3 RRSP pitfalls

Before you contribute, educate yourself.

 

(Photo: William Andrew/Getty Images)

RRSP season has arrived. For the next three months, Canadians will be inundated with articles, broadcasts and ads offering advice on how to manage their registered retirement savings plans.  There may be something to learn from it all, but pitfalls also lurk. Here are three everyone should consider.

 

1. The merits of saving for retirement

RRSP owners will get an earful on the importance of saving for retirement. The magic of compounding returns will be referenced. So will the merits of starting at an early age, as will the need to amass a retirement fund large enough to replace a high percentage of your current income.

Yet paying down debt can be a better way to prepare for retirement, particularly given the present choice between miniscule yields on fixed-income investments and uncertain returns on stocks. If a mortgage charges 4% interest, paying down a chunk of the principal provides a certain 5% to 7% return for most people depending on their tax bracket (the reduction in interest payments frees up this amount of pre-tax income as a percentage of the principal amortized).

With Canadian debt-to-income ratios so high nowadays, there is a lot to be said for paying down financial obligations. Saving for retirement is laudable, but I suspect the benefits are over-promoted due to the incentives for advisers who earn commissions and fees on purchases of financial assets.

2. Where to invest RRSP contributions

During the RRSP season, the media offers suggestions on where to invest RRSP contributions.  But such advice is for a mass audience and the recommended stocks or funds that catch your fancy might not be appropriate for your portfolio.

If you have 75% in stocks and 25% in bonds, for example, you may not want to bring in another stock or equity fund—especially if your target weight was set at 75% or lower for stocks. Going above that exposure could be cause for regret during the next meltdown. Mr. Market won’t accept any excuses about not keeping track of asset allocations or letting a bullish mood lull you into greater risk-taking.

A prospective investment may also give your portfolio too much exposure to a particular region or industry. For example, shares in CP Railway Ltd. might have great fundamentals, but if your portfolio is already loaded with cyclical stocks the result could be a great deal more volatility than you feel comfortable with.

As Modern Portfolio Theory advises, think about how potential investments fit into your portfolio. If your holdings end up moving together, the wide gyrations in performance could lead to some anxious moments, perhaps even panic selling at market troughs. It’s good to have some positions zig when others zag—unless you are a highly risk-tolerant investor.

3.  The benefits of tax savings

Discussions of the tax benefits of RRSPs typically gloss over who they really favour. In fact, they are mainly advantageous to Canadians in the highest tax brackets. This group has a chance of being in a lower tax bracket during their retirement years so that they end up paying less tax over their lifetime (although they could discover otherwise if governments resort to tax hikes to address the country’s financial difficulties). RRSP holders in low tax brackets are much less likely to retire to lower tax brackets and to see a reduction in lifetime tax burdens. Indeed, many find they end up in higher tax brackets. For these Canadians, a Tax Free Saving Account (TFSA) is the better option.

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