Blessed by the Potato

Over on the twitter, people wondered whether to contribute to an RRSP if they have a defined benefit pension plan. The answer depends on a few factors, chief amongst them your expected tax rate in retirement versus your tax rate now (or in the near future if you choose to contribute now but defer the deduction for a while). Other factors can include your situation and plans — if there’s a decent chance you’ll need the money before retirement, it may be best to keep it in a non-registered account until you’re sure you can lock it up.

The short answer is easy though: most of the time an RRSP is better than investing in a non-registered account, even if you have a DB pension. You can think of it like this: you have a pension adjustment if you’re in a DB plan, so you likely only have a bit of RRSP room, with the rest being used by your pension. If you had no pension and lots of room, would you use all of it or only 80%? Maybe you’d be in a case where only using a bit made sense, but likely you’d use it all if you could.

Really the only clear case where you should not use your RRSP is if you expect to be on GIS in your old age (but in that case it’s not likely that you have a job that’s offering a DB pension).

The easy case is when your tax rate in your earning (and saving) years is higher or equal to your tax rate in retirement: the RRSP will make sense (assuming you invest the refund or would invest less if you were using a non-registered account). Indeed, if you do invest the refund the RRSP will beat out the TFSA in terms of returns for the case where your tax rate in your savings years is higher than in retirement.

The harder case is to construct a scenario where your tax rate in retirement is higher in retirement than in your working years. If you’re particularly high in the income spectrum then you could have OAS clawbacks, effectively a 15% surtax on retirement incomes over $71k — which if you’re using a typical DB replacement of 70% means you’d be making over $100k in your working years (over $115k in DB income — say $165k in your working years — and it won’t matter anyway). The most likely case for higher tax rates in retirement is the least predictable one: where your inflation-adjusted income stays the same, but the government of the future has raised tax rates. It’s an analysis paralysis black hole to try to worry about deviations too far from the present set of rules. You could be higher than you are today if you make a lot more later in your career, but then if you expect to move up a tax bracket or two you can still contribute to your RRSP and defer taking the deduction. Still, the answer is not as simple as “skip the RRSP if your tax rate in retirement is higher.”

Even if your tax rate will be higher later, the RRSP can still beat out a non-registered account by allowing for tax-free compounding and easing the record-keeping and reporting burden of investing. The tax-free compounding benefit doesn’t sound that spectacular, but bear in mind that after the first jump the marginal tax brackets in Canada increase fairly shallowly. For instance in Ontario the difference between earning $75k and $90k is only 6%, and that’s made up of a federal 4% jump and provincial 2% increase at similar but not quite identical break points, so you could be “higher” later but have an even smaller difference of maybe just 2%. Would tax-free compounding be worth that?

It’s tough to say because the drag from taxes is not precise, and you can defer some capital gains into retirement, but let’s estimate it: assume you have an 8% nominal return (note that taxes are on nominal returns rather than real returns). Assume that your employment marginal tax rate is 31%, and that through the magic of capital gains partial inclusion, the dividend tax credit, and handwaving, your tax burden on those gains is 12% per year (taking a rate below the half-way mark to try to assume some benefit of capital gains deferral). Then you could invest $10,000 after tax in a non-registered account, earn 8% nominally, and pay $96 in tax the first year, or put the $14,493 pre-tax* into an RRSP, and earn 8% tax-free. After 10 years you’d have $19,745 in your non-registered account versus $31,289 in your RRSP. The tax drag would mean that your tax rate could be as high as 37% after 10 years — 6% higher than our starting tax rate or a full federal + Ontario tax bracket move — and the RRSP would still roughly break even. As time wears on so does the non-registered tax drag — after 28 years in this example the tax-free compounding benefit would offset being hit with OAS clawbacks.

I’m not sure what the correct estimate of the non-registered tax drag would be, but in this example I’m neglecting any tax on deferred capital gains which would further improve the outcome for the RRSP case. I’d ballpark it as somewhere between 1/4 and 1/2 of your marginal tax rate, and likely closer to the high end of that.

