It's called RRSP season. From the time our first post-Christmas credit card bills arrive, we are bombarded for the next two months with ads urging us to invest early and invest often and warning we'll end up working at McDonald's in our old age if we don't max out our RRSPs.
For those who follow the advice, the reward is supposed to be "Freedom 55": walking down the beach with your loved one (and, no doubt, a good supply of Viagra), thanks to your wise financial stewardship. It's a do-it-yourself recipe for retirement security. The flip side of the coin is a blame-the-victim ideology: if someone's poor in retirement, it's their own fault since they didn't pick the right mutual fund.
This year, RRSP sales were hampered by widespread uncertainty about the global financial meltdown (led by the U.S. sub-prime lending crisis). Once again, the private financial system is revealing its propensity to regularly self-destruct, and that alone should give us plenty reason to question trusting our retirement future to the red-suspendered traders throwing darts at dartboards on Bay Street and the other financial centres of the world.
But quite apart from the ongoing rollercoaster of the financial markets, there's another big, unreported problem with the whole notion of self-financed RRSP retirements. Quietly, the fundamental economics of the whole RRSP system have deteriorated markedly in recent years. Millions of frugal Canadians, if even if they follow Bay Street's advice and invest every year, aren't going to get nearly as much from their personal savings as they thought they would.
In fact, do-it-yourself pensions have been hammered by exactly the same economic and demographic forces that have created much better-known problems with group pension plans: Growing life expectancy, lower investment returns, and lower interest rates. For group pension plans, these factors have produced multi-billion dollar funding deficits
- and some very scary headlines. Most group plans are working through these problems, although challenges remain.
For RRSPs, however, the resulting pension "deficits" are parceled into nice little individual packages. Indeed, the whole premise of RRSPs is to shift pension risk and responsibility from governments and employers onto individuals. These personalized deficits never generate big scary headlines. Imagine the Report on Business coverage: "Joe Blow faces $100,000 pension shortfall!" And since neither governments nor employers are harmed (at least not directly) by this hidden crisis, they aren't agitating for change. In aggregate, however, the RRSP crisis will cause enormous pain to millions of Canadians.
Here's the math. Right now, Canadians have $600 billion tied up in RRSPs. (About 70 per cent of that is held by the richest fifth of the population - and the very unequal distribution of RRSPs is another important probl m of this whole do-it-yourself pension system.) Back in the roaring 1990s, financial advisors used to promote RRSPs with logic something like this (all numbers are adjusted for inflation). Suppose you make $50,000, you sock away 5 per cent of that per year and you earn real returns (after inflation) of about 5 per cent. After 30 years you have a tidy nest egg of about $165,000. Assume you'll live 18 years after retiring (in your early 60s), and interest rates continue to earn about 4 per cent (again after inflation). Your RRSP will then generate monthly income of $1,050, replacing over 25 per cent of your pre-retirement income. Throw in public pensions (old age security and CPP) and any workplace pension you may receive, and you won't be living in Bermuda - but you won't be working at McDonald's either.
This whole strategy was iffy at the best of times. In reality, most Canadians have a hell of a time paying their monthly bills, let alone setting aside a few thousand dollars a year for their personal pension. Among that half of Canadians who have an RRSP at all, the median account is only $30,000 - far too small even to finance this modest personal pension. And unfortunately, this RRSP arithmetic has been undermined further by the three unfavourable changes listed above. First, life expectancy has grown by about 2 years (more for men than for women); now your RRSP has to last 20 years, not 18. Second, investment returns have fallen by at least a percentage point (and the old philosophy that stocks reliably earn more
than bonds burst long ago). Third, long-term interest rates (which determine how much pension you can "buy" with your RRSP) have fallen even further, by about 2 percentage points. These seem like small changes, but they add up to huge problems for pensions - just as much for RRSPs as for group plans.
Suddenly, your nest egg after 30 years of scrimping is only $140,000. Worse yet, interest rates are lower, plus you're expected to live longer (how fiscally inconvenient!). So that $140,000 now buys a monthly pension of only $700 - just 16 per cent of your pre-retirement income. You have a pension shortfall of $350 per month or over $4,000 per year, compared to what you thought you would get.
Multiply that by the number of Canadians who've been duped into believing they can buy their own retirement, and you have a pretty big number. To get back that $1,050 monthly pension, contributions should be 50 per cent higher: 7.5 per cent of salary, rather than 5 per cent. Capitalize that unmet funding requirement and we can conclude that Canadians' RRSP funds, in aggregate, are something like $300 billion "too small." I think that deserves a scary headline.
