T h e R e t i r e m e n t S a v i n g s D e b a t e . . . .
I n s i d e o r o u t s i d e t h e R R S P s t r u c t u r e ?
RRSPs have traditionally been viewed as the most efficient, self-funding way to save for retirement. However, following the federal government’s reduction of the capital gains inclusion rate in 2000, some advisors and investors have questioned whether it is more efficient to save for retirement outside of a registered plan. This study focuses on quantitative research (conducted by PH&N) that shows that most investors will benefit from saving for retirement using an RRSP, as opposed to saving using a taxable account. As well, it addresses the qualitative benefits associated with investing using an RRSP that are sometimes overlooked.
“Tax-deferred retirement assets continue to exert substantial influence on the financial services industry. Virtually all working Canadians and most retirees have assets in this market through employer-sponsored programs or individual accounts.”1
- Investor Economics
The Evolution of the Debate
RRSPs have traditionally been viewed as the most efficient, self-funding way to save for retirement but have recently come under scrutiny because of changes in the tax regime. The Registered Retirement Savings Plan (RRSP) was created in 1957 following the federal government’s amendment to the Income Tax Act that was designed to encourage Canadians to save for retirement.2 Prior to the amendment, only those fortunate enough to belong to a company-sponsored pension plan could deduct retirement savings contributions from their income. Deposits to RRSPs were initially very anemic and sporadic. It wasn’t until the late 1970s, when the banks entered the game, that contributions became meaningful and assets contained within these registered plans began to grow exponentially. Since that time, many investors have relied heavily on these products to fund their retirement goals. The main appeal of RRSPs is twofold: the tax deductibility of the contributions, and the associated tax-free (compounding) growth of the assets in the plan.
Recently, however, the merits of contributing to these plans have been challenged. Debates arose in the financial media following the release of the 2000 Federal Budget, in which the federal government reduced the capital gains inclusion rate from 75% to the current 50%. As a result of this tax break, advisors and investors began to question whether it was more efficient to save for retirement outside of a registered plan, where withdrawals are not taxed, and the tax payable on capital gains is reduced. Differing opinions on this topic have created confusion in the minds of investors as to what method of saving will maximize after-tax cash flow in retirement. This article explores the cases for and against saving within an RRSP.
The Case for Saving Outside of an RRSP Supporters of saving for retirement outside of an RRSP focus on a few key benefits of this option and a few common criticisms of RRSPs. These benefits and criticisms, taken from the many articles in the media covering this topic over the past few years, may be summarized as follows:
¡ Withdrawals from a non-registered account are more tax-efficient than withdrawals from an RRSP.
¡ It is possible to invest tax-efficiently outside of an RRSP in such a manner as to pay little or no tax on the growth of investments.
¡ A non-registered account provides slightly more flexibility in that an investor can hold virtually any investment outside of the RRSP.
¡ Borrowing money (leveraging) to invest outside of an RRSP provides the same tax deduction benefits as does investing within an RRSP.
¡ For low income earners, the tax refund from contributing to an RRSP will be minimal.
¡ RRSP withdrawals can lead to significant Old Age Security (OAS) clawbacks.
Some of these statements are valid, while others can be questioned. For example, withdrawals from non-registered accounts are more tax-efficient than withdrawals from RRSPs. However, borrowing money to invest in a non-registered account has risks that are not addressed, and although it is possible to invest tax- efficiently outside of an RRSP, it is unreasonable to assume that tax can be avoided completely.