So yes, there is a very good chance that investing in an RRSP will beat out investing in a non-registered account, even if you move up by a tax bracket over time or face OAS clawbacks.

Basically:

• If you’re really low income, where you expect to get GIS in retirement, then avoid your RRSP. Invest in a TFSA, and if you manage to have more to invest than your TFSA contribution room, invest in a non-registered account.
• If you’ll be in the same or a lower tax bracket in retirement, then definitely maximize your RRSP! Tax arbitrage FTW! Just remember to invest the refund too, where you can.
• If you’ll be in a higher tax bracket then it may still be worth it:

• If you’ll be just one bracket higher, it will quite likely work out better with an RRSP due to the non-registered tax drag.
• If you’re in the OAS clawback range (expected retirement income of ~$71k-$115k in today’s dollars) then consider it carefully, but enough time and non-registered tax drag may still make it worthwhile.

I’ll finish by noting that my rule-of-thumb is simply “TFSA first”. For many the RRSP will come out mathematically optimal (note that the TFSA gets the same benefit of tax-free compounding discussed here), as many people can expect to end up in a lower average tax bracket in retirement. However, the TFSA is more flexible, better for lower-earning people, and moreover is easier to plan around with set contribution limits by year and no pension adjustments, and higher income people can usually find the funds to contribute to both. Mostly though it’s the gap between theory and practice that makes me push the TFSA: most people do not put pre-tax money in their RRSPs (or invest the refunds) — they invest what they have on hand at the time they decide it’s investing day, and then if a refund comes in they spend it. Plus if you figure out later on that an RRSP is better for you, you can easily withdraw from your TFSA and start catching up on your RRSP — if you don’t know any better, the TFSA is a great place to start. Once your TFSA is full, moving on to RRSP next (over non-registered makes sense)**.

Finally, a good related post at Michael James on Money that I couldn’t find a place to link to above.

* – remember that the 31% tax rate is on the pre-tax amount, so the RRSP will have more than $13,100 to invest, but this may come as $13,100 in the first year, then a refund on contributing the refund in a following year, repeating. Or you could fill out the paperwork to get pre-tax money into your RRSP by avoiding tax deductions in the first place.
** – which doesn’t mention the RESP. That depends on your priorities and view towards paying for your kids, but free CESG money is hard to beat so it often goes even ahead of the TFSA.

In the name of efficiency, many places are moving towards using motion detectors to control the lights, which can be annoying when the decision circuits decide the room is empty and turn the lights off on you. On the whole I find sensor-controlled lights more of an inconvenience than a labour saver. Still, if the lights are off more that’s going to save power. Advances in lighting efficiency means it’s not quite as bad as it used to be to leave the lights on, but unless there’s a next-generation LED technology coming, turning them off when you’re not in the room is still going to be a necessity as always-on lighting just isn’t realistic.

However, motion detection isn’t free, either: the sensor uses some electricity, and of course has some capital costs. So the question is how bad do you have to be at turning off the lights for a motion-controlled light system to make sense?

Doing some brief research (I googled it), the sensor is not energetically expensive: drawing roughly half a Watt, that’s only 4 kWh/year. If the sensor is controlling four 100 W incandescents or eight 50 W halogens, that’s only ten hours of accidentally leaving the lights on, less if it’s an even larger room or hallway. Of course with lighting getting more efficient, even setting aside LEDs and using four CFLs of 13 W each, it would take 77 hours of accidental usage to break even, or about 12 minutes per day. And you have to be especially negligent to make it worthwhile to put a sensor on a circuit with only one or two bulbs.

And on the flip side, sensors can lead to more light usage if you rely on the timer to turn the lights off rather than turning them off yourself. If you leave a room long enough for the lights to turn off say 3 times per day, and each time the lights burn for 2 minutes longer than they would have if you just hit the switch on the way out, then that’s an extra 36.5 hours of light caused by the switch. More if there’s more in-and-out traffic through the area, less for more rarely visited spots.