Either individual RRSP holders will have to cough up $300 billion in additional contributions and quickly, or else they will have to tighten their post-retirement belts considerably. Either way, it's a 12-figure burden that's been slipped squarely (and silently) onto the shoulders of individual savers - who are unorganized and have no one to advocate for them.
Maybe the situation isn't quite so bleak. Maybe interest rates will bounce back. Maybe the stock market will never crash again. Maybe Canadians will stop living longer.
More likely, however, millions of Canadians will be sorely disappointed when they retire - even if they did pick the right mutual fund. Worse yet, many will see an even larger share of their savings diverted to Ottawa's clawback on pension benefits. Group pension plans face similar funding challenges, but at least the problem is acknowledged - and in many cases there are unions and pension regulations to defend the rights of current and future pensioners. This huge, hidden crisis in the RRSP system, however, is occurring without any explicit recognition of the costs and pain that will result. This demonstrates the folly of any pension system designed around individual accounts.
| Book Excerpt: The RRSP Myth Note: The following is an excerpt from Paper Boom by Jim Stanford, published in 1999 by Canadian Centre for Policy Alternatives. While somewhat out-of-date, the article remains some of the best analysis of how RRSPs contribute to inequality in Canada. The specific data has changed in the ensuing 10 years, but the basic trends are identical. Canada's RRSP program may qualify as the most "democratic" form of private financial investment in our economy. But this does not imply that RRSPs are especially fair: the majority of RRSP funds are owned by high-income Canadians, while more lower- and middle-income households own economically trivial amounts, or no RRSPs at all. And RRSP tax subsidies are distributed to households in a perverse manner: the RRSP holdings of high-income investors are actually subsidized at a higher rate than those of other Canadians, because of the manner in which these subsidies are calculated. Unlike many other tax subsidy programs (such as the child tax credit for poor families), the RRSP subsidy is calculated as a tax deduction (in which the legal amount of RRSP contributions is deducted from income before the investor's tax bill is calculated), rather than as a tax credit (in which the subsidy is added back at the end of the income tax form, after the individual's taxes have already been calculated). The value of a tax deduction depends on the rate of tax which the investor would otherwise be paying on the income that is deducted. Higher-income taxpayers pay a higher rate of tax, hence the RRSP deduction is worth proportionately more to them, and hence they receive a sweeter subsidy for their Despite these ironies, however, the fact that RRSP investments are subsidized, and that the total tax-subsidized contribution is limited (at present to a maximum of 18% of the previous year's earned income, to a ceiling of $75,000), means that RRSP investments are distributed far more equally across households than are other financial investments. Most working and middle-income Canadians do not come close Most of the unused RRSP room is concentrated at the bottom of the income spectrum, where a shortage of disposable income constrains household saving potential. Surprisingly, then, the distribution of RRSPs is not very equal at all. There are a couple of data sources supporting this conclusion. The income tax data cited earlier break down total RRSP contributions by income category. High-income individuals are far more likely to invest in an RRSP than those with less income. Less than one-quarter of Canadians who earned less than $50,000 contributed to an RRSP in 1995, compared to 70% of those who earned over $50,000, and a whopping $12,000 each (more than $1,000 per month) for those pulling in more than $100,000. The end result: in 1995, a full 50% of RRSP contributions was claimed by just the top 11.7% of tax-filers (those earning over $50,000). The top one-tenth of taxpayers, in other words, accounted for about five times more than their per capita share of RRSP contributions. The top 1.5% of tax filers (those earning over $100,000 in 1995) accounted for 14% of all RRSP contributions - about 10 times greater than their share of the population. So even for this most "democratic" form of (subsidized) financial investment, the clear majority of wealth is concentrated in the highest-income segment of society: a group which perversely claims an even larger share of total government support for these investments. This picture of the unbalanced pattern of RRSP investment in Canada is further confirmed by a second source of data: Statistics Canada's biennial reports on pension fund investments, including RRSPs. According to this data, those Canadians reporting 1995 total income in excess of $80,000 - the top 2.7% of tax payers that year - accounted for almost 20% of all RRSP contribution (and, once again, an even higher share of all RRSP subsidies). In contrast, those taxfilers earned under $40,000 in 1995 (accounting for 80% of all taxfilers) contributed just one-third of all RRSP monies deposited that year, and received an even smaller share of total RRSP subsidies. So even within Canada's RRSP system, which in theory is supposed to support the retirement savings of average citizens, the ownership of financial wealth is highly concentrated. Yet the total stock of RRSPs - some $200 billion by the end of 1995 - still accounts for a small share (perhaps one-eighth) of all household financial investments in Canada. Outside of the RRSP system, wealth is distributed even more unequally; few lower- and middle-income Canadians have any financial assets at all outside of their RRSP holdings.
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