Friday, 21 October 2011

RRSP vs TFSA? Critical Differences and Imponderables

Our last post compared the RRSP with the TFSA strictly on the basis of numbers - which generates the most after-tax income during retirement - and concluded that the TFSA is best for people earning below $37,000 during their working years while the RRSP is best for higher earners. Today we look at other features of these plans to see why that conclusion might not hold up.

Tax Rate Changes - Contribution vs Withdrawal
The RRSP gains a monetary bonus if the tax rate in retirement is lower than when contributions were made and it incurs a penalty if it is higher. The TFSA is completely unaffected by such a tax rate difference (since all contributions are made with after-tax funds and withdrawals are not taxable). In the section titled What happens when rates change? on his lengthy page on RRSPs RetailInvestor works through an example and concludes that "This effect (of a change in tax rates) is the major difference between the TFSA and the RRSP".

Most probably, figuring out whether your retirement tax rate will be higher or lower is well-nigh impossible for most people. On the same page under What are the unknowns that will determine a rate change? RetailInvestor lists many factors that can cause a change, such as: a large RRSP/RRIF (or LIRA/LRIF/LIF) balance at death that all becomes taxable income through deemed disposition tax rules and pushes RRSP income into higher brackets; big lump sum withdrawals for illness, long term care, round-the-world cruises that push RRSP withdrawals into higher brackets; non-registered investment income that might get boosted from inheritances or profitable sale of a home; government decisions to raise or lower taxes. As a result:
  • for top bracket earners ($120,000+) who stand a good chance of taking money out at lower tax rates, the RRSP solidifies its advantage
  • lowest bracket earners will almost certainly experience a rise in tax rates in retirement and thus should forget the RRSP and focus on the TFSA
Savings Discipline
Simply getting around to making contributions is a big psychological challenge for both the TFSA and the RRSP. It isn't the only one however. Each has its own pitfalls and each investor must figure out which ones he/she is most prone to fall prey to. This could be the key factor - obvious though such a comment might be, if you don't save and keep the money in the plan, it cannot grow.

RRSP - The Tax Refund Temptation
The first issue is that in order to get the full value of contributing, compared to a TFSA, the tax refund portion must, in effect, be invested as well. In one example from the TaxTips comparison calculator we used in our previous post, a $5000 RRSP (pre-tax) contribution was, for instance, only equivalent to a $3550 TFSA (post-tax) contribution (the actual equivalent amount varies according to your tax bracket). Put another way, if you have $5000 cash to contribute either to a TFSA or a RRSP but spend the RRSP contribution tax refund you will be far short of your retirement spending goal when the RRSP's deferred taxes have to be paid (see a detailed explanation in the TFSA vs RRSP comparison on Million Dollar Journey). TFSAs don't offer the temptation of the seemingly found money refund, which all too many Canadians succumb to. Score one for TFSAs.

TFSA - The Cookie Jar Temptation
In a recent GlobeInvestor article about TFSAs and RRSPs, Wealthy Barber author David Chilton said he feels the ease of TFSA withdrawal, greased by the thought that the money can be replaced the following year, which is not allowed with RRSP withdrawals, makes it more prone to the withdrawal temptation than the RRSP. Will Canadians delve into their TFSAs for luxury spending more than they have into RRSPs? That remains to be seen. Score a minor plus for the RRSP.

Tax Management
The TFSA has several significant post-retirement tax advantages:

TFSA withdrawals do not count for income-restricted benefits such as OAS and GIS.
  • When you need a bigger lump sum of cash in a particular year e.g. for that cruise, home renovations, health costs, gifts, new car etc, a bigger RRSP/RRIF withdrawal can push you into a higher tax bracket and reduce or eliminate GIS or OAS.
TFSA allows contributions up to any age
  • In contrast, the RRSP must be converted to a RRIF or an annuity i.e. be progressively withdrawn starting by age 71 at the latest. This TFSA feature is very useful to gain tax-free earnings from investing surplus funds, such as on-going cash not needed for current living expenses or perhaps an unexpected lump sum like an inheritance. The cumulative, non-expiring annual $5000 contribution room of a TFSA enhances this advantage. You cannot put inheritances received into a RRIF.
  • Example - Putting these factors together, suppose you withdrew $30,000 extra during retirement from a RRIF, pushing you from $36,000 taxable income to $66,000 that year. That would cost about $10,000 more in taxes for an Ontario resident. Suppose a year later, you received a $30,000 inheritance, you could not put it back into the RRIF. Your choice would be to invest it in a regular taxable account, subject to tax every year, or into a TFSA if you had the contribution room. With the TFSA, the money would come out with zero effect on taxes and the withdrawal would create $30k in contribution room, permitting you to return the inheritance money to tax-free gains.
TFSA simplifies income splitting between couples to lower overall tax
  • Income splitting is easier with the TFSA since both spouses automatically get $5000 in annual contribution room and one spouse can contribute up to that limit to the other's account. With the RRSP, the receiving spouse must have available contribution room built up through earnings, a problem when one spouse is a low- or no-income earner.
TFSA is simpler to manage and figure out.
  • With a RRIF you must content with: having to pay attention to forced RRIF minimum annual withdrawal amounts; and figuring out the net cash available immediately upon withdrawal after witholding tax (from TaxTips) or after tax filing, which amounts will probably differ, for withdrawals above the minimum from a RRIF. With the TFSA, to use the hoary phrase "what you see is what you get". There's no confusion or uncertainty. The amount you withdraw is what shows up in your bank account to spend. There are no tax implications to figure out, things to file in a tax return or later amounts due or refunds. Life is simple, as it should be.
RRSP/RRIF qualifies for Pension Amount
  • One plus of the RRSP is that withdrawals from a RRIF qualify, if you are 65 or older, for the $2000 pension income tax credit (see Canadian Tax Resource's What is Eligible Pension Income? for details). TFSA withdrawals do not qualify.
RRSP/RRIF Witholding Tax superiority
  • Since the US government recognizes only the RRSP/RRIF and not the TFSA as a bona fide retirement account, 15% US-government levied witholding taxes eat away at returns on US-listed ETFs, as we wrote about in Pros and Cons of Cross-Border Shopping in the USA for ETFs. That penalty for TFSAs applies pre- and post-retirement and across all income levels and would also apply to US-listed equities paying dividends or bonds paying interest. That can make a significant difference to returns on such holdings in the long term, as we noted here.
Bottom Line
  1. Highest income earners of $120,000+. Focus on the RRSP first due to the likelihood of a drop in your tax rate. If the RRSP contribution room isn't sufficient for savings goals, put any extra in the TFSA. After retirement the TFSA makes a fine parking spot for surplus funds.
  2. Income earners below $37,000. Focus exclusively on the TFSA. If you are frugal enough to save more than the $5000 contribution limit, then look to the RRSP.
  3. In between $37k and $120k. Save through both TFSA and RRSP to gain the advantages of each and the flexibility of having both.
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.

RRSP vs TFSA? First, the Numbers

Trying to save for retirement but unable to figure out if putting money into an RRSP is better than a TFSA? Welcome to the party, you are not alone.

Our previous blog post RRSP vs TFSA vs RESP vs Non-Registered Taxable Account took a general look and gave rules of thumb. Now we get more specific in comparing the RRSP against the TFSA.

The Calculator offers a free and quite complete tax TFSA vs RRSP Calculator (see screen shot below) that can compare the two in terms of after-tax cash flows from the working and saving years right through retirement. The customization to one's own circumstances includes all the key factors - province of residence to reflect different provincial tax rates, current age, intended age to convert RRSP to RRIF or to begin receiving CPP, how much CPP and OAS entitlement one will have, pension income other than the RRSP or TFSA, amount of contribution to the RRSP, or TFSA (the latter which the calculator adjusts to make it exactly equivalent after-tax to the RRSP contribution) and estimated future portfolio rate of return within the RRSP/TFSA. Behind the scenes the calculator uses the appropriate tax rates, tax clawbacks and credits to show year by year how much spending after-tax money you end with.