It might be because I’ve got investments on the mind, but this sounds like it’s going to shape up to be an analysis focused on risk: if the room is a place you go to infrequently with your hands full (so less likely to turn the lights off, and more likely to have them burn for a long time if your forget), with many high-consumption lights, then the risk of having the lights burning all weekend may outweigh the drain (and capital cost) of the sensor.

There are some other benefits to motion sensor controlled lights, such as infection control. There are also drawbacks, such as the existential crisis that happens every time the sensor fails to see you: are you a ghost and just don’t realize it yet, or is the sensor on the fritz?; and DEAR GOD TURN THE LIGHTS ON ALREADY I’M JUST TRYING TO POOP AND WHY IS IT DARK?

In the end though it doesn’t look like we’re talking about large sums of money either way. 4 kWh/yr will work out to about a dollar in electricity, and the sensor-powered light switches are only a few dollars more than a regular one. For your own private dwelling it may be a toss-up, but for a lightly used commercial washroom the math may make more sense, when the lights could be left on unnecessarily for hours every day. Which is a shame, because those are the same places where the malfunctions are most annoying.

A reader requested this a long time ago, sorry for taking so long Ben!

The age-old question: is the medium the better deal, or the large? The medium may be cheaper per slice, but each slice on the large is bigger…

The math to figure this out is not hugely complicated, but it’s just a bit more than you might be able to do in your head or with a smartphone while you’re hungry and staring at a menu board. What we’re interested in is the area of pizza that you get per dollar. The area of a circle is simply pi * r². Pizzas are sized by their diameter (double the radius). However, there are no points for crust (“pizza bones”), so we’ll subtract 1″ from each diameter (for a typical 0.5″ of crust on each side of the line through the circle) when computing the area factor. Because we’re really just interested in the relative value we don’t necessarily need to do the division by two or multiplication by pi — the pizza value will scale with the square of the adjusted diameter — unless we’re comparing to a square pizza. While some pizza places use their own wacky sizes, or have irregular hand-shaped crusts, most places have settled on standard sizes. I’ve listed the rounder area factors and actual edible areas below:

Small (nominally 10″): Usable diameter of 9″, area factor is 81 (edible area of 63.6 sq. in.).
Medium (nominally 12″): area factor is 121 ( 95 sq. in.).
Large (nominally 14″): area factor is 169 (132 sq. in.).
Extra Large (nominally 18″): area factor is 289 (227 sq. in.).
(note that Pizza Pizza and some other stores have 16″ extra larges)

Square pizzas: most often encountered with party sized pizzas. In this case to make a true comparison you would need the circular pizzas area in square inches. For a 15×21″ (nominal) party pizza, there are 280 sq. in. of edible pizza. Converting into “area factor” above, that would be 356.

To put this into practice then requires a division step with the price. You can divide the price by the area factor to get a price per unit area — then lower is better. However, because pizzas are often priced near $10 or $20, the inverse may be more convenient to work with — pizza units per dollar — in which case the higher the number the better value. For example, if a large is on for $10, the pizza per dollar is 169/$10 = 16.9. If the medium is $8, that’s 121/8 = 15.1; if the party size is $20 that would come to 356/20 = 17.8. In that case the bigger you go, the better your value.

For your convenience, I made a reference card for your wallet. (Be sure to select “actual size” when printing)

I’ll note that dollar per unit pizza should be the preferred unit/method if you want to look at how the value difference scales across pie sizes rather than just which is larger — analogous to the L/100 km measurement system vs MPG issues.

The stats on how many people got nastygrams from the CRA with penalties for over-contributing to their TFSAs this year have come out, and there’s a lot of shock over the fact that this keeps happening. Young recently made that mistake.

