From what we have seen from Part 1, it seems that RRSP’s deserve some more attention than previously afforded. Not in so much as to promote them further, but rather to see if they are truly in your best interest. Our basic analysis is not yet complete though, so let’s keep trucking on! :)
First, let’s recap the results from Part 1. We saw that by saving 10% to her RRSP account, Anna would have $43,700/year in retirement. By instead saving to her non-registered portfolio, she would be able to fund a $51,300/year retirement income. That is a SUBSTANTIAL difference.
Let’s now look at the effects of putting the tax refunds to good use in the next two cases.
Case 3: Anna saves 10% to her RRSP, Uses tax refund to build up a Non-Registered portfolio
Just to be clear, this means that Anna continues to save her 10% every year. In this case, she is depositing the funds to her RRSP account and using the resulting tax refunds to contribute to a non-registered portfolio which will also be used to help fund her retirement income needs. This strategy will yield an after-tax annual income (in today’s dollars) of $53,175/year. I will spare you the Net Worth Accumulation Graph with a Monte Carlo Sensitivity Analysis because it is very similar to the first two graphs, however the probability of success is 75%.
Now we see that the RRSP strategy comes out on top… but not by very much. In fact, by saving to a non-registered portfolio you will almost have the same amount of retirement income of someone who saves to an RRSP AND re-invests the annual tax refund into a non-registered portfolio.
Case 4: Anna saves 10% to her RRSP, re-invests RRSP refund right back to the RRSP
In this final case – we will see what happens if Anna takes the RRSP refund and instead of putting that into a non-registered portfolio, she re-invests it into her RRSP. Therefore, all of her savings and tax refunds are being put into her RRSP and her RRSP alone.
Her annual income decreases, but only slightly, to $52,675/year – with a probability of success of 72%.
Review of all 4 cases
Save to an RRSP, don’t use the refund productively = $43,700/year, 76% Success Rate
Save to a Non-Registered portfolio, don’t have a refund to use = $51,300/year, 74% Success Rate
Save to an RRSP, re-invest all refunds to a non-registered account = $53,175/year, 75% Success Rate
Save to an RRSP, re-invest all refunds to the RRSP = $52,675/year, 72% Success Rate
So what does this tell us? Well, it’s too early to really draw solid conclusions, but we are heading in the right track. To really make sense of the Monte Carlo numbers, we need not only the probabilities of success for each scenario at their optimal income rates, but also the probabilities of success as compared to the baseline income level of $43,700/year.
So… I readjusted each financial plan to allow for $43,700/year in annual after tax income in today’s dollars and calculated (make that: had the computer calculate!) the probabilities of success. Here are the graphs and Success Rates for each case except Case 1 (which we saw in Part 1):
Case 2 @ $43,700/year (Save to non-registered portfolio only) = 91% Success Rate:
Case 3 @ $43,700/year (Save to RRSP, refund to non-registered) = 87% Success Rate:
Case 4 @ $43,700/year (Save to RRSP, refund back to RRSP) = 89% Success Rate:
Remember to note the scale of the Y-axes for each graph.
Now we have some more data to analyze. While there were no surprises (it would be expected that if a strategy were able to yield a higher annual income with a similar success rate, that the success rate would increase dramatically if you decreased the withdrawal rate), we are getting close to turning over all the stones.
Right now, not much has changed with respect to what was revealed in Part 1 – that the belief that RRSP’s are "hands-down" the best way to save for retirement may not be so "hands-down" after all. BUT, we also made some big assumptions that we need to examine. Namely, that Anna can afford to pay the tax on her non-registered investment growth until retirement out of her regular cash-flow. That may be easy to do when she is younger, but very difficult later on. If she can not, in fact, pay for the ongoing taxation, she would have to make withdrawals from her non-registered portfolio on a yearly basis prior to retirement.
Also, we need to look at the changing reality that many people work part-time in the beginning phase of retirement. Retirement is becoming less and less a "full stop" and more and more a smooth transition.
In Part 3, we are going to look at the pre-retirement withdrawal of non-registered investments (to pay the tax bill) as well as post-retirement income. We will conclude with some final thoughts on the reality of using 100% of the tax refund productively for these strategies.
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If Anna is to pay the taxes on the increasing non-registered portfolio, from income, would the comparison be more valid if she also increased her RRSP by the amount she subsidizes her taxable portfolio? In reality the taxable portfolio should pay its own taxes as will the RRSP on withdrawal.
DAvid
Hi David – thank for your question. I wanted to stick to a set cash flow dedicated to retirement savings during the pre-retirement phase – hence, Anna should not pay the taxes out of her other income, but should instead liquidate part of her portfolio to pay those taxes. There is no tax payable by her RRSP during the pre-retirement phase.
Net-net: her cash flow out during pre-retirement is equal. This is the only fair way to make a true apples-to-apples comparison.
I did have all taxes paid for in retirement from ANY source of income. So her RRSP withdrawals and her withdrawals from her non-registered portfolio are all taxed as they should be – and the tax bill is paid for out of those withdrawals.
Since the purpose of this analysis was to compare the effectiveness of non-registered versus registered savings for retirement, I have to put an equal amount of "input" into either strategy. The comparison of the output for each strategy is essentially what we are trying to figure out.
You’ll see I address this further in Part 3.
Does that make sense? If not, please let me know.
As I belive that in 99.9% of cases the interest earning portion of one’s nest egg is better in side an RRSP, I believe that you should have been investigating whether or not it’s better to have the equity portion (which earns dividends & capital gains) inside or outside.
If you could re-run your models with the appropriate adjustment, I’d appreciate it.
I’m also curious as to equities with relatively high dividend payouts vs equities with insignificant dividends. These days, with the average Canadian bank common stock paying a dividend similar to a 5 year GIC, with the advantageous tax treatment of dividends, I wonder if it’s better to hold such inside an RRSP or outside.
Hi Globule2, thank you for your questions. The analyses I made are fairly broad-based and were trying to address what one needs to look at with respect to RRSP savings versus Non-registered savings. However, you’ll note that I addressed some of your concerns in part 3 with the use of corporate class funds with a t-swp structure.
The broad question of equities versus fixed income and where to hold them are answered elsewhere on this blog, but perhaps I’ll make a more in-depth post on the topic as the ones I’ve written are shorter and equally broad in nature.
Really, the answer to your questions need to be addressed by your own financial advisor as there are so many variables that affect the answer it would be impossible to address here (and making meaningful conclusions that could be extrapolated in a blanket like fashion to others).
…things like your tax bracket, rate of withdrawals, how much you are saving, etc.
Sorry I couldn’t be more helpful – but if you had specific numbers for me to look at, I’d be happy to run them for you.
Thanks for the prompt reply.
I did see the bit about corporate class funds, but as someone approaching the question from a self-directed RSP perspective, it’s not what I’m looking for.
If you could run your "Anna" model for the following four portfolios I’d appreciate it.
In all 4 cased, 20% is Canada bonds yielding 4% inside the RSP
a) 80% in XIU ETFs inside the RSP (currently yielding 1.88% dividend)
b) 80% in XIU ETFs outside the RSP
c) 80% in BMO inside the RSP (current div yield 4.75%)
d) 80% in BMO outside the RSP
another scenario, if you have the time, would be look at a combo of c) & d) with the annual % going into the RSP increasing with age (to reflect the fact that the effect of the div tax credit diminishes with income)
Thanks again,
~globule2 in Montreal
Hi Globule – give me a few days as I’m completely swamped with my "other" work this week. :) I’ll get back to you though…
No rush – I understand that it’s "RRSP season"!