Archive for the 'RRSP' Category

Paying Down Debt vs. Contributing to an RRSP

Published
by
Dave
1 year, 9 months ago
in Debt/Credit Cards, RRSP and calculations
. 11 Comments

The Canadian Capitalist had a link to article by the Smoke & Mirrors guy, David Trahair, called “Don’t Invest in an RRSP Before Paying Down Your Mortgage.” He starts off by saying that the conventional wisdom of investing in an RRSP then applying the tax rebate to your mortgage every year is hard to do. Instead, he says, don’t contribute to an RRSP, but put down more principal on your mortgage. If you want to talk psychology about what is “harder to do” I would suggest that contributing your maximum room to an RRSP is a better forced savings plan than applying an extra lump sum on the principal of your mortgage ever year, but that’s just me. Or maybe he’s suggesting you re-amortize for a much shorter period (after forgetting about RRSPs) but he doesn’t say that explicity. His second argument is that banks just want your money for RRSPs so they can charge you “commissions and fees on your contributions” (doesn’t make sense) and because the banks’ ideal is for you to be in constant debt. I don’t buy any of that as a reason to pay down a mortgage instead of an RRSP. What I care about is which one is better for me (regardless of whether the bank benefits). Just like I don’t care about MERs in principle. What I care about is the returns after costs.

In the latter part of the article, he argues why you should pay down your mortgage before contributing to an RRSP by showing an example of a couple in two scenarios. Scenario 1 has them paying their monthly mortgage payment and contributing to an RRSP $4000 each per month and investing the tax refund generated. Scenario 2 has them paying their monthly mortgage payment and instead paying $4000 each onto the principal value of the home. 11 years into Scenario 2 the home is paid off so they redirect what was their mortgage payment into their RRSP (and they invest the tax refund generated into their RRSP). I’ll give you the punchline:

The debt pay-down scenario shows a net worth slightly higher than for the RRSP scenario—a difference of $14,590. So, after 20 years, the Harts would arrive at a similar point
but would have taken a very different journey. The debt pay-down option, however, has two major advantages: it reduces the risk that the Harts could lose their house during the nine years of mortgage-free living, and there is less risk related to investment returns. How much confidence do you have that the markets are going to post better returns than the interest rate on your debt? Are you willing to stake your future on it?

This sounds very reasonable but I am very disappointed in his article for a few reasons. He assumes a rate of return in the RRSP of 5%. This seems unbelievably low to me. There might be a reason for that. Since paying down the mortgage (he assumes a fixed-rate of 6%) is low-risk he’s probably trying to match the risk in the RRSP and the mortgage. I am not sure why you couldn’t at least get 6% in the RRSP for almost the same risk. Secondly I would assume that the majority of people with large mortgages or any mortgage are younger rather than older. We can take on a little risk right? I mean we could at least put half our RRSP in equities and half in fixed income/bonds. A 5% return in an RRSP seems unrealistically low. And this is coming from someone (me) who sets his expectations fairly low (7-8%). Thirdly, he doesn’t explain what would happen if the rate of return were even a bit higher but he takes the time to mention the measly difference in Scenario 1 over Scenario 2: “The debt pay-down scenario shows a net worth slightly
higher than for the RRSP scenario—a difference of $14,590.” Clearly his cooked up his numbers just so that he can say that. Because it’s not even a difference worth mentioning. He even says in the next line: “So, after 20 years the Harts would arrive at a similar point but would have taken a very different journey.”

I tried to replicate his calculations in a spreadsheet of my own so I could try out some other combinations of rates. (You can now skip to the next paragraph if you get bored easily). I was pretty much successful, only off by a small percent. This is due to the complicated way that he decided to handle the tax rebates. When Joe and Karen each contribute $4000 per year to their RRSP they get a tax rebate equal to $4000 multiplied by their marginal tax rate (40% in this case). They take that $1600 tax rebate and contribute $4000+$1600 to their RRSP in the following year. Then they get a $2,240 tax rebate and contribute $4000+$2240, then the following year, $2,496 extra, eventually converging to some value. I already talked about this “snowball effect” before. Note that it is non-existent if you maximize your RRSP contributions every year anyways. (Do not NOT maximize your RRSPs just so you can get this effect. It’s not that exciting.) Anyways, another way to handle this in the simulation would have been to just assume the max contribution room every year was $4000 for each of them or whatever, and contribute the excess cash available into a non-RRSP account. Personally I would do the latter since we maximize our contribution room every year. Any excess monthly cash (that might come available after paying down a mortgage) would go into non-RRSP investments.

