Why You Might Not Need An RRSP
Why borrowing to invest, starting young and choosing RRSP's over paying off debt may not be the best choices for you. This article was written with excerpts from an article written by David Trahair CA. It challenges the big bank notion that RRSP's are the be all and end all of Canadian financial planning. The mythological power of the RRSP is really an accumulation of several claims that have built up over time. Let's look at each in turn. I must admit I have fallen for this myth myself, then I started looking into strategies on how to invest in a bear market, That is when I realized that my advisor made more than I did last year on my money! My bad, it's my responsibility to know where I put my money. I paid my advisor and investment firm $200.00 in "fees" to lose $2000.00 what a bargain. I must be an idiot, well maybe, but likely under-informed. Anyway, here is the rest of the article and no, I am not a financial planner and I'm not giving advice, do with it what you choose.,
1. Start yesterday
Here's the claim: If you want to retire in comfort, you have to put money into your RRSP every year, and it's best to start when you are young. The younger the better. If you start an RRSP when you are just 22 years old and you put $4,000 in per year until you are 65 at an annual rate of return of eight per cent, your RRSP will be worth $1.3 million when you retire!
I am tired of hearing this pitch because it's really nothing more than a slick marketing trick that can be lethal to your financial health. There are many problems with it.
First, consider who is sending the message. It's all the usual suspects: banks, brokerage houses, and most "financial advisers." Why do they want you to fall for this message? Because for every dollar you put in, they get a percentage. It's a guaranteed annuity for them, regardless of what happens to your investments along the way.
When you hand over your money to your adviser or banker to invest in an RRSP, he or she will do as you ask and invest it for you. If he or she invests in a mutual fund, in addition to any upfront commission, he or she will also get a fee from the mutual fund company. You will never know how much your adviser or banker is getting, however, because this cost is buried in the expenses of the mutual fund company. This cost is included in the management expense ratio, or MER. It represents the ratio of costs, including commissions and marketing expenses, as a percentage of the total assets of the mutual fund. All investors in that fund are paying those management expenses, and it can all add up to a lot of money.
For example, say the managers of the mutual fund were able to realize a return on their investments of seven per cent. If the MER is two per cent, the overall rate of return on that mutual fund would be only the net amount of five per cent. The theory is that the managers are being rewarded for generating above-average returns. That's fine if they do indeed generate that kind of return, but in many cases they don't. Your broker and the mutual fund company win. You lose, avoid these kind of scams.
The second problem with this claim is that it ignores some basic facts of life. Where is the typical 22-year-old going to come up with $4,000 per year? He or she has possibly just graduated from university and perhaps has a student loan. As with any debt, that loan will have a fixed interest rate that in many cases will exceed what can be earned in the RRSP. Nor should a 22-year-old borrow the money to invest in an RRSP. Increasing debt at this age is the last thing anyone should be considering. No one is even allowed to invest in an RRSP until he or she has a job or other earned income to create RRSP contribution room.
2. Borrow if you don't have the funds
"Don't have the cash for an RRSP contribution? No problem. We'll lend you the money!"
You can hear that offer every February. Here's why you shouldn't listen to it.
Borrowing to invest makes sense in the long term only if the rate of return exceeds the interest rate on the loan. Obviously, it doesn't make sense to borrow at five per cent to invest in a term deposit making only 2 per cent! If you do borrow to invest, you are essentially agreeing to put all your eggs in one basket -- the stock market -- and hoping that it beats the rate on your loan. Once again, this strategy play directly into the hands of those people who make a living off your finances.
3. Invest in an RRSP before paying down the mortgage
This question of whether or not it's wise to invest in an RRSP before paying off the mortgage also comes up every year. The usual answer is that you should contribute the maximum to your RRSP and use the tax refund to pay down your mortgage. Sounds like a good compromise, doesn't it? This way, the finance company gets your investment money and it's up to you to be disciplined enough to actually use the refund to pay down your mortgage. Of course, that's easier said than done.
First of all, you need to be able to afford to pay down your mortgage. In other words, you mustn't need the refund for anything else, such as paying down other debt or taking a much-needed vacation. Second, usually you can only pay down a mortgage when the finance company allows you to. Often that's only once a year and is limited to 15 to 20 per cent of the outstanding balance. You have to be very disciplined and make sure you put the refund into a safe place until then.
The reality is that investing in an RRSP and using the tax refund to pay down the mortgage is usually not a compromise at all. The people who send this message are, in fact, simply wanting you to invest in an RRSP. Period. I am saying pay down the mortgage instead. Period.
I'm sure you kind of get the idea of how I feel about banks and financial institutions. There are no shortages of greedy wolves lining up to fleece you of your hard earned money. Educate and protect yourself. There are many alternatives to RRSP's.