How your savings accounts really work: RRSP, TFSA, LIRA, LRSP, DB, DC

The government has created multiple structures to help Canadians save efficiently and have a retirement that relies less on full government programs such as the CPP (Canadian Pension Plan) or OAS (Old Age Security) and more on individual savings: RRSP, TFSA, Locked-in RRSP, Investment accounts, DC, DB….

The distinction between these can be confusing for some so we’ve decided to take some time to explain them. First, we will use examples to make it easier for people to understand some of these concepts.

Imagine an account like being a pocket in your clothes, let’s say your left front pants pocket is a TFSA (Tax Free Savings Account); your front right pocket is an RRSP, your back left pocket is a Locked-in RRSP and your back right pocket is a Defined Contribution Plan provided by work.

In each of these pockets, you will put dollars…if left alone there is really no benefit in just putting dollars there. For you to benefit, those dollars need to be invested so that they can grow.

Most people simply buy GICs or Mutual funds at the bank and think they have done the job and that their savings are working. Well that could not be further from the truth. What you have done is just put water on a pot at a very low temperature and hoping it will become hot enough for you to use for tea or coffee. If you want growth from the accounts, they need to be invested (stocks, bonds, private equity or some well performing mutual funds albeit the latter can be pretty hard to find these days). By doing this you’re turning the temperature up and your pot will boil the water and when you need it for your tea it will be hot enough for you assuming you let it sit long enough.

Why GIC and some mutual funds do not do the job in growing your accounts?:

For the same reason your mortgage rates are very low, the GIC rates are also very low. For the most part the bank uses those GIC deposits to fund mortgage loans and then take their cut before giving you your interest. Now imagine a 5 year rate today paying 1.5% (see Cannex)%, the bank take their hefty commission of .75% and you’re left in your 5 year GIC with .75%. You might say: “Well this is not so bad, at least I don’t risk losing money on the market and my principal is protected.”

The notion that your principal is protected doesn’t hold well as the inflation rate is at roughly 2 % (meaning the prices of good you can buy at any given year grow by that much) but your principal is only growing at .75% so you’re losing at least 1.25% every year in purchasing power (and this is guaranteed).

If you had bought stocks (assuming an index or using a decent portfolio management firm like BlueSky Investment Counsel), your long-term average return in your portfolio as a whole would be much higher. Sure, there will be times when your funds are down but with enough time horizon you will be in a much better position when those funds are needed. At 7% return which is the average long term return of equities (see…Historical returns per asset class), you double your principal every 10 years thanks to the power of the compounding effect.

Meanwhile mutual funds are just a product that pools the dollars of a lot of people and charge hefty fees to manage it. Most of the time they do not do better than a simple market Index ETF which is much cheaper. If you have an overall portfolio with your total accounts above $250,000, you are better off finding an investment firm with no product bias like BlueSky Investment Counsel to help you manage it unless you can do it yourself (which is always better if you have the skills and time).

Now here are the benefits specific to each account:

RRSP: a Registered Retirement Savings Plan allows you to put in money before it is taxed. If you put in money after it is taxed (a portion of your net pay), then the government refunds you the amount of the taxes retained by your company (that’s why you receive money when you contribute to an RRSP). When it comes time to have access to these funds, you will need to pay taxes before accessing them, however. The goal is to grow it as much as possible before accessing these funds when you will be retired and not making any money or very little. At that time your tax rate will be very low and you will benefit from that to provide you with income to supplement CPP and other funds you may have access to.

You typically can contribute up to 18% of your salary up to $27,230 for 2020.* See our article on contribution limits

TFSA:  A tax Free Saving Account doesn’t really mean tax-free since for this account, you put after tax money in but you don’t get the tax paid back. However, when the account grows, you can take the funds with your gains at any time without paying any further taxes. It has its own schedule* in terms of how much you can put in it. If you withdraw from it this year, you get to reimburse that amount at any time in the future but you don’t have to; you don’t lose that room/saving capacity in the future after December 31^st of the year you withdrew it from.

 * See our article on contribution limits

DC and DB:

Defined Contribution Plan or Defined Benefit Plan are government plans that allow your employer to help you save while you work there.

A Defined Benefit plan says exactly how much you will get at retirement based on your tenure at work and your salary level. The investment risk burden is carried by your employer as the benefit is an amount owed to you just like your CPP.

A Defined Contribution plan is the opposite as it puts the investment risk in your hands. You typically contribute a portion and your employer contributes a portion, but you choose how and where to invest it. Typically, employers have an insurance company that handles the investment for them such as Sunlife, Manulife or Great West Life. We usually advise employees to open-up their own LIRA and LRSP accounts depending if the plan is registered provincially or federally, respectively. Having control over the investments can help ensure if the company is going bankrupt, your plan is not at risk. An example of this would be the Sears bankruptcy Sears DB showcase risk and how it engulfed the employees DB plans.

LIRA and LRSP: A Locked-in RRSP comes in 2 forms: a LIRA – Locked In Retirement Account or LRSP – Locked in Registered Saving Plan. The first is registered provincially and the latter federally.

Essentially these accounts lock your funds until your retirement years at which point you start withdrawing from them and pay taxes on the amount withdrawn based on your overall income. You may be able to draw from a LIRA in certain circumstances where you need to pay rent see…Unlocking Locked-in RSP rules

At BlueSky Investment Counsel, we advise and manage all these types of accounts so feel free to reach out if you have any questions.