No discussion about retirement income is complete without considering the impacts to income when one spouse dies. Consider the following hypothetical client scenario.
Meet Maureen and Henry, a retired couple in their late 60s with retirement income from three sources: Henry’s company pension, government programs — the Canada Pension Plan (CPP) and Old Age Security (OAS) — and their retirement savings. Their gross income is nearly $95,000 a year and net income is about $81,000.
Henry recently died after suffering a sudden heart attack. As Maureen grieves the loss of her partner and gets used to living on her own, she’s also finding that Henry’s death is having an unexpected negative effect on her finances. Her gross monthly income has fallen from about $8,000 to about $5,850 per month, or $71,000 per year, a decrease of about 25%. She now has an after-tax income of $57,120, a decrease of almost $24,000 per year.
She is earning less and paying more in taxes than when Henry was alive. What happened?
The answer is a combination of a decrease in the household’s entitlement under Henry’s company pension plan, a reduction in CPP and OAS, and the inability to split income for tax purposes.
On the income side, Maureen now receives less from Henry’s company pension plan. Upon the death of the pensioner, the survivor’s entitlement is based on the pension plan contract terms and, quite often, on the survivor option that the original pension member chose at the time of retirement. Often, the contract will offer a pensioner the ability to purchase an annuity for their surviving spouse as a percentage of the pensioner’s pension payment. The greater the percentage provided to the survivor, the lower the monthly payment that the pensioner receives.
In Maureen and Henry’s case, Henry chose a survivor pension for Maureen of 60% of his pension. While Henry was alive, he received a pension of $35,000 per year. Applying the 60% survivor pension means that Maureen will now receive $21,000 per year.
The rules respecting a CPP survivor’s benefit are complex; however, when a pensioner such as Henry dies, the survivor’s monthly entitlement under CPP normally changes. The amount of the change is based on a formula, and the entitlement is also subject to a maximum amount. The formula accounts for several factors, including the amount the deceased received, whether the survivor received CPP benefits and the survivor’s age.
Generally, if the survivor (spouse or common-law partner) wasn’t receiving CPP benefits and is over age 65, they could receive 60% of the deceased’s pension as their survivor benefit. If the survivor wasn’t receiving CPP benefits and is under 65, they could receive a flat rate portion plus 37.5% of the deceased’s pension.
If the survivor was receiving benefits (either retirement or disability) prior to the spouse’s death, they’re entitled to a combined payment, which is subject to complex rules.
When the survivor was previously receiving a CPP retirement benefit, the maximum combined benefit the survivor can receive is the maximum retirement pension for an individual (which is more than the maximum survivor’s benefit) — currently $1,203.75 monthly. Therefore, if spouses were each entitled to that maximum amount, the household income from CPP after the first spouse’s death would decrease from $2,407.50 to $1,203.75.
However, most Canadians don’t receive the maximum benefit. The average CPP retirement benefit is $619.68 per month or $7,436.16 per year.
Maureen and Henry were fairly typical and received a combined household benefit of $1,350 per month or $16,200 per year while Henry was alive.
Applying the complex rules associated with a survivor benefit means that Maureen will now experience a decrease in CPP income and will receive $1,086 per month or $13,032 per year, a decline of $3,168 per year.
Even more detrimental for Maureen is the effect of Henry’s death on the household’s OAS benefits.
The quantum of a person’s OAS benefit depends on how long they’ve been resident in Canada. A person who has lived in Canada for a period greater than 40 years after age 18 is entitled to the maximum benefit of $7,623.12 per year.
In Maureen and Henry’s case, both met the criteria and were entitled to the maximum benefit, meaning the household received about $15,246 per year. However, no survivor benefit is offered under OAS. So, after Henry’s death, his OAS is lost. Maureen will be entitled to only her benefit of $7,623.
The changes from these three sources amount to a decline of about $24,800 per year ($14,000 + $3,168 + $7,623).
Maureen believes the decline isn’t as bleak as it appears, because the less you earn, the less you pay in taxes. She’s therefore confident that her net income won’t be as hard hit as her gross income.
Unfortunately, she’s wrong.
When Henry was alive, the household had an effective tax rate of 14.74%, but now Maureen has an effective rate of 19.55%. How is this possible?
While Henry was alive, they were able to take advantage of the income splitting rules available to retired couples: up to 50% of eligible pension income can be split between spouses.
The definition of eligible pension income depends on age.
For all ages, eligible pension income includes periodic pension payments and successor annuitant RRIF payments on death of a spouse.
Those 65 or older, like Maureen and Henry, may also split RRIF payments, LIF payments and certain annuity payments, usually sourced by insurance companies.
In Quebec eligible pension income is only for those age 65 and older.
Because of Canada’s individual graduated tax rate system, the inability to split income with a spouse can lead to higher tax rates for the income earner. In fact, when Maureen converts her RRSPs to RRIFs, she might find another unwelcome surprise. When Henry died, his RRSPs transferred to her through a spousal rollover. Much as this was beneficial, it could also mean larger than expected minimum RRIF withdrawals down the road, translating to another unwelcome tax surprise.
Maureen isn’t alone. Many widows and widowers are surprised to find the devastating impact the death of their partner can have on their finances.
All too often, retirement planning is focused on the couple’s income and whether they’ve saved enough, after considering income splitting strategies, with little consideration for the survivor’s income.
In Maureen’s case, she and Henry saved a significant nest egg, and she’ll adjust. However, both from a peace-of-mind and planning perspective, these issues should’ve been explored years earlier as part of their retirement discussion.