RRSP Implementation

So okay, you’ve got RRSPs basically figured out. The problem is that even once you understand that an RRSP is basically just a license to invest in whatever without paying taxes (at least, for now) there’s still a bunch of mystery there. It’s a very jargon-dense environment, and for someone who finds the whole topic sort of foreign, a “developing markets small cap hedge fund” is a great big barrier to entry. Besides which, you don’t know how you’re going to find any money to put into one of these things, or how much would be enough anyhow. In a way, you’re worse off for having read my last post (sorry about that) because now you get how simple things ought to be, and you’re STILL out in the cold.

In this post, which comes hot on the heels of the last one only because of the near-expiry of this year’s RRSP deadline and because I like you, I’ll try to give you some suggestions. But you have to promise you won’t sue me, because I might-just-might make actual recommendations, and they might not be right for you, so this is the part where you really have to make your own call.

How Much is Enough?

If it makes you feel better, you’re not the only one asking this question. And how would you like the answer anyhow? In terms of amount to save per month? Or required annual growth rate? Or required final balance? There are a hundred different numbers and rules of thumb for each of those angles, and maybe they’re all good, but it’s easy to get confused. You can come to your own conclusions about that eventually, but you need a way to get started and staring down a sentence like “Retiring with $2.5million should allow for a modest but comfortable income that you can count on year after year” makes it hard to see any point to socking away $75 at a time.

Let’s turn it around. 10% of your income seems like a lot, but most people who grit their teeth and set up an automatic withdrawal for that amount report that after a few months, they don’t really miss it. The ones who do have bigger problems and might want to go all the way back here, to my post on day to day money management. 10% of your income is also a nice place to sit because contribution maximums to your RRSP are closer to 20% so that gives you room to boost it up if you’re feeling saucy, but in any case allows you to congratulate yourself on contributing more than half the maximum contribution. Finally, 10% is a goodly amount of money over a few years. It means that after 4 years or so, with some modest growth, you’ve got half a year’s earnings in there. Being able to retire for half a year doesn’t really help you very much, but seeing that you’ve made that kind of progress is something you can and should feel some pride in. If you want to get started but 10% is just too much, even knowing that you’ll get some of that back in tax refunds, then start with 6% or 8% and work your way up. Resist the urge to start at 5% because it’s a round number and people get stuck on round numbers.

What Do I Buy?

In my last article, I recommended people at least get themselves set up with one of the simple-interest RRSPs while they think about things, so that their money starts working today. That’s still good advice, but if you’re ready for something more interesting, great. For most people, the next step is a discount brokerage account. Don’t be scared by this, a brokerage account is only as scary as you make it, and discount just means they are leaving you to your own devices (by contrast, a “full” brokerage account means that you get to say “my broker put me onto this hot new biotech” and so on. You also get to pay much more for this.) Most banks offer three levels of scary-word-enablement:

  1. Mutual Funds
  2. Mutual Funds, Stocks, Bonds
  3. Mutual Funds, Stocks, Bonds, Margin Trading, Options and other derivatives, OMG WOW

The only cost to set one up should be the annual fee, which for basic accounts hovers around $25/$40 per year, and for the exciting accounts closer to $100. Most of these accounts will waive your fee once your balance gets into the 5 figures ($15k for some places, $25k for others).

The reason brokerage accounts are usually the next step is that with a brokerage account you can basically invest in almost everything that isn’t crazy. The reason mutual fund accounts are cheaper than general purpose accounts is that a) mutual funds bury their costs in other places, and b) mutual funds are generally marketed as the “easy” way to invest because someone else handles things for you. The appeal with mutual funds is, you still get to decide how much risk you’re willing to handle, but instead of buying individual stocks, the mutual fund sells you “units” of their nicely diversified and managed portfolio. They are a very good way to diversify quickly, but their commission structure makes them a nasty surprise to novices. Sometimes you pay commissions to buy the fund units (“front end load”); sometimes you pay a commission to sell the units (“back end load”), and ALL mutual funds have an annual “Management Expense Ratio” — basically a stated percentage that they take right off the top every year. For a typical mutual fund, even one without front- or back-end loads, the MER tends to be 2.5% to 3.5%. So no matter what, whether their return is positive or negative, whether they are genuises or idiots, you’re paying them $300 a year for every $10000 you have invested with them. Considering most investors are happy to have a 9% year, a 3% chunk is a lot to pay.

You could, of course, just buy the individual stocks you want, based on hot tips, or detailed reasoning, or the financial section of the brampton guardian. Regular readers are familiar with my opinions on the wisdom of active stock trading.