There is one fairly obvious scenario in which investing inside an RRSP may not seem to make sense. This is when an individual has a very low income (and the tax refund that they will receive from investing inside an RRSP is therefore minimal), and they anticipate that they will face a much higher tax bracket in retirement. Under this scenario, their withdrawals in retirement would be taxed at a higher rate than their current rate of tax, and the benefits of the tax refund from the contribution therefore would be negated. Yet, even under this scenario, the individual would have to invest in a tax-efficient manner (e.g., avoid fixed income products) to make up for the tax- free compounding of growth foregone by not investing in an RRSP. Furthermore, an individual could contribute
1 Investor Economics. Household Balance Sheet Report: 2001 Edition. Page 47. Toronto, ON.
2 This article addresses both RRSPs & RRIFs (Registered Retirement Income Funds).
It does not make sense for an individual who has a perpetually low annual taxable income to contribute significant funds to an RRSP if their withdrawals in retirement will be taxed at a higher rate than their current tax rate. Such situations are rare, but may arise, for instance, if an individual with significant accumulated unused contribution room from having invested little in RRSPs receives an inheritance close to retirement. At Phillips, Hager & North, we believe there are two important benefits to saving for retirement outside of a registered account. These are:
1. There is no minimum withdrawal requirement for a non-registered account, as there is for a RRIF. This allows for greater flexibility with respect to adjusting the amount of desired income in retirement.
2. Should an individual decide to retire early or withdraw funds for emergency purposes, they are not penalized by withholding taxes.
The Case for Saving Within an RRSP
Adversaries of RRSPs often point to their own mathematical models to support their view that saving outside of a registered plan leads to greater after-tax cash flows. In some instances, their arguments are valid. However, for the majority of Canadian workers, it is still beneficial to save for retirement through RRSPs. Many of the mathematical models referenced by opponents use unrealistic assumptions in their calculations.
For example, they often ignore or understate the effect of taxes on the growth of non-registered assets, and they often assume that the tax refund generated from an RRSP contribution is spent rather than re-invested. We examined three different investment scenarios (i.e., three different asset mixes) to determine whether or not the after-tax cash flows provided from an RRSP account are greater than those provided by a non-registered (taxable) account. The three asset mix policies that we considered were:
1. 100% Bonds Portfolio (low volatility, income-oriented investment objective)
2. 40% Bonds; 60% Equities Portfolio (moderate volatility, balanced investment objective)
3. 100% Equities Portfolio (high volatility, growth investment objective)
As noted, we believe that the assumptions used by those favouring taxable accounts are questionable in many instances. We have attempted to redress the analysis by using what we consider to be more realistic suppositions. Specifically, we assumed that all tax refunds resulting from RRSP contributions would be re-invested into a taxable (non-registered) retirement savings account. A detailed list of all of our assumptions is provided in the appendix and endnotes.
Our calculations show that investing for retirement within an RRSP provides more after-tax cash flow than investing outside of a registered account under all three asset mix scenarios. The results, which are discussed below, show the estate value at each age. Phrased differently, these figures simply represent the post-liquidation, after-tax value of all holdings.
100% Bond Portfolio
A bond represents the least tax-efficient type of investment, as it pays out interest income that is taxed at an investor’s highest marginal tax rate. For this reason, it is beneficial to shelter interest income received from bond investments inside an RRSP account. Our calculations show that bond investments within an RRSP will produce considerably higher after-tax cash flows than those outside of an RRSP. The difference is accentuated as the time horizon in retirement increases. This is no surprise, as even advocates of saving outside of registered plans support the notion that RRSPs are more useful (efficient) for highly taxed investments. Even in retirement, much of the interest income generated from the bond portfolio can be sheltered from income tax within the RRIF structure. The following graph shows the results of our calculations:
RRSP vs. Non-RRSP Savings Asset Mix: All-Bond Portfolio
$1,800
$800
$400 0
$200
$600
$1,600
Total after-tax estate (000s)
$1,000
$1,200
$1,400
39 43 47 51 55 59 63 67 71 75 79 83 87
Age
Non-RRSP bond portfolio RRSP bond portfolio
40% Bonds, 60% Equities Portfolio
The balanced portfolio that we analyzed produced similar results. While not as dramatic, the conclusion drawn from the calculations here also demonstrates the benefits of saving within a registered plan. The chart below illustrates this.