After you select all the variables and click "Calculate" the big blue text line tells you whether the TFSA or the RRSP is best overall. Wonderful!

The Results
We tested across a range of income levels from $35,000 to $120,000 for a hypothetical single 30 year old in the various provinces. The bottom line number we look for is what percent of after-tax disposable income the RRSP/TFSA replaces, the higher the better.

  • TFSA Always Wins for the $35,000 Wage Earner - that's in every province; the result is mainly due to not losing out on benefits like OAS and GIS
  • RRSP Always Wins for All Higher Pre-Retirement Income Levels - MillionDollar Journey's post TFSA vs RRSP - Best Retirement Vehicle? puts the cut-off more precisely at $37,000
  • The Margin of Advantage is Always Quite Small, No More than About 1.5% - that's right, across all income levels and the scenarios discussed below, whether the TFSA or the RRSP wins, the total lifetime cash flows, as expressed in their Net Present Value, and shown at the bottom of the Calculator's Results table, is never very greatly different!
  • TFSA Alone is Not Adequate for High Income Earners - the $5000 annual contribution limit on the TFSA makes it impossible for those at $120,000 to save enough to achieve even minimal 60% income replacement. Thus, in practical terms, the RRSP is a required element for retirement saving for high earners.
Key Scenarios
Next we looked at a couple of scenarios for the assumptions that matter the most: a) portfolio return - instead of our base 3%, we tried 5%, which we dub the "Excellent Market Returns" scenario, and b) savings to be depleted over 20 years (by age 85) instead of our base 30 years, which we call the "Die per Average Life Expectancy" scenario.
  • Higher Portfolio Rates of Return Matter More than How Long the Savings Must Last - Effective investing matters. The results of our scenarios show a much greater effect in retirement disposable income from a change in returns to 5% than shortening the retirement period from 30 to 20 years. A low-cost portfolio that includes a good portion of higher-return, though riskier equities, makes a big difference, as we blogged about in our previous post.
Those are the numbers. Overall, it looks as though the TFSA should be the automatic choice for low earners - those earning $37,000 or less - and the RRSP the preferred vehicle for those in the highest income category. In between, it doesn't seem to matter much.

However, there are other considerations that can change the picture and in our view affect the best strategy, as we will explain in our next post.

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.

Monday, 17 October 2011

What is a Viable Mix for Retirement Savings Success?

Are you on track for building a financially sustainable retirement? How can you know if you are making progress whether you are 35 or 55?

Saving and investing enough depends on several factors that inter-twine and affect one another:
- what age you stop working and retire,
- how many years you save,
- your savings rate,
- your desired retirement spending,
- how long you will live,
- the returns from the portfolio where your savings are invested.
In addition, there is the make-up of the portfolio between stocks, bonds and other asset classes to decide.

It is easy to see that deciding on a viable mix can seem dauntingly complex. Obviously, the longer you work and save, delaying retirement, the lower the required savings rate needs to be. The more stocks in the portfolio as opposed to bonds, the higher the return should be, but there is more chance of stocks doing one of their familiar nose-dives at the wrong time, just at the start of retirement. The question everyone faces: what are the numbers to use?

The Past as a Guide
One way to get a good idea, if not a definitive answer, since we can never be sure the future will be exactly the same, is to look at what happened and what worked in the past. Using a long enough period that includes recessions, inflationary periods, depressions, booms, wars, financial crises, bubbles and crashes, we can gain some confidence that the numbers might be worth considering.