Ditto you could buy individual bond issues through your brokerage account, either government or corporate. The institution administering your account can help you understand how to find bonds and buy and sell them, but if you want their advice on which stocks, bonds, or funds to buy, you will have to pay them more.

Stocks, bonds, mutual funds. That is basically the next step. To have an RRSP with something crazier than that requires things to start getting wacky, and I am not thinking you want to get wacky just yet. If this gives you enough to feel ready to get going, then go. The final thing I’m going to talk about is a simple setup for your account that won’t cost you much in fees, and gives you broad diversification and simple management. It’s not for everyone, but it’s a pretty safe way to get started, and it might also kick major ass.

The Armchair Portfolio

I’ve talked about this before but I was at once too detailed and too rushed, so I’m going to try a second time. We know that a mutual fund is just a pool that holds a bunch of stocks and lets you buy units instead of buying the stocks individually. The downside is that the expertise involved in managing these funds (or so they claim) results in high commissions and management fees which eat your profit. Which is a shame, because otherwise funds are a great way to get diversified quickly and easily. Well, there is another kind of mutual fund.

Index funds are funds set up for a boring investor. They drop the claim of intense expertise, and with it, they drop the commissions and expenses way down. No loads to buy or sell, and an MER of more like 0.4% instead of 3.2%. The way they can do this is by using the expertise that other companies are already giving away. You’ve heard of the S&P 500 and maybe you also suspect that this is a list of approximately 500 big American companies that, when their price fluctuations are taken together into a single score, give a pretty good indicator of the overall market conditions. This is called an Index, and there are lots of them. What an index fund does is, instead of trying to pick winners and dump losers, it just tries very hard to hold whatever the S&P 500 does, and move just like the S&P 500. Or, if it’s a Canadian index fund, what the TSX300 does. Or if it’s a canadian bond index fund, what the Scotia Capital Markets Index does. Or if it’s a Eurasian index fund, what the Morgan Stanley Europe, Australia, and the Far East (MSCE EAFE) index does. No cleverness, no expense, just buying the whole market (or at least a representative chunk of it). Since businesses tend to improve efficiency, since production quality tends to improve, markets, as a whole, tend to go up. And so do your index funds. And since we’re keeping it simple here, we won’t even try to guess where the big growth is going to be next, we’ll just split our money up very evenly. The armchair portfolio:

  • 25% in Big Canadian Companies (a TSX300 index fund)
  • 25% in Big US Companies (an S&P500 index fund)
  • 25% in Big Overseas Companies (an EAFE index fund)
  • 25% in Quality Canadian Bonds (a Scotia Capital Bond index fund)

None of these funds should have expenses higher than half a percent, nor should they have loads. As your money builds in your RRSP, you buy these funds in the appropriate ratio. Once a year or so, you check whether any fund has gone above 30% because it outgrew its peers, or below 20% because it fell behind. If so, you sell a winner to prop up a loser until the numbers are back to roughly 25/25/25/25 again.

That’s it. That’s my recommendation. If you get through this article, set up the account, and start saving, you are officially in my good books, and I would love to hear about it.

4 comments

  1. You are a wonderful man and I love you dearly. You are also a lifesaver.

    Of course, that’s been true for years, but all your recent posts about financial managment cause it to bear repeating. ^_^

    So I have two questions. When people talk about 10% of your income, are they talking about income before or after taxes? I’m assuming before, but I wanted to make sure.

    Also, knowing how much to invest each month is great, but do you need a bigger deposit to start with? It doesn’t seem likely that I’d be able to buy much in the way of index funds in my first month out, especially if I’m trying to get them in a ratio like that. Would it be better to stick it in one of the boring account RRSPs for a year until there’s actually a decent amount of money in it first?

  2. The idea of 10% is 10% of gross, but I deliberately left it vague so that people who need to give themselves permission to contribute a little less can do 10% of after tax instead. If you’re paying about 30% tax, then 10% of net is about 7% of gross — if you then take your tax deduction and roll that into your RRSP as well, you get up to about 9% of gross, and then you’re most of the way to 10% anyhow. 🙂

    As for big initial deposits, you don’t need one. You can start today, depositing the cash, and depending on the brokerage you’re with, they might even give you a few points of interest anyhow. Most index funds require relatively small entry purchases, $500 for some, $1000 for others, but once you hold a given fund, you can make “top-up” purchases for as little as $100. And since index funds are no-load, there is no commission or transaction cost for doing this.

  3. My husband put an RRSP into his own name and said that I put it in for him, then he took it out this year without me knowing it and I was taxed on this. Is this legal? I was not aware of him doing this.

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