You Won’t Believe How RRSPs Can Ruin Your Retirement!

h64ocNo seriously, you won’t believe it. That’s because RRSPs really can’t ruin your retirement, and yet every year someone, somewhere writes an article about the RRSP Tax Trap! This year’s contribution is from the Globe and Mail, which was also the source of last year’s main entry (also by the same author). The argument in these articles is that your RRSPs can become a taxation nightmare, forcing up your annual income and making you pay a higher marginal tax rate in retirement than you did in your working years! Cue panic.

Wondering why you don’t hear this complaint more? Why you don’t see lots of special reports on the nightly news of some sad-sack sitting at his kitchen table opening letters and then explaining to the camera how he “never foresaw the tax nightmare he’s in” happening? That’s because this particular issue is often overlooked as being one of having too much money, and is not widely regarded as a significant problem by most people (in fact the opposite for most Canadians is true). And while it’s true that being wealthy can create more complexity in investment strategies the “mo’ money, mo’ problems” aspect here has yet to stir a vast number of people to forgo their wealth and move to a commune.

The crux of these regular articles however (the reason why your average middle class Canadian should worry) is because RRSPs don’t save you taxes, but DEFER them. This emphasis on deferral, that your taxes will come back to haunt you is the kind of half truth that the media cheaply peddles without much thought for whether it does any real harm to the investor reading the article. It’s also bad math, because in addition to the taxes you deferred by contributing to your RRSP, there is also all the taxes you didn’t pay over the lifetime of the investment.

Let’s create a simple scenario to better illustrate what I mean. Assume the following things:

  1. You are 50.
  2. You currently earn, and will never earn more than $125,000 from now until you are 71.
  3. That you contribute every year $22,000 to your RRSP
  4. That your investments will return an average of 6% per year.
  5. That you start your RRSPs at age 50 with $100,000
  6. You invest $5500 of your tax refund into a TFSA with a 6% ROI

Let’s also create a second scenario, identical to the first, but instead of saving in an RRSP you do it in an unregistered savings account, splitting the $22,000 contribution between that and a TFSA, with a taxable rebalance triggered every 5 years. In all other respects the scenarios would be identical. What would happen?

Well thanks to excel it would look something like this:

20 Year Savings Plan

That gap in returns is the compounding difference of avoiding ongoing taxes from rebalancing and investing a portion of your tax refund into your TFSA. In essence you made each dollar travel farther over that twenty years by utilizing your RRSP more than you did without out, to the tune of nearly 25% additional savings.

There are a lot of ways to play with this, with numerous avenues to improve or refine this scenario, but no matter how you slice up these hypothetical scenarios there will never be a version where having less money is inherently better than having more. Having more is the whole reason you’ve been saving in RRSPs in the first place.

h64pl

That isn’t to say that you shouldn’t be mindful of taxes in retirement, or that your retirement strategies shouldn’t include things like debt reduction or trying to maximize different investment pools, like TFSAs. It also doesn’t mean that there aren’t ways to be more sensible with your savings for retirement. What it does mean though is that realistic threats to your retirement are unlikely to come from having saved too much, and that concerns over your taxes being too high because you were good at saving your money is the literal definition of a first world problem. In short, don’t worry that your RRSPs are going to ruin your retirement when they will likely underpin a successful retirement plan.

What Your RRSP Should Have In Common With The CPP

rrsp-eggTo many Canadians the CPP is something that you simply receive when you turn 65, (or 70, or 60, depending on when you want or need it) with little consideration for how the program works or is run. That’s too bad because the CPP is successful, enlightening and puts its American counterpart, Social Security, to shame.

You’ve probably heard American politicians decrying the state of Social Security, claiming that it is broken and will one day run out of money. That’s a frightening prospect for those who will depend on it in the future. Social Security is a trust that buys US debt, and its use of US Treasuries (low risk debt issued by the US government) is crippling that program and even puts it at odds with attempts to improve government financial health (it’s more complicated than this, but it’s a useful guide). In comparison the CPP isn’t bound by the same restrictions, and operates as a sovereign wealth fund.

A sovereign wealth fund is simply a fancy way to describe a program that can buy assets, which is exactly what the CPP does. The Canada Pension Plan may be larger and more elaborate than your RRSP, but it can look very similar. The CPP has exposure to Canadian, American, European and Emerging Market equity. It invests in fixed income both domestically and abroad, and while it may also participate in private equity deals (like when the CPP bought Neiman Marcus) in essence the investments in the CPP are aiming to do exactly what your RRSP does.

CPP Breakdown

The big lesson here is really about risk though. The CPP is one of the 10 largest pension plans in the world. It’s wildly successful and is run in such a way as to be sustainable for the next 75 years. The same cannot be said for Social Security. But by taking the “safest” option Social Security is failing in its job and will run out of money by 2033. But by buying real assets and investing sensibly the CPP is far more likely to survive and continue to thrive through all of our lifetimes.

What’s also notable is what the CPP isn’t trying to do. It isn’t concentrated in Canada. It doesn’t need to get a substantial rate of return, and it doesn’t need every sector to outperform. It needs consistent returns to realize its goals, and that’s how it’s positioned. By being diversified and not trying to time the market, the CPP finds success for all Canadian investors.

I’ve said in conversation that if there was an opportunity to invest directly in the CPP I would take it. However until then the best thing investors can do is take the CPPs lessons to heart!