Anyways, if you just increase the RRSP rate of return a little bit, as you can see in this modified spreadsheet, the RRSP case beats the pay-down-debt case. If you increase the rate it beats it by a wider margin but never by much.

I think the takeaways here are:

  • That paying off a mortgage is a great low-risk investment.
  • Make sure you look carefully at any assumptions used in calculations by accountants and financial advisors. Are they realistic?
  • When looking at a return, never forget about the risk associated with that return.

Popularity: 25% [?]

My Investment Advice for Young Adults

Published
by
Dave
1 year, 10 months ago
in Debt/Credit Cards, Investing, Personal Finance, RRSP, Rewards, Saving and Spending
. 5 Comments

Rather than just bash Rob Carrick’s advice for young people, I’ll offer up my own advice:

  • Start investing as early as you can. The earlier the better.
  • As soon as you have some money, invest some of it. If you have a paper-route or a part-time job, invest 10-20% of it for the long term. Get in the habit. Invest monthly. You won’t miss that money.
  • If you are babysitting for cash, tutoring for cash, earning tips, basically if you earning ANY employment income, file a tax return and declare all your income to build up RRSP contribution room.
  • If you have RRSP contribution room, start an RRSP and contribute to it. Find a company that will not charge you any annual RRSP fee. I recommend something like TD’s Mutual Fund Account. Set up an automatic monthly contribution if you have steady income. Max out your available contribution room every year.
  • Set up one or more ING Direct Savings accounts or one ore more savings accounts at your bank. If there is anything big that you want to save up for, use that to save up for it.
  • Don’t get a credit card unless you have to. Keep your credit card limit low. Pay off your balance every month. Don’t be dazzled by rewards plans.
  • When you get a large chunk of money from a birthday, a scholarship/bursary, a tax refund, don’t put it in your chequing account or convert it to cash. Deposit it into a savings account. Sit on it for a bit. Don’t make an impulsive purchase.

Think any of my advice is bad? Think I am missing something? Let me know.

Popularity: 26% [?]

Rob Carrick’s [Bad] Advice to Young People: RRSPs? Nah.

Published
by
Dave
1 year, 10 months ago
in Advisors/Brokers, Personal Finance and RRSP
. 6 Comments

Rob Carrick’s receent article is a beauty. His headline is “Under 25? Live it up! Financial advisers can wait.” The article gives very confusing advice, and is by no means “financial and investing wisdom” as he claims. It’s the opposite of wisdom, whatever that is. He main goal point seems to be that young adults should wait before starting to invest (”RRSPs? Nah.” he says) and that they should stay away from the financial industry.

His logic goes like this. The “the financial industry is always trawling for new clients” so don’t invest until you are older. “There’s no need to let the financial industry get its hooks into you just yet.” If you do some investing, “get aggressive, sure, when you’re young, but hold off on the adviser.” “Be wary of the financial industry at any age.” Did the financial industry abuse Rob Carrick as a child? When you’re a bit older, sure go ahead, get an advisor, he says. “My advice to people in their early 20s is to live a little, and then visit an adviser when you really need to.” “Expert help can be indispensable if financial matters baffle you.” He uses an example of a TD poll that concluded that people aged 18-24 are least likely to have consulted a financial planner. Rob, TD is not in the same business as the fast food industry. Advertising targeted at children/young adults is OK.

Rob makes a feeble argument as to why you should until you are 28 to invest rather than, say, 22. Here goes:

There’s a good, strong argument for contributing to RRSPs as young as possible, of course. The earlier you put money in a plan, the longer it has to compound tax-free. If you put $1,000 in an RRSP at age 22, you’ll have $18,344 at age 65 if you assume an annual return of 7 per cent. If you wait until 28 (the TD poll found this is the average age for starting an RRSP), you’ll have $12,223, and if you wait until you’re 32, you’ll have $9,325.

