While taxable accounts are better for some, RRSPs still rule

In September of this year, I took an in-depth look at the merits of using a RRSP versus a regular (non-registered) investment account to build retirement savings. In that report, I concluded that the RRSP remained the most effective tool in general. The key to making the RRSP a viable option was to put some of the tax savings to work. What follows is a revision of my earlier work that more accurately quantifies this issue, and includes proposed changes tabled in the October 18, 2000 Federal mini-budget.

My previous research on this topic, while useful, had its limitations. First, it was assumed that investors have the same amount of money to put towards both options. Later, we’ll see why this isn’t a reflection of reality for many. Another limitation was the focus on after-tax rates of return using an average percentage withdrawal rate. The reality is that drawing income from a portfolio is anything but even. Rather than a straight percentage, investors typically start with a fixed dollar amount, and presumably increase it slightly each year to sustain their standard of living (i.e. index the withdrawal). If you look at the dollars withdrawn as a percentage of the portfolio value, it actually increases to a rather high proportion, until fully depleted. Consider an investor who draws an income from her portfolio. Assuming a level 7% annualized return and a beginning withdrawal rate of about 6.0%, the portfolio runs out of money towards the beginning of the 27th year. More specifically, the beginning withdrawal rate of 6.0% of the portfolio value goes up each year - ranging as high as 93.6% in year 26 (and of course 100% in year 27).

What this means is that the portfolio doesn’t last as long as implicitly assumed in my previous work, which also means less tax is deferred and for a shorter period (i.e. tax benefit of the RRSP is diminished somewhat). Combine that more realistic scenario with lower tax rates overall and still lower tax rates on capital gains, and you’ve got the making of a potentially very tough decision. However, my new research will hopefully shed a bit more light on what’s best in various situations.

This recent work more closely parallels the work of Talbot Stevens, a London Ontario-based financial researcher and educator. His work, as does mine, focusses on the level of after-tax income generated throughout retirement. The simplest way to illustrate this is to express the income as a percentage of the initial contribution. Remember that each contribution produces different amounts of retirement income. For instance, contributing $10,000 twenty years before retirement will produce more income than the same amount invested made just five years prior to retirement. Tables I to IV will illustrates the relative merits of various approaches assuming the same amount of money is available for each alternative.

Table I below illustrates the results of investing the same amount of money in each alternative. When the tax savings from RRSP contributions are simply spent, the regular investment is the clear winner, producing about 15% more after-tax retirement income. In order to make the two alternatives equal, at least 34.20% of the tax savings must be reinvested into a regular investment (i.e. the break-even tax savings reinvestment rate). Reinvesting 50% and 100% of the tax savings results in 20% and 40% more after-tax retirement income, respectively, as compared to contributing to a RRSP and simply spending the tax savings. In summary, for the situation noted below in Table I, the RRSP option is only worthwhile if a minimum of 34.20% of the tax savings from RSP contributions can be invested elsewhere.

Table II below shows the same situation, but with only ten years remaining until retirement. The overall conclusions are consistent with the twenty-year time frame shown in Table I.

What about those in the highest tax bracket? The numbers change somewhat, but the conclusions remain consistent. However, in this situation, we also assume that higher income individuals will also be in a higher average tax bracket during retirement, compared to their middle income counterparts. Table III below supports similar conclusions reached above. Notice the impact of taxation. A tax rate that is about 11 percentage points higher (33.33% vs. 22.00%) results in an after-tax income that is nearly 15% lower (16.38% of initial contribution vs. 14.00%). As retirement gets closer, that gap in retirement income caused by differing tax rates widens because the higher taxes are deferred for a shorter amount of time.

Everything illustrated up to now has assumed that exactly same amount of money is available to invest in either alternative. While some may be in that situation, many are not. Let’s look at an example. Steve is in a 33 1/3% marginal tax bracket with an expected additional tax owing of $2,000. His total available cash flow is $6,000, so he has two choices:

0. Pay the $2,000 tax bill and invest $4,000 elsewhere; or

0. Invest $6,000 in his RRSP, thereby wiping out his tax bill with no reinvestment of tax savings.

Table V below shows that while a regular investment produces a higher proportionate amount of after-tax retirement income (as above), the actual dollar amount is substantially less because less money is available for investment outside of the RRSP. In fact, contributing to a RRSP in this situation yields 30% more in after-tax retirement income.

Tables VI and VII below show that while that gap narrows as retirement nears, the RRSP is still the superior retirement vehicle of choice - even as close as 5 years until retirement.

Since we’ve determined that having more to invest in a RRSP is more valuable than a lesser amount in a regular investment, how much more is needed up front in a RRSP to beat a regular investment? Returning to our example above, Steve has a maximum amount of total cash flow available ($6,000) to cover his tax bill and his retirement savings. In his case, a RRSP contribution of $4,610 would generate an equal dollar amount of after-tax retirement income as the regular investment of $4,000. Steve was in a 33 1/3% tax bracket, but what about lower income individuals.

The lowest income bracket will be about 22 to 23 per cent. For simplicity, let’s assume that Nancy is in the 23 per cent marginal bracket, has twenty years before retirement, has a total of $2,000 available for investment, and faces a tax bill of $460. Her two choices are:

0. pay the tax bill of $460 and invest the remaining $1,540 in a regular investment; or

0. contribute the entire $2,000 to a RRSP, thereby wiping out the entire tax bill.

Using our proportions above for the twenty year time frame, we already know that a regular investment will produce a retirement income of 18.88 per cent of the initial contribution - or $291 on the $1,540 investment. (We can use the same proportions because we’ve assumed the same average tax rate in retirement in these cases.) The RRSP will generate $328 (or 16.38 per cent) from its $2,000 initial investment. The bottom line is that even in the lower tax bracket, the RRSP can still result in a retirement income that is about 13 per cent higher than using a regular investment.

This is a complex topic that requires a very personalized answer for each case. Investor behaviour can play a big part in evaluating which option is best but not all situations can be formulated into a spreadsheet. I doubt that the mini-budget made a huge difference in this decision, except to make the RRSP less attractive for some investors. While the rules of thumb mentioned in the last article don’t apply across the board, we can conclude this month’s article with more wide-sweeping guidelines in making this very tough decision.

The RRSP is usually the optimal choice for retirement funding when:

0. investing exclusively in GICs or other investments generating mostly interest income;

0. the identical amount of money is available for both options and at least 34 per cent to 40 per cent of the tax savings can be reinvested elsewhere; or

0. the amount of money available to invest in the RRSP exceeds that available for a regular investment by at least 15 per cent.

Opting to save for retirement outside of a RRSP is smart when:

0. the identical amount of money is available for both options and less than 34 per cent of the tax savings can be reinvested elsewhere;

0. your regular investments are positioned more aggressively to the extent you can earn an annualized return that is at least 1 percentage point higher than your RRSP; or

0. You expect your tax rate in retirement to substantially exceed that before retirement (i.e. if saving mainly for estate purposes rather than to generate retirement income).

Last week’s article should have illustrated the RRSP’s limitations and that occasionally, conventional wisdom should be challenged. I hope this week’s article provides a broader view of how various factors impact this decision and reminds us of when the RRSP shines as a financial planning vehicle.