RRSP vs. Non-RRSP Savings
Asset Mix: 40% Bonds / 60% Equities Portfolio
We assumed that the refund from the RRSP contribution would be invested in a non-registered account according to the same asset mix policy governing the contributions to the registered account. Yet, further tax efficiencies could be achieved by employing a simple financial planning strategy, whereby fixed income investments are made primarily in the sheltered RRSP account, and equity investments in the non-registered account. The investor’s overall asset mix would not change, but the tax efficiency would be greater and the benefits of saving to an RRSP account would be accentuated.
100% Equities Portfolio
Our calculation methodology applied to an all-stock portfolio shows that the after-tax estate value of a tax- sheltered (registered) account is greater than that of a non-registered account. Many of the arguments that suggest otherwise assume that the tax refund generated from an RRSP contribution is not re-invested, or they underestimate the tax payable on the growth of non- registered equity investments (as previously mentioned). Our calculations produce the following results:
RRSP vs. Non-RRSP Savings Asset Mix: All-Equity Portfolio
Notes about the Charts
The difference in after-tax wealth may not seem significant. However, it must be remembered that these figures represent the after-tax estate values of the portfolios. Pre-tax values are not shown, but are much greater in registered accounts than in non-registered accounts because of the effect of tax-free compounding. Upon liquidation, however, registered accounts are taxed at much higher levels than non-registered accounts, reducing the after-tax difference between the two. In the 100% Bonds Portfolio, the difference in the after-tax estate value between the RRSP and the non- RRSP portfolio becomes much more dramatic in retirement. This is because the RRSP portfolio is worth significantly more on a pre-tax basis, and this greater amount of accumulated capital is not eroded as quickly by redemptions in retirement.
$12,000
$2,000 0
$10,000
Total after-tax estate (000s)
$4,000
$6,000
$8,000
39 43 47 51 55 59 63 67 71 75 79 83 87
Age Non-RRSP equity portfolio RRSP equity portfolio
$6,000
$1,000 0
$5,000
Total after-tax estate (000s)
$2,000
$3,000
$4,000
39 43 47 51 55 59 63 67 71 75 79 83 87
Age Non-RRSP 40/60 portfolio RRSP 40/60 portfolio
Qualitative Benefits
Aside from the monetary benefits illustrated above that are strictly a result of quantitative analysis, there are several qualitative, or non-mathematical factors that are often ignored in the retirement savings debate. We have identified five such benefits that deserve recognition: 1. The tax deductibility of contributions and the annual
RRSP deadline reinforce a savings discipline that might otherwise be absent.
2. Regardless of whether the tax refund is reinvested or not, it must be assigned some benefit. In our calculations, we assume the refund is reinvested. This allows us to easily assign it a monetary value. Some individuals may use the refund for home repairs or to take a vacation. In these circumstances, the benefit derived is not clear but the refund still has some monetary and/or perceived value.
3. The use of spousal RRSPs allow for income splitting opportunities in retirement.
4. Withdrawals from RRSPs are taxed as income. Because of this, individuals who are still working are less tempted to dip into their retirement savings to fund a discretionary purchase.
5. Saving in an RRSP eases the administrative burden of regularly updating the adjusted cost base of your investments so that you can later calculate capital gains on dispositions.
Conclusion
Our analysis shows that saving for retirement using a registered plan (RRSP) is more beneficial than saving in a non-registered, taxable account. There are a few exceptions to this, but for the most part, this conclusion will hold true for the majority of middle- and upper- income earners. The general conclusions that may be drawn from our analysis are as follows:
¡ Higher equity content in a portfolio reduces the advantage of saving within an RRSP. However, the end result of using a registered plan is still more beneficial than pursuing the taxable savings alternative.
¡ Changes in the progressive tax rates could impact which savings scenario provides the most after-tax capital. If the capital gains inclusion rate is further reduced, the benefits of holding equities within a registered plan will also be further reduced.