I will say it again: the onus is on you to track it yourself. The web portal is known to be dramatically out-of-date. IMHO the CRA should just take it down because it’s misleading and the opposite of helpful. Young suggests calling to get a more up-to-date reckoning. This may be more up-to-date than carbon dating the archeological evidence in the sedimentary layers of the web portal, but I can guarantee someone will be caught by this system also being out-of-date at some point. There is no getting around the fact that the CRA can’t give you an updated contribution limit if the banks haven’t sent them the information (and as an aside, it’s really weird to me that phoning will get you more up-to-date information than the computer system, like we live in an age where there’s a pile of paper forms on somebody’s desk that haven’t been entered into the computer yet). And the CRA will not accept responsibility for telling you that you have contribution room left when they later determine that you don’t.

I make tracking it simple on myself: I max it out in one call the first week of January, and then forget about it for the rest of the year. Now that’s only possible because I had non-registered savings and investments when the TFSA was launched, and continued to have non-registered funds every year, so I just have to call up TD, make an in-kind transfer of some shares, and contribute whatever cash is needed to round out to the limit (which I can then use to buy e-series with inside the TFSA).

But whether you have a simple system so you don’t screw it up (like contributing in one chunk, or an automatic monthly contribution that keeps you under the limit), track it religiously, or go through all your statements on an as-needed basis to forensically re-create the events in question, ultimately it’s up to you to not over-contribute.

I didn’t like the recent MoneySense tale of a capitulating bear in Toronto. It had some good stuff in there, but it was sandwiched by some awful thinking that does the readers a disservice.

Sandi picked up on one good bit: “It’s a purchase—it’s what I’ve been saving my money for.” While I do harp a lot on the insane costs and the importance of making a good comparison to renting, the purpose of that comparison is to make an informed choice of how to best spend your money for you. Many people are willing to spend more to own for the “pride of ownership” (me? Well, given how awesome this house is and the services our landlords provide, as well as seeing the risks inherent to owning, I would need a discount to owning to take the plunge). But how much more is always the question. So you do your comparison and you may say “meh, an extra $2k per year plus so much extra risk, that’s worth it to us.” Of course for many in Toronto and Vancouver, after running some scenarios it may be more like “Fuckity-buckity! It costs how much more to own?” So he said that money is for spending (which it is), and that his house is not an investment (which I suppose it’s not), but then never really clarified for readers how much more he was looking at or that it was a trade-off he was willing to make because yearly beach vacations are dumb and bad and nobody likes them anyway.

He does do a number of things right: he checks to see if his budget can handle an increase in rates; that he can survive a decent 20% correction and still stay above water in case he needs to move; he acknowledges that prices may fall and is not buying with visions of future gains in his eyes; and he’s not planning to move for a long time (though as a snarky aside, the assumption that he’s not planning to sell for at least 20 years may be a bit optimistic for someone in the magazine industry…).

However, the article also uses some seriously specious reasoning which brackets that good stuff. The worst was right up front:

“The reason is simple: I want to eventually retire with a paid-off house, and I was running out of time.”

There are many paths between not having a paid-off house today, and having a paid-off one in retirement (and that is not even commenting on the goal itself). For example, you can rent your larger family home right up until the day you retire — investing the difference the whole time — and then buy your retirement pad (which may be a downsizer from your working/family life place you rented) all in cash. Boom, paid off in one day and saved one round of transaction fees too. At no point does a mortgage have to come into it. Indeed, given the basic affordability issues he talked about in the preceding paragraph, the last way to get to a paid-off house in retirement should be to buy one now. The last part of that statement also makes no sense: there is no time limit, other than actually entering retirement. You don’t get to having a paid-off retirement pad any more surely from paying off a mortgage on a too-costly house at a young age than you do from renting and saving.

Let’s replace “house” with some other thing that isn’t so loaded and traditionally linked with a mortgage and the point should be clearer: “I want to eventually retire with a paid-off boat.” Well now it’s clearer: you could buy a boat now with a boat loan and pay it down, or you could rent a boat, save up, and buy one with cash when appropriate. That makes even more sense if you think there’s a good chance boats might be 20% cheaper in the future and that renting is less expensive for now — how does buying now make sense if your goal is to have one at some point before retirement? If there was a big boat sale on then maybe it would make sense to take the plunge and get a loan if you needed to. Instead, it looks like many buyers these days are getting suckered by the no interest until 2018 promotional event.