By these numbers, the right age to start contributing to an RRSP is 28. You just lose too much in tax-free compounding if you wait until 32. And what about the $6,121 in gains you miss out on by delaying until age 28? Call it a fair price for enjoying your youth and not rushing into financial adulthood.

I’m not sure how he concludes that the magic age is 28 from those numbers. May I remind you Rob that one is only allowed to contribute up to 18% of one’s gross income into an RRSP every year. In the worst case that would lead to an 18% reduction in enjoyment, in the best case, it would lead to less spending on unnecessary things and minimal impact on enjoyment. You said it yourself Rob, “There’s a good, strong argument for contributing to RRSPs as young as possible, of course. The earlier you put money in a plan, the longer it has to compound tax-free.”

Popularity: 12% [?]

Result of Poll: What annualized return on your retirement portfolio do you expect in the next 10-20 years?

Published
by
Dave
1 year, 10 months ago
in Investing and RRSP
. 0 Comments

I’m kind of embarrassed about this, but I had this poll on my sidebar for almost a year now. I kind of forgot about it. It’s now gotten 106 votes (not necessarily unique votes, I think it allows 1 vote per IP address). Here are the results:

What annualized return on your retirement portfolio do you expect in the next 10-20 years?

  • <5%: 2% (2)
  • 5-6%: 8% (9)
  • 7-8%: 40% (42)
  • 9-10%: 26% (28)
  • 11-12%: 8% (9)
  • 13-14%: 3% (3)
  • 15-16%: 3% (3)
  • >16%: 9% (10)

Total Votes : 106

It’s good to see that most people are in the 7-8% range. It’s good to think conservative, at least when estimating what return you will get in the future in order to estimate how much you will have when you retire. It is interesting that I asked what return people expected on their “retirement portfolio” and some people actually selected the “above 16%” box. I find it hard to take that seriously. You would have to be taking on far more risk in order to expect that kind of return, and taking on a lot of risk in a retirement portfolio is not something you want to do.

Anyways, I’ll be removing the poll feature now. It’s part of an effort to clean up my site a bit by removing the clutter.

Popularity: 9% [?]

The Home Buyers’ Plan (HBP)

Published
by
Dave
1 year, 10 months ago
in RRSP and Real Estate/Housing
. 15 Comments

A few weekends ago I was at a taxation seminar put on by a local accounting firm and they were pretty much saying that you should use the HBP. They mentioned it several times. They even went on to say that if you currently have some other debt, say a student line of credit, you should be concentrating on paying that off rather than contributing to an RRSP. Well I don’t know if I agree with that, especially if your line of credit is at prime, as ours is. Not only that, but contributing to an RRSP gives a tax rebate (which you can then throw onto the debt after having maxed out your RRSPs); paying down debt doesn’t. They were pretty insistent that paying off debt should be the first priority. But, they said, you should contribute to your RRSP up to the $20,000 so that you can take advantage of the Home Buyers’ Plan. Huh? They really made it sound like you should contribute just $20,000 to your RRSP, then ignore it and continue paying down debt. It didn’t really make any sense to me.

At one point I raised my hand and asked: “Can you compare withdrawing $20,000 from a line of credit to pay for a down payment vs. withdrawing $20,000 from my RRSP? for example, if my line of credit is at 6% or so and my RRSP is earning maybe 8 or 9%?” Their argument was that they thought I would have to have a much larger return in our RRSP compared to our line of credit to make it worthwhile. Their second argument was that you never know what will happen to interest rates in the future. Their answers weren’t that satisfactory and I expected a bit more from accountants. To make a long story short, after I got home, I started reading about the Home Buyer’s Plan.