¡ The higher the income level, the greater the benefit of saving within an RRSP. A higher income implies a larger tax refund from RRSP savings. Furthermore, the higher an individual’s income, the higher the taxes payable on the proportion of interest, dividends and realized capital gains generated by the non-registered account.
¡ The benefit of saving in an RRSP increases as the investment time horizon increases. Longevity extends the period that assets can compound tax-deferred in a RRSP/RRIF.
¡ The probability of an investor outliving their capital is reduced through investing in an RRSP because this option allows for greater capital accumulation.
Appendix
Assumptions Used in Our Calculations
¡ Calculations use an annual income of $100,000 (indexed to inflation). Average British Columbia tax brackets (provided by Deloitte & Touche) are also indexed and are applied to all calculations.i
¡ RRSP contributions are maximized and indexed to the levels provided by the federal government.
¡ All tax refunds resulting from RRSP contributions are invested in a non-registered retirement savings account using the same asset mix as the RRSP.
¡ An individual’s net annual savings after expenses are invested in a taxable retirement savings account. Expenses constitute 40% of gross employment income, and are indexed to inflation.
¡ Equities provide a level of return of 8% over the investment horizon.ii
¡ Bonds provide a level of return of 5% over the investment horizon, consisting entirely of interest income.
¡ In the non-registered accounts, taxes are paid annually on interest, dividends, and realized capital gains.iii
¡ Unrealized capital gains in the non-registered account accrue on a tax-deferred basis until disposition.
¡ In the RRSP, interest, dividends and capital gains (realized and unrealized) rolled over and compound tax-free until they are withdrawn, at which point they become fully taxable as income.
¡ A retirement age of 65 is used, at which point withdrawals begin.
¡ In retirement, the post-tax amount withdrawn each year is equivalent to the investor’s pre-retirement income (after taxes and savings have been deducted) so that the lifestyle they are used to living is maintained.
¡ Contributions to the RRSP and non-registered account begin at the age of 40.iv
¡ Upon death, all accounts are liquidated and taxed accordingly. A Note about the Old Age Security (OAS) Clawback
The OAS clawback is a tool that the federal government uses to re-collect retirement benefits that were paid out to individuals whose income in retirement exceeds a certain level. Currently, the clawback comes into effect for those individuals whose annual retirement income exceeds $59,790.v The clawback reduces OAS benefits by 15 cents per dollar for any amount of net income that exceeds $59,790. The maximum OAS payment that an individual may receive is roughly $5,700 per annum, and such payments are available to anyone over the age of 65 (who meets certain residency requirements).
i Calculations were also done using an annual income level of $40,000. The results were similar (although not as dramatic). ii This return is based on a 6% growth rate and 2% dividend.
iii Dividends are eligible for the dividend tax credit. In the non-registered account, one half of realized capital gains are included in the calculation of annual taxable income. Many articles on this topic assume that all equity returns in non-registered accounts will be in the form of unrealized capital gains. We find this assumption to be suspect. In index funds, dividends are flowed through to their unitholders and capital gains may be realized when the composition of the index changes. In individual stock portfolios, a reasonable investor would periodically rebalance their account. Actively managed mutual funds also periodically trigger gains when they rotate among stocks or sectors. In our analysis, we use an annual realized capital gains rate of 1.5% because this has been the average capital gains distribution from the PH&N Canadian Equity Fund over the last 20 years. The resulting taxes payable create a drag on the portfolio because not all distributions are reinvested, as a portion of them end up in the hands of the government via income tax.
iv Calculations were also done using a contribution starting age of 30. Under this scenario, the ending figures favour investing in an RRSP account over a non- registered account even more so.
v As of December 2004.
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Phillips Hager & North Investment Management is an operating division of RBC Global Asset Management Inc. (RBC GAM), an indirect, wholly-owned subsidiary of Royal Bank of Canada. RBC GAM is the manager and principal portfolio advisor of the PH&N Funds and the principal distributor of the Series O units of the Funds. “PH&N” and
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Copyright RBC Global Asset Management Inc., 2010. Publication date: August 10, 2005
