|
A growing number of Canadians rely on defined contribution (DC) plans such as money
purchase pension plans and group registered retirement savings plans (RRSPs) for
their retirement security. However, because of low contribution limits, executives
and other high-paid employees find these arrangements don't meet their retirement
needs.
Despite the mounting chorus of criticism, the federal government is unlikely to do
much about this problem any time soon. Senior civil servants and politicians are
covered under retirement arrangements that are not capped in any way and so the
sense of urgency, or empathy, just isn't there. This, in turn, puts a strain on DC
plan sponsors. They are forced to use instruments like supplemental employee
retirement plans to create phantom retirement savings.
It would be ideal not to have to obtain Ottawa's permission to save for retirement.
Indeed, wouldn't it be wonderful if Canadians could accumulate retirement savings
just as effectively in a taxable savings vehicle? We could put away as much as we
wanted, when we wanted and invest it as we see fit.
Until recently, this idea seemed ludicrous. Tax-assisted plans not only provide an
immediate tax deduction for contributions, they also shelter investment income from
tax until the proceeds are paid out in cash.
LOWER TAXES
Recent changes to our tax system, however, have made taxable savings plans more
attractive. First, personal income tax rates have dropped. In Ontario, for
instance, the highest marginal rate has come down about 7% in the last few years.
Lower rates mean investors get to keep more of the investment income they earn in a
taxable savings plan. They also reduce the value of the tax-deductible
contributions--the lower the tax rates the smaller the tax refund.
In addition, the portion of capital gains that is subject to income tax (the
capital gains inclusion rate) has been pared down to 50%. This change can have an
even greater impact than the reductions in marginal income tax rates. If you invest
100% in equities, your total return is made up of capital gains and dividends.
In a taxable savings plan, these options both receive favourable tax treatment. But
in a tax-assisted plan they don't. All proceeds that are eventually paid are
subject to tax at ordinary rates, even if all of the investment income is in the
form of capital gains.
As tax rates fall, one wonders whether a taxable savings plan would actually do
better than a tax-assisted plan. If so, it would then be useful to know the
threshold--that is, that magical figure for income tax rates and capital gains
inclusion rates below which an individual is better off investing outside of a
tax-assisted plan.
Searching for this financial unicorn involved running a number of economic and tax
scenarios. To take full advantage of the capital gains rules, it was assumed that
an investment portfolio consisted only of equities. Interestingly, the process
revealed that the marginal income tax rate does make a difference, as does the
capital gains inclusion rate. The lower they fall, the better taxable savings plans
look.
GROUND RULES
First, some background on the methodology. In the projections of tax-assisted
savings, assume that $1,000 is contributed each year for 25 years, after which the
proceeds are pulled out in a lump sum with the appropriate amount of tax paid.
Under the taxable savings plan, assume that $1,000 less income tax is invested
annually over the same period. Income tax has to be deducted for an
apples-to-apples comparison, doing so leaves the taxable savings plan investor in
the same after-tax financial position as the RRSP investor.
Assuming a 46% combined federal/provincial marginal tax rate, for example, the
investor has $540 to deposit annually in the taxable savings plan, not $1,000. In
the accumulation phase, assume the return is composed entirely of capital gains. In
fact, a small portion is derived from dividends but this could be practically
ignored since the marginal tax rates on dividends are only a little higher than on
capital gains (see "It's all relative," below).
If the 1996 tax rates were still in effect, saving with after-tax dollars would be
quite a discouraging undertaking. The net accumulation is barely half what it is
under a tax-assisted plan. The picture has improved markedly since then, though.
One can accumulate about 45% more under a taxable savings plan now. Even with the
lower tax rates we now enjoy, tax-assisted plans are still superior, but not by as
big a margin.
As for the future, consider this rosy scenario, which is more of a wish than a
prediction. Assume that by 2010 the highest marginal tax rate is 40% and the
capital gains inclusion rate has dropped to 25%. If this happy set of circumstances
comes to pass, RRSPs would still be better than taxable savings plans, but not by
much. Clearly, reaching a magical threshold is not going to be easy.
