Retirement Savings Plans: Are They Really a Good Investment?
Author: Brad Howland
First Posted: March, 2002
RRSP's and IRA's are hyped endlessly by the financial services industry. You have to wonder why. Are they really such a good investment? Who do they benefit the most, the people contributing to the plans or those who have a vested interest in selling them?
For the vast majority of people, the most important investment decision they must make is whether to contribute to a retirement savings plan or pay down the mortgage. A lot of money is spent each RRSP/IRA season on print and TV advertising trying to convince you that retirement savings plans are the way to go. As far as I can tell, no money–zilch, nada–is spent to inform you that investing in your own mortgage might be a better choice. Why?
The answer is simple, and a little nauseating, at least to me. If you invest in a retirement savings plan there is a slim chance that you will derive some benefit from it, however, most of the benefit goes to those who:
- earn commissions from selling it to you (i.e. financial advisors)
- get to use your money for the length of time it is locked away in the plan (i.e. banks), and
- don't have to give you as much money later in life because you lowered your standard of living enough to save up some cash (i.e. governments).
On the other hand, if you use your hard-earned cash to pay down your mortgage (or enjoy life now, as you live it) the only person who will gain by it is you! You and you alone will enjoy the benefits of:
- vastly reduced interest payments over the amortization period of your mortgage (those poor banks!)
- a mortgage/rent free retirement, with the possibility of using your equity to fund additional recreational or rental property
- the unprecedented ability to increase the value of your investment through your own blood, sweat, and tears (i.e. by renovating), and
- no reduction in your allowable government pensions.
Are RRSP's and IRA's a good investment? I used to think they were because of the tax savings, but it is important to remember that this is not a tax deduction, but a tax deferral. You have to pay the piper sometime, and you will pay tax on the money you are socking away now when you retire and start withdrawing money from the plan. The universal rationalization is that when you retire you will be in a lower tax bracket, and therefore will pay less tax on the money. But is this necessarily true? Can you predict the future? I can think of quite a few situations in which you might be in the same or even a higher tax bracket at retirement. For example, perhaps you are now self-employed and able to lower your net income substantially with legitimate business deductions. Or, perhaps you will receive a big inheritance some point in your life. Maybe you'll even win the lottery. Anything can happen!
"When was the last time you took anyone travelling or sailing in your RRSP? What enjoyment do you receive from your RRSP? You don't sleep on it, in it or with it. You don't show it off to your friends and you wouldn't have bought it if it wasn't a tax deduction."
~ David Ingram
Investments generally fall into three categories, or some combination of three categories: interest (income), dividends, and capital gains (growth). It's a terrible idea to hold dividend or growth investments inside a retirement savings plan. This is because income from dividends or capital gains receives extremely favorable tax treatment. In Canada dividend income receives both Federal and Provincial Dividend Tax Credits, and only 50% of Capital Gains are taxable. It's true that when you put these investments into a retirement plan the tax is deferred until you retire, but when it is eventually withdrawn, you will lose all favorable tax treatment because the money will be taxed as ordinary income.
It's clear that the only kind of investment it makes sense to hold inside a retirement savings plan is one that produces interest, and interest investments have been shown to produce dismal returns over the long term when compared to growth investments. Put all of your retirement money into a bond fund, and you'll be lucky to walk away with anything after inflation and taxes do their work! (Please note: people closer to retirement should put more of their funds into income investments to conserve capital.)
The financial expert replies: "Retirement savings plans are still a good investment because you can take your current tax savings and reinvest them in the plan–the cumulative effect puts you ahead." Well, maybe, but I don't believe that cumulative effect is nearly as effective as paying down the mortgage. Any simple mortgage calculator will show you the stunning reduction in interest that occurs when you make extra mortgage payments.
Real estate is a great investment, because it almost always increases in value well ahead of inflation. Sure there are fluctuations based on location and local markets, but the general trend is up. It can be tough raising enough cash for a down payment on a first home. Luckily there are books out there that tell you how to do it, such as Robert Thomson's Hot Tips for Real Estate Investors. Hot Tips discusses eight ways to find the money for that "steal of a deal," two of which I used personally to finance my own first home.
Which gives me a nice segue into the topic of next month's article, "Why Buy a Condo?" by Robert Thomson. Bob will discuss how his daughter-in-law, with a good, steady job paying $20/hour, $2,000 in savings, and monthly rent payments of $600, was able to buy a nice one bedroom condo in Victoria for $100,000.