RRSP Structured Poorly For Long Retirement
In Alberta, a couple we’ll call Peter, 88, and Maureen, 62, have created an inefficient structure for their RRSPs. Peter, a retired banker, used his registered plan as a source for a home mortgage loan. Unlike the RRSP Home Buyers Plan, which limits RRSP withdrawals for first-time home buyers to $25,000 and thus regulates borrowing leverage, the RRSP-financed mortgage was popular when interest rates were triple today’s rates 20 or 30 years ago.
Maureen, a registered nurse, and Peter have to pay mortgage interest and principal to his RRSP. It is running as a Registered Retirement Income Fund, but within that structure, it is still an operating RRSP.
It worked as a way to save mortgage interest in the past when Peter was in a high tax bracket.
He did the smart thing in setting it up and he and Maureen figured that they would prefer to pay themselves high single digit interest rather than their bank. Moreover, rather than having to pay the mortgage with after tax dollars, they actually kept that money for themselves. It was a good plan.
Now it is an inefficient structure for what could be a long retirement for Maureen after Peter’s passing. Their RRSP has been turned into a low-yield investment that generates little money for the couple.
In a time of low interest rates, Peter has built a poor legacy for Maureen and their three middle-aged children.
Their spending, currently $5,501 a month net of debt service and savings, will be hard to sustain when Maureen loses Peter’s Old Age Security, most of his pensions and the ability to split pension income. They need to get more out of their RRSPs if Maureen is to have a comfortable retirement.
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Peter and Maureen.
“This is a story about a couple with a vast age difference who have an RRSP with the wrong assets for their needs.”
They can’t change their government or work pensions, but they can boost returns from their RRSPs. Currently, almost 40% of RRSPs are invested in their own mortgage at 3.08%. They pay their mortgage with after-tax income, but in their low-to-middle tax brackets, the savings with the low interest they pay themselves are not as much as the income they are losing by not being in higher-yielding stocks and investment-grade corporate bonds. The mortgage has, in effect, tied up 55% of their RRSPs with a low-yield, no-growth investment.
Best move, Mr. Moran says, is for the bank that holds their RRSP to swap the mortgage out and take it over, something it has agreed to do without charges. From the point of view of the RRSP, it’s just like trading stocks or changing mutual funds. The bank would get the mortgage and Peter would get cash to invest.
The values of the swap have to be equal on both sides and mortgage insurance has to be maintained. The couple will remain in debt to the bank as the replacement lender.
With the money the bank pays for the mortgage, they can buy large-cap stocks that pay dividends of 4% to 5.5%. In the end, they will have a higher return than they get on their own money in their mortgage and they have potential upside growth in dividend-paying stocks.
Other risks to the pension need to be reduced, however. Peter has a preference for mid- to small-cap stocks. Those stocks are currently the core of the couple’s non-mortgage registered assets. Peter has energy plays, gold mines and a few large-cap bank and telco stocks. It is not well diversified and is not a suitable foundation for a retirement that will depend heavily on RRIF income. They need to add public utilities and telecom stocks with dividend yields of 5%, more chartered bank shares with yields in the 4.0% to 5.0% range, and ETFs made up of stocks that pay dividends of 4.0% or more whose issuers have paid them without fail for 10 or more years, Mr. Moran says.
The yield of their RRIFs would rise with the move to letting their bank lend mortgage money and the shift to higher-yield stocks. They would pay their mortgage lender directly, still at low interest rates. The changes would double annual investment income to about $25,000 per year. It’s a good move for the portfolio, for income for the couple now and, given the couple’s age difference, for Maureen when she no longer has Peter.
(c) 2013 The Financial Post, Used by Permission