Wednesday, April 21, 2010

Head Fake?

Why were my RRSP returns so anaemic over the last decade or two?

RRSP or Registered Retirement Savings Plans are the best thing other than apple pie, or so we are led to believe. Well, I have an RRSP and its returns have been not very exciting. My Quicken files haven’t been corrupted since 2003 and my return was 4.33% per year. Not counting tepid performance for the many years before that.

I always paid the maximum or near maximum contributions, but the RRSP was always the poorest performer in my portfolio with 2008 being the exception. For two decades interest rates have been declining, and although I made some disastrous forays into the stock market (Nortel and Air Canada), the bulk of the RRSP was focussed on interest income. If it wasn’t for a long term investment in Vermillion Oil & Gas with an annual return of 17.85% starting in 1998 for around $7.50, the portfolio would have performed even more dismal.

One of the big financial events over the last decade has been the falling income tax rates, here in Alberta from 52% or so to as low as 38% last year. The other major event was the falling inflation rate and with that falling government deficits which like a never-ending reinforcement cycle resulted in falling interest rates. All these events are now coming to an end. I don’t foresee a return to the high interest rates of the early 1980s but similarities with the 1970-1980 decades are uncanny.

So, I made this little spreadsheet showing falling interest rates which were typically 10% in year 1 (assuming 7% inflation) and at 0% in year 10 with an inflation rate of 1.2%. I assumed the declines of both inflation and interest rates were gradual. I did the same for the income tax rate (See table I below). I made each year a $1000 contribution to my RRSP which resulted in a tax refund that varied depending on the prevailing income tax rate and the net investment increased accordingly.

Table 1 – After Tax Real Returns on Annual RRSP contribution of $1000.00

For example, in year 1, the $1000 contribution resulted in a refund of $520 and the net investment was $480. The $1000 earned 10% interest or $100. When withdrawn in the next year, at a lower tax rate, that was an after tax return of $49.56. After deducting that year’s inflation my return on $480 actually invested would have been 3.3%. In year 10 that return would have been -1.2%.

Of course, in real life, I would have earned over the entire 10 year period a lot more (see table II). A one-time contribution of $1000 would have again been an actual investment of $480. After 10 years of falling interest rates, it would have resulted in a $1623.75 RRSP balance, which when withdrawn today would have been worth $1006.72 on an after tax basis. Within the RRSP the return would have been 4.97% (very close to my real life performance since 2003) and on an after tax basis (with an actual investment of $480) the return was 7.69%. So what did inflation do?

Well the purchase value of $480 year 1 dollars declined to $315.22 and the real inflation corrected return was: $1066.34 and after tax that would have been: $449.31. So when everything has been said and done,  my $480 initial invested money would have been worth on an after tax and after inflation basis: $449.31, I lost close to $40 in purchasing power. In real life, since 2003 my return inside the RRSP was 4.33% so I guess I did do even worse. Well, at least I still have all my marbles, or do I?

To add insult to injury, I will confess I invested a lot of my RRSP money in Canada Government Bonds. They got my money for years for free!. Ah, well at least I didn’t invest in Canada SAVINGS Bonds!!!!

Table 2. Performance of One-time $1000 RRSP contribution (see rates and years as Table I)

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