Friday, 18 January 2013

Cash in a TFSA or RRSP - What are the best choices?

2013 has arrived and it is TFSA and RRSP season.

Cash going in - how much can you contribute?
The arrival of 2013 brings with it new contribution room for TFSA accounts. There is an increased limit of $5500 this year, up from the $5000 per year for the four years TFSAs have existed. For someone who has never made any contributions, the previous year contribution room is not lost, so there is $25,500 in total contribution room.

This is also the time to consider making an RRSP contribution applicable to the 2012 tax year before the March 1st deadline. The maximum contribution room (aka deduction limit) for 2012 is $22,970 but previous years' unused room may also be used to push the year limit higher. Those who have already contributed for 2012 may take advantage of the 2013 limit of $23,820.

Cash is in - now what?
Getting the cash into a TFSA/RRSP investment account is an important first step. But suppose you have not done your annual investment review (see our posts Goals, Performance and Rebalancing and Tax Matters) and have not decided exactly how to invest the funds. In the meantime, the parked cash is earning nothing since most if not all mainstream online brokers pay 0% interest on cash balances at the moment. Or, suppose you want to keep the money in some highly secure form as near to cash as possible but still earning something e.g. when a TFSA is used as a just-in-case of emergency fund. Let's look at the main options.

Cash-like alternatives
We limit the options to those where a) the initial minimum investment is reasonably near the amounts for the annual contribution limits of TFSAs and RRSPs i.e. we exclude securities like bankers acceptances and commercial paper which typically require a purchase of $50,000 and;.b) the securities mature within a year or less.

We find the following choices:
  • Cash in broker account - the straw man that pays nothing (0%) though it is always and instantaneously available
  • High Interest Savings account - equivalent to bank accounts in terms of security (backed by Canada Deposit Insurance Corporation), paying up to 1.25%;
  • GICs, Cashable and Non-cashable - the standard safe investment we all know and trust, with cashables paying 1.25% and non-cashables 1.70%
  • Government Bonds - we compare the Government of Canada bond, whose triple AAA credit rating is the highest possible and just as good or better than any other government rating, including the USA (only AA+); now paying about 0.8%
  • Corporate Bonds - we consider only those of investment grade BBB or better, paying 1.0 to 1.4% depending on the issuer
  • Money Market Mutual Funds - the funds invest in various types of investment grade securities with a maturity of one year or less; there isn't a future expected rate actually published, so we had to presume that if interest rates remain stable, past returns will be about the same too - that's how we estimated that the best in class (see Morningstar's rating for our example Beutel Goodman Money Market Class D here) should return about 1%
Comparison factors - it's not just the interest rate
Yes, the interest rate earned does matter a lot. We think as a minimum that the rate of return should meet or exceed the CPI inflation rate, which in the latest release by Stats Can in December stood at 0.8%. That's one reason for not leaving the cash sitting un-invested in the broker account - in real terms there is a gradual loss of purchasing power. It matters especially if the funds are intended to stay indefinitely in secure cash-like investments. Fortunately, all our choices meet or beat inflation when held in a tax-protected TFSA or RRSP.

The other factors that may be important or not, depending on the use or potential need for the money -
  • liquidity / how fast can you get the money into cash; 
  • interest payout frequency
  • what happens to the rate of return for the investment if interest rates start rising or falling in case you sell early or hold for a year (some follow the trend up or down, others go in the opposite direction, others don't change); 
  • what is the minimum initial purchase/deposit; 
  • how auto-pilot is the investment - do interest payments get put back into the investment to keep accumulating or do they get paid out as cash that then sits in your 0% broker account till you do something; does the investment continue indefinitely or require action at maturity; 
  • default security - who exactly backs up the investment to ensure you don't lose your capital, though that doesn't mean some of the choices like the bonds won't change value if interest rates go up or down.
Comparison table - the details
click image to enlarge it

Is there a best choice?
In general, no, we do not think so, since each alternative has some limiting characteristics. For example, the one-year GIC pays the most at 1.7% and that's the return you get no matter what interest rates do, but the money is locked up and inaccessible for a year. High interest savings accounts offer quick access to the money and interest is reinvested automatically as long as you hold the account but the minimum amount is substantial. The value of bonds can fall if interest rates rise (which is more likely these days?) so there may even be a negative return.

We should also mention that higher interest rates are available on TFSA savings accounts, such as shown on TFSA Best Rates, by going direct to smaller institutions. But that means opening a separate account (will you open a new one very year depending who has the highest rates at the time or try to transfer from one to the other if the rate is changed later etc) and losing the flexibility of having the other investment options available at the online broker.  Is it worth the extra 1% or so ($55 on a $5500 contribution)?

The choices, the pros and cons, are dissimilar enough in matching against the likely range of individual investor circumstances that we don't think there is one best answer for everyone. We hope our comparison provides readers a good leg up on where to find their own best option.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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