Enter researcher professor Wade Pfau of the National Graduate Institute for Policy Studies in Tokyo, Japan, who has done some interesting number-crunching in his paper Getting on Track for a Sustainable Retirement: A Reality Check on Saving and Work. He has figured out what various combinations of retirement age, income replacement level and asset allocation would have ensured that a person would never have run out of money up to age 100 (few of us get to live as long as Jack Rabbit Johannsen) assuming that the person had already saved a certain amount to date. In other words, he has looked at the worst case scenario for anyone retiring anytime during most of the 20th century (though he cannot go beyond anyone who would be less than 100 in 2010 e.g. a 55 year old retiree of 1965, who would have 45 years of retirement by 2010, or a 65 year old retiree of 1975, who would have 35 years).

The Example of a 55 Year Old
Pfau uses as his base case the example of a 55 year old making decisions about what to do. This is what Pfau determined.
  • To maintain a spending rate of 50% of final salary, a person could have retired at 67 if he/she had already accumulated savings of six times his/her annual salary and was prepared to save 15% of their annual salary continually till retirement using a mix of 60% stock (S&P Composite Index) and 40% fixed income (six-month commercial paper) - see the blue-circled cell in the top panel of the table below copied from the paper. For instance, a person earning $60,000 per year would need to have $360,000 in retirement savings already and to set aside $9,000 per year till age 67.
  • If the person lowered the stock allocation to 40%, retirement age would rise to 70 - per the middle panel blue-circled cell
  • If the person wanted a higher 60% of final salary replacement spending level, retirement age would rise to 69 - per the lower panel blue-circled cell
  • If the person had only saved up four times their annual salary so far and could only manage to save 10% of earnings per year, retirement age would rise to 72 - per the upper panel red-circled cell.

Ages 35, 40, 45, 50 or 60
Prof. Pfau has used the same assumptions and methods to calculate the path forward for individuals 35, 45, 50 and 60 in his blog post Getting on Track for Retirement. The table for 40-year olds is here in another post.

Taking one example from these tables, we see that a 35 year old with zero retirement savings today could still retire at 66 (blue-circled cell in the table below) at the 50% spending rate by saving 15% per year.

Stock Allocation Sweet Spot 40 to 60%
One fascinating fact coming out of the middle panel of all the tables, whatever the age at which the look forward starts, is that an optimal allocation percentage to stocks looks to lie between 40% and 60%. A higher allocation to stocks lowers possible retirement age little if at all. Below 40%, the safety of fixed income comes with a significantly increasing higher retirement age, due no doubt to the much lower returns historically achieved by fixed income.

Lower Income Replacement Gives Earlier Retirement
A 10% cut in income replacement rate from 50% to 40% has as much effect in lowering viable retirement age - three years, from 67 to 64 - as having saved eight times your salary by age 55 instead of only six times (see the green circled cells in the first table above). In the example of the $60,000 earner, is it easier or more worthwhile to save $480,000 instead of $360,000 by age 55, or cut annual retirement spending from $30,000 to $24,000.

Caveats and Cautions
We believe that though very useful, the tables should be used to ballpark and to judge rough trade-offs, not to set precise expectations.
  • Data is for the USA and though similar, Canadian investment returns have not been identical and will not be in future either. Whether this means higher or lower, we cannot be sure since Prof. Pfau has not run any numbers for Canada.
  • Investment management fees have not been deducted as the study uses index data. That would lower returns and raise potential retirement age and required savings rates to obtain the same income replacement rate.
  • A constant spending rate throughout retirement probably over-estimates what usually happens as people slow down as age advances. People also can cut back if returns are poor. Similarly, setting 100 as the age to which income is required overdoes it since life expectancy, while it continues to creep up constantly, is still only just over 80. Applying those factors would all enable a lower retirement age or lower savings rate.
The test that the portfolio should never have run out of money is very stringent. The high required savings rates are necessary in a minority of all the years considered, as Pfau's figure 4 shows. Taking a chance that the retirement years will be blessed with reasonable investment returns may suffice. Which part of the past will the future be like? No one knows. Pfau lays out an ultra-cautious approach. It may not even suffice if the future brings something worse than any period yet recorded. We sincerely hope, and expect, not.

