Registered Retirement Income Funds (RRIFs) are the most popular RRSP maturity option, the other two being annuities and lump sum withdrawals. The RRIF was invented to provide flexibility and control to the RRSP owner, so it may come as a surprise to readers that the RRIF’s lack of flexibility in today’s economic environment is resulting in calls for changes to the way Canadians create retirement income from their maturing RRSP.

RRIFs have 3 main purposes. The first is to create regular income that hopefully will not be outlived. The second is to give planholders control over their capital and how it is invested. Finally, it is the vehicle through which the government recovers its deferred tax revenue. This last point is of particular importance since the advent of the OAS ‘clawback’ tax, which can place seniors in an unexpectedly high tax bracket. It is also because of this tax issue that RRIFs fail as an effective estate planning tool.

The first generation RRIF became available in the late 1970s. It only addressed the investment flexibility problem – the term (to age 90) and the payment formula (one, divided by ninety minus your age, times the account value) were fixed. For people living past 90, non registered savings had to suffice.

In the 1980s, income flexibility was introduced. High interest rates of that decade (remember the 19 1/4% CSBs?) kept account values high, and we could even roll pension income over into our RRSPs. These factors kept the flaws in RRIF design hidden. Finally in the early 1990s a third generation RRIF emerged that extended past age 90. However, the government of the day was in poor shape financially, and saw RRIFs as a source of tax revenue. Thus, the pre-age 78 income minimums were increased, and the maturity age was lowered to 69 (since restored to 71). It is this version of the RRIF with which we must work today, so let us see how RRIFs in today’s economic climate fulfill the 3 objectives above.

Once a RRIF planholder is in his or her 70s, the legislated minimum amount that must be withdrawn from a RRIF increases annually beyond 7%. In other words, if the investments in the RRIF earn less than 7%, capital is eroded and future minimum incomes decline. To preserve income, let alone provide inflation protection, one would have to take out more than the minimum. This erodes capital even faster, thereby running the real risk of outliving the plan. Strike one.

Let’s call our mythical planholder Bob. Bob has always managed his own investments, including his RRSP. Entering 2008, Bob was a big fan of energy stocks – after all, oil was $140 a barrel and heading up. He had some bank stocks, some bonds, and some international equity mutual funds for diversification. When the market crashed in the fall of 2008, Bob took his RRIF payments by selling the bonds. However, they soon ran out. Bob now has to sell stocks at prices still well below their June 2008 highs. He did his 25% “repayment” in February, but kept those proceeds in cash for his early 2009 RRIF payments. Bob is now cannibalizing his capital, and his RRIF may never recover. Strike two.

Meanwhile, how is the taxman doing through all this? Well, as we saw in the early ‘90s, the government was looking everywhere for more tax money. They hit the RRSP/RRIF system, and then went after the Old Age Security (OAS) program. Effective in 1991, all OAS recipients earning above a certain level of income were subject to the ‘Social Benefits Repayment’ – a 15% tax on income that clawed back the OAS. RRIF income was included in the calculation, and of course a minimum amount had to be taken as income whether needed or not. You could say that your RRIF has made planning around the OAS clawback more difficult. Home run for the tax man.

Recently there have been positive developments on the retirement front. The first $2,000 of pension income is taxed at preferential rates. Pension and RRIF income can be split with your spouse, unlike regular employment or investment income. And, we can now save up to $5000 per year into a Tax Free Savings Account (TFSA), eliminating tax on any earnings earned in the plan.

So does all this mean that RRIFs have outlived their usefulness? Far from it – we just have to be more careful how we use them. Let’s see how.

If the RRSP is your main source of retirement income, then consider a life annuity for part of your portfolio. As the name suggests, these pay an income for life, regardless of how long you (or your spouse and you, if married) live. Since annuities are guaranteed, they can be considered for portfolio allocation purposes as part of the fixed income component of your investments. Other parts of your portfolio can be more growth-oriented, allowing for future inflation protection.

Choose the timing of RRSP/RRIF income to minimize the tax bite. While age 71 is the maximum age to buy a RRIF, there is no minimum age. If you retire before age 65, there may be years of little or no taxable income when RRSP money can be withdrawn at a favourable tax rate. The bottom tax bracket (federally) has been increased to over $40,000, so even if you don’t need the income, withdraw the money from the RRSP and pay a small tax bill. Immediately reinvest the money in your TFSA or regular investment account. Many financial planners have software that can help you identify and exploit these low tax opportunities.

Similarly, taking your early CPP at age 60 results in a lower payment than if you wait until the traditional starting age 65. This is not a penalty, just an actuarial recognition of the fact that early recipients will receive more payments. But CPP is taxable, so lower is better if the OAS clawback comes into play.

If you have non-RRSP assets as well, then use the RRSP for what it does best – shelter fully taxable income. Most people with balanced portfolios can minimize overall income tax by keeping tax-preferred dividends and capital gains outside the RRSP and putting bonds, GICs, and other fixed income investments inside the RRSP. As we have discussed, the resulting RRIF will probably earn less than 7%, meaning that the plan’s income will decrease throughout retirement. To supplement the declining RRIF, structure the non-registered investments for income creation. For example, if dividends are used, then the overall tax bill should decline as RRIF income is replaced by the more favourably taxed dividends.

Finally, get involved. There are advocacy groups out there who recognize that further improvements to RRIFs could make the program even more useful. Many potential changes would be beneficial. RRIF minimums could be reduced to reflect today’s low interest rates. The maturity age could be pushed back to 75 or later, reflecting the need and desire for many Canadians to work longer. ‘Holidays’ from paying tax on RRIF income could be granted under certain circumstances. Why stop here? With the cost of housing in major urban centres way out of reach for our children and grandchildren, we could get very creative and suggest that RRIF proceeds could pass tax-free to children or grandchildren if used for the purchase of a home.

Retirement saving is a critical challenge for Canadians of all ages. Much effort is being spent on examining the accumulation side of building retirement assets through pension plans and RRSPs. Perhaps it is time to also focus on the income side – by updating RRIFs!