Rob Smith, author of Dollars From Change and Dave at Investing Intelligently had a couple of comments on yesterday’s post that you should consider when deciding if a RRSP contribution is right for you:
- Rob pointed out that RRSPs are important because you are “maximizing the tax rate of deductible contributions and minimizing the tax rate on eventual withdrawals”. In other words, you want to contribute money on which you would have otherwise paid tax at a higher rate and withdraw it when you will be paying tax at a lower rate.
- Dave made an excellent post on the mortgage versus RRSP debate and concluded that the answer depends on what assumptions are made. You can assume that your RRSP portfolio will have returns in the low single digits and show that a mortgage pay down is better, but it may not be a realistic assumption.
- Rob also suggested a simple rule of thumb: try to keep your home equity (value of the home less the mortgage on it) and your RRSP roughly equal. If one is much lower than the other, then perhaps that’s where you should put your money to work this year.
- The anti-RRSP crowd also complain about all the bad things that happen if you have accumulated too much money in your RRSP (OAS claw back! high taxes!). But how realistic is this concern (which is, admittedly, a nice one to have) for the vast majority of Canadians? According to Statistics Canada, even families in the 55 to 64 age group, who are presumably close to retirement, have a median value of $60,000 in their RRSPs.
Winners of the Giveaway: As Margot generously offered a free copy of her book for the giveaway, there are two winners: Patricia and Bob. Congratulations to them and thanks to everyone for participating.
If you didn’t win, you can always order a copy of the book (priced at $22.50 including shipping) from the Spend Smarter website. I think you will pick up a tip or two that more than pays for the price of the book. I should also point out that this is a public service announcement and I do not receive any benefit from the sales of the book. I’ll also take this opportunity to thank Margot for taking the time for the interview and wish her every success with her book.
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17 responses so far ↓
1 Dave // Feb 8, 2007 at 1:06 am
Rob makes a good point as far as tax rates are concerned. The calculations I was critiquing assumed the same marginal tax rate when contributing to the RRSP and the same when withdrawing from the RRSP later. For some this may be true, for others, maybe not. Again, it’s an assumption and one that can affect the results you get out in the end.
2 Mike // Feb 8, 2007 at 8:29 am
I have a solution to get around the OAS clawback - if you have “too much” then just retire earlier than planned.
3 Canadian Capitalist // Feb 8, 2007 at 9:22 am
Mike: Exactly! Having too much in the RRSP is a very nice problem to have. You can simply retire early and start withdrawing money. But realistically, how many people have this problem??
4 Al R // Feb 8, 2007 at 9:28 am
It’s interesting that people are so fixated on getting OAS - which is supposed to be an income support so that the elderly (especially those without a sufficient CPP income stream) don’t find themselves in poverty. Not saving up so that you can receive OAS after you hit 65 isn’t terribly different from deciding to halve your income so that you can qualify for the National Child Benefit.
I’d like to see the clawback start at a much lower level (e.g. $40,000) that more accurately reflects the level at which an individual needs extra help from the government. As a bonus, the savings could be put towards other priorities, such as tax cuts that help out the economy and create wealth for everyone.
Anyway, my $0.02…
5 Mike // Feb 8, 2007 at 9:39 am
Interesting point Al - I think you’re right that the clawback could be lower if OAS is indeed to help lower income people - a couple that makes more 60k each (which I think is when the clawback starts) is not low income.
I disagree with the ‘not saving up to get OAS’ part - If my wife & I are in a situation where we have OAS clawback then that’s bad planning because we don’t make that much now. I am planning to get the OAS and if I have to retire a bit earlier to make it happen - then I’m willing to make that sacrifice.
CC - not too many people have this problem but I think there will be a few more in the future since retirement planning is a bit more mainstream compared to 20 years ago. However it will always be the minority who have a fully (or over) funded rrsp - of course that depends on your definition of ‘fully funded’.
6 larry macdonald // Feb 8, 2007 at 10:38 am
Just thinking out loud here …. what is a reasonable return to expect on RRSP holdings? Historically, equities have averaged about 9% a year. For equity mutual-fund investors, take an average 2.2% off for MERs, and the expected return is 6.8% a year.
If we follow conventional portfolio theory and hold a portfolio balanced over stocks and bonds (say 60% stocks and 40% bonds like the average pension fund), the expected return goes down to about 5.5%.
A further consideration is investor behavior. Studies by DALBAR show that the average mutual fund investor earns a lot less than reported returns. That’s because they succumb to market sentiment and end up buying high and selling low.
If they underperform reported returns by 1/3 or so as DALBAR studies seem to indicate, the return earned by the investor with a balanced portfolio would then be closer to 4% (for the investor using exchange traded funds, it would be closer to 5.5%).
7 Mike // Feb 8, 2007 at 11:25 am
Great point about investor behaviour Larry - for all the analysis/complaints about excessive costs, ideal asset allocation, active/passive management etc, there are a lot of us who can identify our own behaviour as the biggest cost to our portfolios, I know I can. While I haven’t been too bad, in the past I have been guilty of chasing returns, greed (LSIFs), panicking (see 2000,2001) etc. This year is the first year where as a result of reading various blogs, books etc I created a formal investment plan, set it up (mainly the asset allocation part) and the last part of the plan is to stick with it - even when the markets go down for extended periods of time. That will be the hardest part but hopefully blogs like this one & Larry’s will help get me through those tough times.