The Home Buyers’ Plan is often touted as a magical way to get $20,000 needed for a down payment. I say “magical” because it is often explained in a very simple way without discussing the disadvantages, or any discussion of the alternatives. Here are some examples of what I am talking about:

  1. Assumption Life makes the assumption that The Home Buyers’ Plan (HBP) is a “winning formula.” “This winning formula can thus help you fulfil your dream to own while also making it possible to maximize your RRSP contributions.”
  2. This TD article “A Larger Down Payment Means Greater Savings“
  3. This article from North Shore Credit Union talks about the Home Buyer’s and lists the only downside as being “If the $20,000 were left in the RRSP for 15 years, given an annual 3% rate of return, it would grow to approximately $31,200.” 3%!!! I hope that is real return!

As for #1 above, I think the HBP actually makes it harder to maximize your RRSPs. You will now owe money back to your RRSP and you may be saddled with a fat mortgage on a house that is slightly more expensive than what you might have normally bought had you not taken money out of your RRSPs. You might have a tough time paying off that big mortgage, paying of your RRSPs, and maxing them out every year going forward.

Contrary to what TD says in #2 above, although a down payment means greater savings, I don’t think the HBP necessarily means “great savings.” Here is a comparison between HBP and non-HBP using actual numbers (10% compound return in RRSP, 8% interest on mortgage). It works out roughly the same.

#3 is just laughable. I don’t know where they get their 3% rate of return from. They also claim that “if the homebuyer doesn’t use the RRSP, he/she will acquire a larger mortgage and may possibly even need to purchase mortgage insurance for a high-ratio home loan, which is 3.75% of the mortgage amount.” First of all, 3.75% is wrong, the max is 3.25% or 2.90% (I can’t figure out which, I think it was just lowered though). Perhaps their numbers are out of date. Second of all, if you’re buying a house on the North Shore (North Vancouver), $20,000 isn’t going to lead to a 3.75% premium (from 0%), although it may move you from a lower premium bracket (3.25%) to a higher one (3.75%).

Here’s what I see as the basic alternative to the HBP: Leave the $20,000 in your RRSP and add an extra $20,000 on to your house’s mortgage. This might leave you short of the 25% mark required for you to be exempt from the CMHC premium (of up to 2.75%). Or, it might move you from one CMHC premium bracket to another. This leaves you with a few alternatives, hold off on buying a home until you’ve saved up another $20,000 or take out a loan for $20,000, thus avoiding the CMHC premium (actually I am not sure if the CMHC looks at your other debt or not, if they do consider your other debts, what I just said may not work). You can get everything in between here. In the case where you have 0% down payment you could, again, take out a $20,000 loan or just increase your mortgage by $20,000.

I’d also like to remind you how little $20,000 is nowadays, especially if you are living in Vancouver and buying a condo for $400,000. A 25% down payment would be $100,000. If I get $20,000 of that from my RRSP or from a loan, it not too significant. If you are a couple, the Home Buyer’s plan allows you to take $20,000 from each RRSP which makes it a bit more significant.

The big downside of the Home Buyer’s Plan is that the rates of return from the equities and fixed-income investments in your RRSP may be much better than the interest rate on your mortgage. The amount of lost gains in your RRSP from taking out the $20,000 may be more than the amount of interest you save by reducing the size of your mortgage. The main upside of the home buyer’s plan is that it might allow you to reduce the amount of your CMHC premium. However, another way to reduce the amount of your CMHC premium would be to take out a loan and apply it to your mortgage. In this case, the same logic I used in the beginning of this paragraph also applies. Your RRSP’s rate of return might be higher than the interest rate on your loan. Another downside of HBP is that it can be a disadvantage to have your RRSP descend from $20,000 to $0, let’s say. First of all, when you have $25,000 or more in an RRSP, at some institutions this means you are except from the $125 annual RRSP management fee. Secondly, at E*Trade, for example, when you hit $50,000 in assets your commissions are reduced from $19.99 to $9.99/trade. Lastly, if a bear market is just winding down, that is the worst time to be selling $20,000 in equities from your RRSP.

There is a book from the CMHC called “Impact of the Home Buyers’ Plan on Housing Demand.” It says that “even when the individual has to borrow to make the repayments to the RRSP, there is still a net financial gain.” I think what they are trying to say is that taking money out of the RRSP under the HBP and then paying it back into the RRSP by taking out a loan. I would like to see their actual numbers but I can’t get the report to download.

Popularity: 12% [?]

