What is the best long-term strategy for investing inside a pension plan versus in a TFSA?
FP Answers puts your investing questions to the experts. This week our expert is Allan Norman, a fee-only lifestyle financial planner with Atlantis Financial Inc. The questions were compiled by financial journalist Julie Cazzin.
Ihave started a new job and my employer offers a defined-contribution (DC) pension plan that matches my contributions at five per cent of my annual salary. How should I invest this money? I was given a list of eight mutual funds to choose from. I’m 25 years old and invest my taxfree savings account (TFSA) money at a 50/50 equity-tofixed income split and plan to continue with this for all my money outside the DC plan. But should I invest the money in the DC plan differently since I’m looking at a 30-year horizon? Also, what are the fees/mers on these types of accounts? Should I consider opting out, and why? — Thanks, Gina
❚ FP Answers: Hi Gina, you are lucky your employer offers a DC plan, and it matches your contributions up to five per cent. Not all DC plans are the same, but there are some common characteristics I will touch on below.
First, let’s tackle your question about how to invest your money. You will be asked to complete a risk tolerance questionnaire when you sign up for the plan. Your answers are intended to direct you to an appropriate investment portfolio, meaning how much money to hold in bonds and how much in equities.
The challenge I see with this approach is, at 25 years old, you may not have a lot of investment experience and/ or knowledge, which will impact your answers. How does someone quickly gain investment knowledge and experience? Through computer simulation, such as the calculator offered by Wealth Meta.
For example, you can see the historical returns of U.S. equity, bond, and mixed portfolios during the 1990to-2020 period, a 30-year time frame such as the one you are about to embark on, as well as the returns for each year. The result shows equities have the largest up and down movements year to year, but also the highest average return.
The calculator also shows historical 10-year time periods, and U.S. equities outperformed U.S. bonds in each one, with the exception of decades starting in 1930 and 2000. The average rate of return from 1928 to 2020 for U.S. equities was 9.8 per cent before fees, and it was 4.9 per cent for U.S. bonds before fees.
Finally, use Meta Wealth’s retirement withdrawal calculator to see how long your money may last based on historical returns. Type in the dollar amount you think you will need to have saved by retirement and the amount you want to draw from the investments. The calculator will then show you a range of outcomes depending on the year you retired.
OK, let’s get back to the question of how to invest your money.
Equities in the past have fluctuated a lot more than bonds, but they have also provided a higher return over most time periods of 10 years or more — keep in mind past returns are not indicative of future returns.
Now do the risk tolerance questionnaire to decide how much money should go to bonds and equities. Then phone a representative of the plan and ask for information about the individual funds. They are there to help and will be expecting your call.
Most importantly, make an investment decision since your employer will not make it for you. I once spoke to someone who was in a DC plan for 20 years and never paid attention to it. The money sat in cash the whole time and earned very little interest — something you’ll want to avoid.
Deciding on how to invest also depends on what you plan to use the money for. If both your TFSA and DC plans are to be used for retirement, I suggest being more aggressive in your TFSA, because withdrawals from a TFSA are tax-free, so that is where you want your biggest gains.
It is tough to make a case for opting out of a DC plan. For one thing, the fees charged on the funds you purchase in the plan are normally less than if you were to purchase the same funds outside the plan. Furthermore, your employer is matching your contributions up to five per cent of your income, and it’s the most efficient way to contribute to a registered pension plan.
Money contributed to a DC plan is done before tax is taken off your paycheque. You are getting the tax deduction right away and investing the deduction. For example, an Ontario resident earning $75,000 a year, and investing five per cent of their income would be contributing $3,750 per year.
Most people contributing to a registered retirement savings plan (RRSP) use after-tax pay and don’t reinvest the Rrsp-related tax refund back into the RRSP. If the same Ontario resident contributed five per cent of their after-tax income to their RRSP, the amount would be $2,996 per year. It may seem like a small difference, but it can be huge over 30 years.
If you do decide to have an RRSP outside the DC plan, watch your contribution limit. Don’t assume it’s 18 per cent of your annual income. The employer’s matching amount takes away from your RRSP contribution room, something that will be noted in the “pension adjustment” line in your Notice of Assessment. It’s always best to check your notice to confirm your RRSP contribution room.
Finally, you may find the amount your employer contributed to the plan goes to a locked-in retirement account (LIRA) when you leave that employer. Don’t worry about that. The simple explanation is you can invest the money in a LIRA however you like, but you can’t withdraw it until after age 55.
You have to convert funds from your LIRA to a Life Income Fund (LIF) when you want to withdraw funds from it and the amount you can withdraw is restricted. This varies by province and whether it is registered as a federal or provincial plan.
Gina, you have a great opportunity with the DCP. Use it. Do your best to make the full contributions and get the matching amount from your employer, even if it means reducing your TFSA contributions.