8 Canadian Capitalist // Feb 8, 2007 at 12:16 pm
Larry: My expectations for future returns are in the 7-8% range but that is because my portfolio will be 80% in equities with a significant portion in small caps. For a traditional portfolio (60% equities 40% bonds), I’ve seen pension plans making assumptions of 5% returns.
You are also correct that fees and investment behaviour such as frequent trading and performance chasing greatly reduces returns. From my own experience and from the behaviour of people around me, I think investors are their own worst enemy.
9 hepman // Feb 8, 2007 at 5:52 pm
Many people talk about how their homes will be used to fund retirement as a reason not to invest in RRSP’s. I think this is dangerous. What if the population keeps level or even drops and all the boomers start selling their homes. Fewer people buying and more selling. Prices start to drop and their goes the retirement nest egg you were counting on. What about diversification? All your assets in real estate, that’s great diversification!
10 Phil S // Feb 8, 2007 at 6:18 pm
RSPs aren’t for everybody. For example, business owners don’t have any “earned income” as defined by Rev Can so aren’t eligible for an RSP. Lower tax bracket Canadians don’t have any tax incentive to contribute and the wealthy usually don’t need an RSP since they have enough money to retire at any time anyways. It’s really only us middle class working stiffs who need it as a tax break.
11 Phil S // Feb 8, 2007 at 6:22 pm
Mike. While I agree that most LSIFs are poor investment choices, I don’t think they are ALL bad and I definitely like the idea behind that investment vehicle. For example, if you had an LSIF that was run by people of the same calibre as a private equity firm, then you would get great returns. The obvious problem is that most of these funds are run by financial hacks who are only in it to charge exhorbitant MERs (9%+) and made stupid investments that probably put money into companies started by their friends. If this investment vehicle weren’t so abused, then I think it would be a great investment vehicle.
12 Mike // Feb 9, 2007 at 12:29 am
Phil, at this point I refuse to accept the idea that there is an LSIF anywhere that isn’t out to collect my money and then spend it on boozy office parties and their wives home businesses while they laugh at both the government saps like me for funding their shenanigans!
But seriously - you stated it perfectly - the idea is there, too bad the criminals took over. I also really don’t care if there is the odd “non-bad” fund - if you have a basket of apples and have to search through the whole basket to find one good apple…just throw the whole damn thing out!! And press charges where appropriate.
13 Mike // Feb 9, 2007 at 12:42 am
and furthermore…how did these tax breaks get started? I remember something about how the initial funds were sponsored or associated with unions? Was the gov’t trying to suck a few votes with this thing?
My question is why does this particular “asset class” even need tax breaks…we’re not talking about art galleries here or charities. Did Google get some special tax break before they went public to ‘help them out’? YouTube? MySpace? What about Tim Hortons? Surely that poor Canadian company couldn’t have been successful without some sort of special tax break before it went public?
Ok the valium is starting to kick in - time for bed.
p.s. in my previous post I meant to say “the government AND saps like me”. My rage against these funds makes it hard to type
14 Phil S // Feb 9, 2007 at 9:03 am
Hi Mike. I certainly don’t disagree with you and I own shares of a couple of private equity firms in my investment account where I didn’t get any tax breaks. I have also bought LSIFs in the past and got burned by a couple of them.
The way that the KPMG guide explained it to me is that the government wanted to promote venture capital in Canada. They obviously wanted to put restrictions on it so that the money isn’t used to invest in existing publicly listed companies, it shouldn’t be invested out of the country and they didn’t want short term traders jumping into and out of venture capital either. Government recognized that small businesses and entrepreneurs drive innovation in Canada which eventually lead to prosperity, larger companies, jobs, yada yada.
I really really like the “spirit” behind what they’re trying to achieve. It’s just unfortunate that the early adopters of this asset class are mostly crooks or at the very least incompetent hacks.
15 Canadian Capitalist // Feb 9, 2007 at 11:44 am
My opinion on LSIFs are similar to Mike’s. Average investors are easily sucked into investing in them and they are almost always dogs. Not to mention, according to David Swensen, average investors shouldn’t even try to get exposure to the private equity asset class, which he calls non-core.
There is another reason why advisers push this product hard. They have a built in 6% up front commission, MER’s that average 5% and a very poor track record. To add insult to injury, you can’t even easily dump them.
16 Phil S // Feb 9, 2007 at 1:16 pm
I don’t understand the systematic aversion to private equity. Private equity is just not publicly listed assets and it can be a variety of asset classes. If you buy a rental property (and many people do), then that’s private equity. And a publicly listed private equity firm gives you access to non-listed companies through a listed company. I prefer the ones that mix it up with private debt so as to be able to generate revenues, instead of pure venture capital. Perhaps that David Swensen guy might be referring to venture capital, which is more risky?
17 Dave // Feb 9, 2007 at 1:18 pm
“Not saving up so that you can receive OAS after you hit 65 isn’t terribly different from deciding to halve your income so that you can qualify for the National Child Benefit.”
I love the analogy!
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