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.

Thursday, 6 October 2011

Investor Forecast: Stormy Weather, Not Falling Sky

Since early this year, it feels as though there have constant steep drops in stock markets with every upward recovery being smaller and then followed by an even bigger decline. Indeed, the numbers confirm the impression: S&P TSX Composite Index's 1-year price return is -7.3%, the year-to-date price return is -14.8%, the price change since 2011 peak on April 5 -19.4%. The Google Finance chart of this period really doesn't look pretty.

Is the "Sky Falling"? - The feeling that things can and quite possibly might get even worse is quite understandable. Major country economies are weak, possibly heading into recession. On top of that, if a default by Greece could provoke a chain reaction to other European countries, what might be the result of country defaults considering that a mere investment bank's (Lehman) downfall in 2008 led to that horrendous market crash?

Answer: No, though there are definite menacing clouds, we believe the Sky is Not Falling. As we blogged about a few months back in Investing Risk: Defaults, or how often do investments go belly up?, country defaults happen, the last peak episode being around 1990 according to the chart in that post. The world weathered that period. Whether various authorities manage to prevent the seemingly inevitable default of Greece, the world economy is likely to survive and then revive after such an occurrence. Also instructive is the history of the recurrence of significant market losing periods, which we blogged about in Investing Risk: Historical Worst Volatility, Business Cycles, Crashes and Crises. The lesson of history is that it may take many years to recover but recovery does ensue, even in the very worst episodes of the past.

What therefore should we as investors do?

Action item 1 - Set Expectation to Long Holding Period for Equities: Our allocation of money to stocks must go along with an expectation of a holding period of at least ten years before we intend to cash in and start spending the money. The knowledge that we will not be needing the funds for many years will allow us to weather the financial storm and its aftermath. Setting our expectations appropriately helps us sleep better and avoid panic selling.

Action item 2 - Rebalance the Portfolio: A portfolio should contain target percentages of cash, fixed income and equities in proportions which we suggest should be explicitly set out, as we explained in the post on Investment Policy. Since equities have declined quite a bit while fixed income has stayed constant or gone up (e.g. the iShares DEX Universe Bond Index ETF - TSX: XBB - is up 2.6% over the past year), it is quite likely the equity vs fixed income percentages have gone out of whack. If the proportions have gone far enough askew, then now is an opportune time to take the cash or sell fixed income to buy equities. For more see our post on Rebalancing - What, Why and How.

Current stock market valuations are encouraging in that sense as they are at levels low enough to promise reasonable future returns for equities. Using the sources we blogged about in February 2010 in Is the Stock Market Over- or Under-Valued?, the signs are more promising or at least not worse now than back then.
  •'s Shawn Allen figured as of September 28th that the TSX Composite Index fair value is somewhere around 11,838, implying an investor could get an 8% return over a ten-year holding period. With the TSX gyrating around that level as of Oct.13th, the prospects are quite reasonable.
  • Ben Stein and Phil DeMuth's Yes, You Can Time the Market indicators (Price, P/E Ratio, Dividend Yield, Earnings Yield vs AAA Bonds) for the S&P 500 bellwether US market index as of September 30th were all flashing Green for Buy.
  • The CAPE vs q Ratio calculated by Smithers & Co. on September 16th showed the S&P 500 to be still over-priced at a price level of 1216, not much different from February 2010, but today the S&P 500 is lower at about 1200 so it would be less over-priced.
  • In the same vein, the Schiller CAPE ratio is the same at 19.8 as it was in February 2010, and thus still exceeds the long-term average of 16.
The most fearful situation for most is having to face the unknown. It is easier to face adversity when it is defined. We hope that with the above facts in mind, our investor readers can be more confident and less anxious for the long term.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above commentary is not an investment recommendation. It rests 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.