Education Savings Options: RESP, TFSA or RRSP?

Back in 2007 I compared the RESP and the RRSP as investment savings options for funding higher education, excluding the TFSA since it did not yet exist. The conclusion at the time was that the first $2500 of savings should go into an RESP to take advantage of the free money (courtesy of other taxpayers) available from the federal government in the form of the Canada Education Savings Grant. The $500 annual CESG (20% of contributions up to $500 per year and $7200 maximum lifetime - more details here from TaxTips.ca) made all the difference.

It's time to revisit the question. First, the TFSA now exists. Second, an anonymous comment this past July on the original post suggested the RRSP might be better if one takes into account the possibility that the student can transfer up to $5000 in annual tuition deduction during the time of eventual study, which gives the parent a 15% tax credit (i.e. $750) on the tuition transferred. Excellent question! With interesting results too.

I've built a downloadable spreadsheet (look for the download link on the right hand side of the web page once the spreadsheet opens up as a Google doc in your browser) for readers to play with beyond what I have already done.

Conditions Applied to My Analysis:

• Parent Must Have Enough RRSP Contribution Room - The whole analysis presumes you can put in $2500 per year new money plus up to $2100 reinvesting the tax refund each contribution generates, plus the reinvested refund on the reinvested refund, plus the reinvested refund on the reinvested refund on the reinvested refund etc ... (remember that child's song, there's a hole in the bottom of the sea? this is the tax refund version of it); that's why the RRSP part of the spreadsheet extends way out to the right. At the top Ontario marginal tax rate of 46.41% (see TaxTips.ca's tables for personal tax rates in each Province, which readers can use to check what happens in their own bailiwick) that means needing another $2100 or so of extra annual contribution room. Doing this gives the RRSP option its most favourable conditions.
• Only $2500 in Annual Contributions - This condition is to give the RESP its most favourable conditions, namely that it gets the most free CESG money, so that each contribution buck is getting the most bang.
• Child Must Not Have Enough Income to be Liable for Taxes during Higher Education Years - As I noted in the original post, the RESP's advantage disappears if the student has to pay taxes, even at the lowest tax bracket (see the Student_Taxable tab in the spreadsheet).
  

Results: (the summary numbers for the discussion below are in the Results tab and the calculation table with inputs you can use to plug in your own numbers is in the RESP_RRSP_TFSA tab; other tabs contain the calculation tables from the original post)

1) RESP is (Almost) Always Best ... if the Child Takes Post-Secondary Higher Education - No matter what the parent's tax rate, the RESP comes out ahead after tax, as shown by the green numbers. The only circumstance when it does not is when, as shown by the red numbers in the Results tab, the parent's tax rate at time of withdrawal is at least three tax brackets lower than at time of contribution - e.g. taxable income goes down from $100k to $70k as in retirement - and the investments earn a low (2%) to medium (5%) annual return. In this latter case, the RRSP wins, but not by much.

2) TFSA Wins if the Child Does Not Attend Higher Education and Parent's Tax Rate Stays the Same - The green numbers under TFSA show that no matter what tax rate the parent is in and regardless of investment returns, the TFSA does better, but not by a lot, than both the RESP and the RRSP.

3) RRSP Wins if Child Does Not Attend Higher Education and Parent's Tax Rate Drops at Withdrawal - The green numbers in the RRSP column show that the RRSP does better and better the more the parent's tax bracket drops between the date of contribution and withdrawal. The higher the investment return, the bigger the effect. When it is three brackets lower and there are high (8%) returns, the net difference is $25,000 more than the RESP and $15,000 more than the TFSA.

Bottom Line:

• if you are confident that your child will go to college/university before you retire, put that first $2500 into the RESP; if you have several kids, the chances should be higher that at least one of them will go on.
  
• if you really are not sure your child will go on to higher education , then the RRSP is the better hedging option. The TFSA's advantage when the child does go on isn't big enough to offset the TFSA's lower results compared the RRSP when the child does not go on. Also in the RRPS's favour is that the RRSP's disadvantage compared even to the RESP when the child goes on is much less when investment returns are low and you are in the lower tax brackets.
  
• if you believe that your income will drop two or more tax brackets by the time the higher education decision will need to be taken, the RRSP looks better even than the RESP. When there is no higher education the RRSP is always superior to the RESP and even when there is higher education, at two brackets lower you are ahead except at high investment returns. If your investments within the education account are cautious and low risk, low to medium returns are what you will get.
  

Putting Financial Education on the Right Track

IndependentInvestor.info's superb review (dare I say definitive critique) of the failings of current investor education programs leaves one quite depressed. It seems the result of investor education is that the average person is worse off!