This whole “running out of time” thing reminds me of the Stockdale Paradox*: James Stockdale was in a POW camp in the Vietnam war for almost 8 years. When asked about his coping strategy, he said:

“I never lost faith in the end of the story, I never doubted not only that I would get out, but also that I would prevail in the end…”

When asked who didn’t make it out of Vietnam, Stockdale replied: “Oh, that’s easy, the optimists. Oh, they were the ones who said, ‘We’re going to be out by Christmas.’ And Christmas would come, and Christmas would go. Then they’d say, ‘We’re going to be out by Easter.’ And Easter would come, and Easter would go. And then Thanksgiving, and then it would be Christmas again. And they died of a broken heart.”

The paradox is that you have to believe in the fundamentals, that sanity will return. Trust the math, trust the logic, and trust that you will prevail in the end, but do not be too optimistic — the unrealistic hope for short-term salvation that is dashed again and again will wear you down and end you over time. You need to live in the gritty reality we face. When the bubble first started becoming a “popular” concern around 2008, some were calling for corrections to be as fast or faster than the US, especially given that we had the opportunity of witnessing their meltdown as a kind of sneak preview. I always figured it would be a slow, grinding process — but even I have been greatly surprised by how long the insanity has gone on for, originally pegging 2012 as the timeframe to be prepared to wait (4-5 years). The differences between the US and Canada that people loved to point out (such as how subprime lending was arranged, or non-recourse states) were largely differences of accelerating factors. It would make a Canadian implosion a painful, drawn-out affair compared to the US’s relatively fast (but still multi-year) implosion, but did not immunize us from a bubble.

Christmas has come and gone, and Easter too, but that does not mean that prices will continue to grow at triple the rate of inflation forever until only the Pentaverate** can buy in Toronto.

That’s why I focus so much on the price:rent metric and rent-vs-buy comparison: you have to live somewhere, so you may as well settle in somewhere nice because it’s gonna be a while. Even after the crash, it’s likely that there will be an undershoot in prices that will last for years, so you’ll have plenty of time to dance out of a stock portfolio. Of course you invest it.

Anyway, back to the MoneySense article at hand and the other half of the bracket — the conclusion:

“So do I feel like I got a good deal on my house? Not at all. By historical measures, I overpaid by quite a bit. But it was either that or no house at all…”

Either that or no house at all? That’s a false dichotomy. A really obviously bad one at that. Where has he been living until today? Is this another instance of the implicit assumption that if you don’t own you must be homeless, that renting is somehow equivalent to cowering under a sheet of cardboard? For such a massive purchase and component of the typical household budget, there is a surprising degree of reliance on memes, mantras, tradition, false dichotomies, and surface analysis. A bubble is as much about belief and memes as it is about interest rates, new developments, and price momentum. To see it as the conclusion in MoneySense by a self-described happy renter was infuriating. This isn’t “native advertising” in the Sun saying that, this is the concluding remark from the MoneySense editor-in-chief, and it just washes away all that good stuff about considering risks that came right above it.

Ugh.

Update/clarification from G+: in the article I’m not trying to slam the individual choice he made (the outcome). It’s not the choice I made, it may be sub-optimal, but he’s done his risk assessment and whatever, that’s his choice. So it’s all good there in the middle “here’s my choice, I’ve got my eyes open, and I’m prepared to deal with the consequences.” What set me off was that the good part is undermined by bracketing it in with things that basically say “and I had no choice whatsoever and was forced to do this.” Which just kind of blew the top off Mt. St. Potato, because I know people who would see that as being just as good as “rent is throwing your money away” or whatever. All the careful risk stuff sounds like an unnecessary aside when it’s the only choice there is anyway.

* – Hat-tip to Brooklin Investor for reminding me of this tale at precisely the right time for this rant.
** – The Queen, the Vatican, the Gettys, the Rothschilds, and Colonel Sanders before he went tits-up.