Consider projections based on five scenarios for progressively lower capital gains
inclusion rates. As the capital gains inclusion rate approaches zero, we are
tantalizingly close to the threshold where taxable savings plans approach the
tax-effectiveness of RRSPs (see "Counting capital gains," right). But still, we are
not quite there yet. Either the capital gains inclusion rate or the marginal income
tax rate has to be zero to reach the elusive threshold.
OLD ASSUMPTIONS
The scenarios described so far assume that tax rates stay constant throughout the
entire accumulation period, when in fact, this is almost certainly not going to be
true. Not only do the federal and provincial governments change tax rates from time
to time, individuals go through different marginal tax rates during their careers
as their earnings change. Given this, it is important to consider what happens if
tax rates experience either a secular decline or rise.
If marginal income tax rates are high now but decline near retirement, it helps
tax-assisted plans a lot more than it does taxable plans. Not surprisingly, if
marginal income rates are low now but climb in future years, it is a lot more
damaging to tax-assisted plans than to taxable plans.
This scenario is not so far-fetched. Many investors will move to a higher income
tax bracket during their careers. As they do, taxable savings plans start to look
attractive (see "The tax factor below").
An individual in mid-career earning $55,000 currently has a marginal income tax
rate of about 36%, depending on the province that he or she resides in. By
retirement, that person could easily rise to the highest tax bracket, which might
be 46% as is now the case in Ontario. If that happens, the accumulation under a
taxable savings plan is just a notch below tax-assisted plans.
If tax rates rise, as they are wont to do, the investor can actually be better off
outside of an RRSP. Anybody who is not in the top income tax bracket now but
expects to be in the future should think twice about contributing the maximum to a
tax-assisted plan now. That money might be better invested in paying down the
mortgage.
Sponsors of tax-assisted DC plans might be remiss in encouraging younger employees
to contribute the maximum, especially when those employees are in lower income tax
brackets and moving up. Just think of the scenario 20 years from now if members
launch a class action suit because their employer encouraged them to contribute too
much in their early years.
INVESTMENT ISSUES
A test of a number of investment-related factors likely to affect the comparisons
here reveals that the lower the investment return, the better it is for taxable
savings plans versus tax-assisted plans.
While the study assumes no difference in the expected pre-tax return, inside or
outside a tax-assisted plan, it is fair to question whether an unfettered portfolio
would do better. Tax-assisted plans are subject to investment restrictions that
don't apply to taxable vehicles, in particular, the 30% foreign content limit. With
a wider choice of investments, an investor might obtain a higher return. If a
non-restricted, taxable portfolio can achieve a return that is 1% to 2% higher, it
would close any remaining gap between taxable savings plans and their tax-assisted
counterparts.
Seductive as it sounds, this line of thought was not pursued too vigorously. Why?
First, one can get around the 30% Foreign Property Rule in tax-assisted plans by
using derivatives. Second, actively managed international equity funds tend to have
a higher management expense ratio and this could offset the greater expected return
of foreign equities.
Portfolio turnover also has an impact. No turnover implies a buy and hold strategy
in which no capital gains will be realized--and taxed--until the end of the capital
accumulation period. Turnover of 100% means that all capital gains are realized on
at least an annual basis and subject to tax in the same year. The lower the
investment turnover, the better taxable savings plans perform. At the extreme, no
asset turnover and no dividends means that all investment gains would be
tax-sheltered during the accumulation phase, just like a tax-assisted plan.
Of course there is the question of whether it is prudent to invest 100% of a
taxable portfolio in equities. It certainly can be, especially if the taxable
savings plan merely supplements investments in a tax-assisted plan, or even the
investment in a house. Configuring a balanced retirement savings portfolio with the
right mix of stocks and bonds does not mean that each investment vehicle needs to
be balanced, only the total. An individual who has both a tax-assisted and a
taxable savings plan should hold any fixed income investments in the former
vehicle.
Overall, the dynamics dictating asset mix and investment strategy are fundamentally
different for taxable savings plans. The emphasis with taxable arrangements should
be on minimizing turnover and interest income.
Tax-assisted retirement vehicles won't vanish overnight but their advantage over
taxable savings has been diminishing. In some cases, the advantage has disappeared
completely. The worry, of course, is that the future direction of tax rates will
not always be downwards. Should it reverse, we could find ourselves right back
where we started. BC
|
News
News
