in participation applied two years later. So, the email and the highlighted contribution rate did not just accelerate participation — they increased participation overall.

There are several other recent studies that point to a similar impact on behaviour by introducing nudges that positively influence financial decisions. What I found interesting about this particular study was that it suggests that something as simple as deciding how much to save for retirement could discourage a saver from saving, period.

Trying to determine how much to save for retirement is not easy. Workers must consider whether to save, how much to contribute, which accounts they should use and what investments to buy.

Tax Free Savings Accounts have been around for more than 10 years now and have largely benefited both low and high-income savers. However, it may be that for some, the complexity of choosing between a tax-deferred registered savings plan like a Registered Retirement Savings Plan (RRSP) or a tax-free TFSA is just another disincentive to begin saving.

Although it pains me to speak in generalities about financial decisions that should be highly personal in nature, here goes nothing.

If a 40-year old saves 10 per cent of their salary each year and works until age 65, using conservative assumptions, they may be able to replace more than 50 per cent of their final year’s salary in retirement — including Canada Pension Plan (CPP) and Old Age Security (OAS) — adjusted annually for inflation. I say “may” because it depends what they have saved prior to age 40, and I have assumed nothing in this example. I have also assumed they have an average income and have contributed to the CPP and lived in Canada for most of their adult life.