E*Trade Might Eventually Allow Exchange-Free Trades in RRSP

Published
by
Dave
1 year, 10 months ago
in Costs and RRSP
. 1 Comment

I emailed E*Trade Canada about buying and selling USD investments inside an RRSP. This was before I knew anything about at all. Eventually I received this reply:

You can only keep Canadian dollar in rrsp account. You can buy US stocks but the money will be converted to CDN dollars. It is not possible to sell US stock and then buy more US stocks without converting to USD to CDN. Etrade is working towards a option so that you do not have to convert funds back and forth in rsp account.

Sounds promising. At least they are looking into it. Although the more I think about it, this forced exchange between USD and CAD currencies is not such a bad thing. As I’ve said before, my biggest problem before was that I would trade too much. Buying and selling things, reacting to the market. With the 4% exchange hit, it is much less likely that I am going to want to go back to my old active trading ways.

Popularity: 10% [?]

Foreign Currency Investments and Exchange Spreads Inside Your RRSP

Published
by
Dave
1 year, 10 months ago
in Costs and RRSP
. 3 Comments

Well finally my E*Trade account has been set up and my XIC ETF has been transferred over and now I am just waiting for the mutual funds.

I was confused by something I read in E*Trade’s help:

E*TRADE Canada offers a U.S. dollar trading account and a Canadian dollar trading account for customers who wish to trade (and pay for their trades) in the currency of the market in which they trade, thereby insulating themselves from exposure resulting from fluctuations in Canadian/US dollar foreign exchange rates. This enables you to trade U.S. securities in your U.S. dollar account, and Canadian securities in your Canadian dollar account (except for registered accounts, which are available in Canadian currency only)

For a second, I thought this might mean that I could only trade Canadian-dollar based investments inside my RRSP. I realized that was probably not the case as I am sure that it was possible to hold USD based investments inside your RRSP. What they MUST mean is that the cash portion of the RRSP must be in CAD, therefore, every time you buy or sell a USD investment inside your RRSP you will be hit with the exchange spread. Apparently TD Waterhouse can do “wash trades” where you can buy a USD money market fund (and get hit with the exchange) but then you can sell part of that and buy a US stock, for example, without having to go back to Canadian dollars in between. Or vice versa, you can sell part of the stock and go back to cash (the money market fund is like cash) without incurring any expense from the exchange. You have to call TD for these trades and cannot do them online.

It turns out that Canadians are allowed to hold foreign currencies inside an RRSP, it’s just that no one has implemented it yet. A guy from Ontario is suing BMO over this issue. The spreads are about 4-5%. So if you take $20,000 CAD and change it to USD and then change it back to CAD, you will have about 4-5% less than what you had when you started. That is almost $1000 CAD. I am looking forward to hearing what happens in this case. I hope that once one company decides to (or is forced to) allow clients to hold USD or to trade between two USD investments without incurring exchange spread costs, that all the other online brokers will follow suit.

Update (2007/03/01): Larry McDonald talks about this in his article “Beware of the details of foreign diversification.”

Popularity: 13% [?]

Canadian RRSP Statistics

Published
by
Dave
2 years ago
in RRSP
. 2 Comments

The Canadian Capitalist linked to a Stats Canada article about Canadians and their RRSP contributions. I found some of the results interesting:

“As in recent years, almost 86% of taxfilers were eligible to contribute for the 2005 tax year. Of these, about 31% actually made contributions.” - This makes me feel glad about our situation, that we are certainly in that 31% minority, but it is a bit disturbing that the vast majority of people (69%) did not make an RRSP contribution. What does this say about our education system? There is not a single mandatory high school course in B.C. that teaches students about RRSPs (or anything financial related) yet it is mandatory to take all sorts of other useless (relatively-speaking) courses.

The median contribution from Vancouverites was $3,160. I am proud of the fact that we are contributing almost double that amount per person (effectively maxing out our contributions), while definitely not making double Vancouver’s median income. It is going to be a challenge next year as our effective income in 2006 has increased significantly since my wife worked for all of 2006 (compared to half of 2005) but we are committed to contributing our 18% which should be easily achievable just by reducing our loan payments. Overall in Canada taxfilers contributed $30.6 billion, which represents “only about 7% of the total room available to eligible taxfilers.” I think the reason that is so low is because of the 31% statistic above. At least I think that the 7% is including all taxfilers, including those who did not contribute at all.