Education doesn't work? At all, ever? The notion that education does not work is rather contrary to a foundation of the modern world. Saying it does not work today should not mean it cannot work.

One basic problem appears to be that current investor education programs, in the interest of being "fair" and "balanced" and presenting all alternatives, ends up suggesting that active investing, whether directly through stock picking and market timing, or through buying high-cost funds, gives the investor as good an outcome as buying and holding passive, whole-of-market, low-fee, index funds. The facts unfortunately deny such a position.

The fact is that government and regulatory organizations, who probably know the truth, are the ones in charge of investor ed. How can they be expected to say that a massive part of a huge industry is doing it wrong? It doesn't look like they are the right people to be leading the effort.

One of the interesting links from InvestorInfo is to the Financial Education Institute of Canada, a private company that provides seminars to employees. The Institute gets paid by employers. It emphasizes its product neutrality and gets the correct answer (index ETFs). We need more of that. Employers are a good path for providing better education to individuals.

There's another fix that employers are in a great position to implement. The most important investment money for individuals is their retirement savings, which flows through defined benefit or defined contribution pension plans at their employer. Two of the big faults of individual investors - 1) picking the actively-managed, high-cost funds and, 2) not saving enough - can be vastly improved through changing the default options in plans. Instead of some active fund, when a new employee enters a plan, make the default the index ETF. Defaults have been found in the USA to have a huge influence on participants' plan choices (e.g. download The Future of Lifecycle Saving and Investing conference proceedings and search for the word "default").

For the "not saving" bit, add another option: provide a little checkbox to have some or all of a pay increase go automatically to increased deductions for pension. Apparently our faulty brains find it a lot easier to commit future money than present money to savings. Money we never see we don't miss. Such defaults address one of the big gaps in making investor education useful in practice, namely that success is not just about knowing facts (like the differential performance of active vs index funds). It is also crucially about countering and avoiding bad reactions and decisions to which we are all subject, as behavioural finance research has embarassingly revealed.

Canada's Place in World University Rankings

How do Canada's universities rate when compared with the best in the world. Pretty darn good, I'd have to conclude after looking through the just-published latest Times Higher Education - QS World University Rankings 2009. The ranking are based primarily on ratings of 9300 academics around the world, along with, in order of declining importance, research productivity, student-faculty ratios, employer reviews and proportions of international faculty and students.

• Canada took 11 of the top 200 spots, better than many other countries with much larger populations, like Germany with only 10, France with 4
• Canada had 12 in the top 200 last year - apparently Asian universities are moving into the top rankings displacing mainly US universities (and what longer term effects will the recession aftermath do to further erode that result?) - competition is hotting up and Canada has no cause for complacency as all but McGill and U of T moved lower in the rankings. See also the 2008 vs 2009 table
  
• the USA (54 of the top 200) and the UK (29) dominate the world higher education business, with all of the top ten between them and 18 of the top 20
• in terms of "punching above its weight" in terms of population, Canada is 3rd in the world, at a ratio of about 0.33 (11 universities for a population of 33.8 million) behind the leader UK (ratio 0.47) and Australia (ratio 0.41); the USA is way behind at a measely ratio of 0.18; if one subdivides the UK as Scots are fond of doing(!), wee Scotland with only five million people has the highest ratio of all with 4 universities in the list - ratio = 0.8! ... too bad it doesn't have a very good football team, so everyone could be happy...
• McGill is the best university in Canada and number 18 in the world, followed by:
  

U of Toronto (29th),
UBC (40th),
U of Alberta (59th),
U of Montréal (107th),
U of Waterloo (113th),
Queen's (118th),
McMaster (143rd)
Calgary (149th)
Western (151st)
Simon Fraser (196th)

These Times-QS rankings correspond fairly well with those of Maclean's magazine, which also put McGill on top amongst the medical/doctoral schools, though Queen's is second there and Dalhousie, Saskatchewan and Ottawa rate ahead of Western.

Investing In One's Children - the Payoff

Readers may have noticed my blogging absence in the last few weeks. One of the reasons for the absence is that I have been enjoying one of my kids' graduation from medical school. Though the achievement is primarily hers, there is definitely an enormous pride and pleasure for me as a parent to see the fruit of many years of time, effort and money spent raising her. The payoff of such investment is primarily emotional for the parent but for the child there is also the tangible reward of higher earnings. Doctors are extremely well paid (though saddled initially with average education debt for a new doctor apparently in the order of $150k) but higher education means higher pay on average across the board - by almost 40% in Canada over secondary education according to the Education Counts website (which also shows that women earn only about 60% what men do ... the fact that about two-thirds of the new doctors in the class were women will chip away at that statistic). Education perfectly fits with the idea of investment as something that pays off later.