Popularity: 9% [?]

Investing Inside an RRSP vs. Outside an RRSP

Published
by
Dave
2 years, 8 months ago
in RRSP and Taxes
. 3 Comments

There were a couple of blog articles recently about investing inside an RRSP vs. investing outside an RRSP. Frugal Focus discusses a report by Phillips, Hagar & North called “The Retirement Savings Debate: Inside or outside the RRSP structure.” He makes note of the fact that

the publication of this report preceeds two potentially important events - the November 2005 announcment by the former Liberal government regarding changes to taxation for dividend income and the yet-unrealized election promise by the new Conservative government to allow capital gains to be eliminated for individuals on the sale of assets when the proceeds are reinvested within six months

The Canadian Capitalist orginally blogged about this and focused on an article by Derek Foster (author of “Stop Working”) in Canadian MoneySaver magazine that discussed ways of investing outside your RRSP. Foster has some interesting ideas, like this one:

Suppose you were planning to put $6,000/year into an RRSP to save for your retirement. You would be contributing to your RRSP and getting a portion of that back because you could use the RRSP contribution as a deduction. Thus, your out-of-pocket annual expense would be $6,000, less the amount of tax money you have refunded.

Another method of achieving the same result is to take out a secured line of credit (let’s say $100,000 @6%) and invest it in good quality, blue chip, dividend-paying equities. Now you’ll be paying the $6,000 towards interest instead of putting it into an RRSP, but you will still get the same deduction as your out-of-pocket expenses are exactly the same! Money borrowed to invest is tax deductible. The only difference is that now you have $100,000 invested in a non-registered account that holds dividend-paying stocks rather than a contribution of $6,000 every year in your RRSP. You get the benefit of the dividend tax credit, while still getting a full deduction on the $6,000 interest payment (exactly the same effect as contributing to an RRSP).

The Canadian Capitalist has a good argument for why leveraging may not work. The Phillips, Hager & North report mentions leveraging as one of the purported advantages of investing outside of an RRSP, although they mention that “borrowing money to invest in a non-registered accoutn has risks that are not addressed. . . ”

I strongly recommend reading the Phillips, Hager & North article. It is only 7 pages of easy-to-read material. Here is the conclusion though, for those with little time on their hands:

Our analysis shows that saving for retirement using a registered plan (RRSP) is more beneficial than saving in a non-registered, taxable account. There are a few exceptions to this, but for the most part, this conclusion will hold true for the majority of middle- and upperincome earners.

Popularity: 16% [?]

How is Your Spouse’s Portfolio Managed?

Published
by
Dave
2 years, 8 months ago
in Advisors/Brokers, Costs and RRSP
. 1 Comment

I had assumed my financial advisor was going to manage my RRSP portfolio and my spouse’s separately. ie. I thought he was going to have an asset allocation model for her and an asset allocation model for me and each was going to be totally independent. I was going to suggest to him a long time ago that we use a spousal RRSP for one of us and put all our monthly contributions into one account. One of us would contribute to our RRSP directly, the other would contribute to the spousal RRSP of their spouse. It would be as if we had one portfolio. Except our RRSPs would get really lop-sided after doing that for a while and we would have to switch to the other RRSP and start contributing into it as well. That doesn’t seem like the optimal way to do things.

I just found out today that he is planning on manage my RRSP and my wife’s together, treating the two RRSP accounts as one massive portfolio. So I could have the international and US stuff, for example, and my wife could have the Canadian and the fixed income. This would be much more efficient from a cost perspective. If we bought all ETFs all at once for example (one ETF for each market: US, Cdn, Int., Bonds) our commissions would be cut in half. Instead of buying 8 ETFs (4 each) we would just buy 4 ETFs (2 each). I didn’t think advisors ever did this because it would be harder to manage because underneath they are separate accounts. But I’m glad that mine does! What about your spouse? Is his or her portfolio managed together with yours as one large portofolio?

Popularity: 3% [?]

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