INCREASE YOUR CHILD'S RESP EARNINGS BY 1.3%

I just increased my RESP returns by 1.3%.

When I initiated my son's RESP, I decided to set up a monthly contribution which went to a special RESP mutual fund. This fund, the RBC Target 2020 Education Fund, is designed to gradually shift from a heavy (high-growth) equity exposure to a more conservative asset allocation as a child nears his graduation date. It carries an MER of 2.08%.

This week I changed my monthly contribution to four separate RBC Index funds which should replicate the Target Education Fund's performance - at a much lower cost. The RESP's MER is now 0.74%. Consequently, our returns should now be 1.34% higher. Not bad, eh?

IS YOUR PORTFOLIO'S EXPECTED RATE OF RETURN TOO HIGH?

How realistic is it to forecast that your investment portfolio will grow by 8% or more?

To determine my monthly RESP contributions, I calculated that by saving $140 per month I should be able to cover a good portion of my son's future university costs. Assuming an annual rate of return of 7%, sixteen years from now this monthly payment should come to $63,000 (note that I'm including the CESG contribution in this calculation). However, am I being overly ambitious in expecting a rate of return of 7%, per year?

The table below contains data on annual real equity returns over a 103 year period. Note that the real rate of return on Canadian equities has been 5.9%*. Assuming an annual inflation rate of 2.5%, this translates to a nominal rate of return of 8.4%. If 40% of my RESP contribution is going into a bond fund that returns 5.94%, I can safely expect my son's RESP portfolio to earn 7.4% per year.


In short, using the last 100 years as a guide, we have reasonable evidence to assume a rate of return of 8.4% for the equity portion of our portfolio. However, if a significant portion of your portfolio is comprised of bonds, it may be time to revise your expectations.

*You can refer to this post for an explanation on the difference between the geometric vs. arithmetic mean.

RESP FUNDS

I began a RESP for my son a couple of months after his birth. At the time I was very eager to start saving for his education, so I began investing into a Target Education fund without giving it too much thought. This fund is managed to gradually shift its asset mix from equities to money market funds as its “target” date approaches and seemed like a good hands-off approach to save for my son’s macaroni and cheese consumption come the year 2023.

I recently revisited this investment choice and realized the following. The Target fund has a MER of 2.08% and all it does is hold other funds, managed by the same institution, which in turn have MER’s in the 1.5% – 2.0% range. So I’m being charged twice for saving for my child’s education.

I plan to rectify this situation by switching my contributions to my bank's Canadian Index Fund, US Currency Neutral Equity Index fund, and Canadian Bond Index fund. I’ll place about 35% of my monthly contribution to the bond fund and the rest will be split between the Canadian and US index funds. The MER on these index funds averages about 0.70%, so I should be able to increase my yearly returns by about 138 bps (2.08% minus 0.07%). Over the next 16 years this could translate into an extra $4,000 for his studies.

Think of all the extra macaroni and cheese this will allow him to buy. I can hear him thanking me already.

RESP ASSUMPTIONS

When I began a RESP about a year ago, I made some quick ad hoc assumptions on a simple spreadsheet to calculate how much I should be setting aside each month for future University costs. This week I decided to throw a bit more rigor into these assumptions and found the following.

First, the tools available on the web from banks/finance companies (try this one) overestimate inflation and expected future yearly tuition increases, thereby suggesting higher than necessary monthly RESP contributions. When filling out these online calculators, for example, presumed inflation will default to 3% and tuition increases to 10%. However, one may safely set these assumptions to 2% and 3.9%, respectively, given that the Bank of Canada manages its monetary policy around an inflation target of between 1% and 3% and that tuition increases have averaged 3.9% from 2000-2006.

Second, some calculators give you the option to maximize your Registered Education Savings Plan (RESP) savings or maximize your Canada Education Savings Grant (CESG). What does this mean?

The contribution limits for a RESP are $4,000 per year for each beneficiary of the plan, with a lifetime maximum of $42,000 per beneficiary. Consequently, under the RESP option the tool will suggest you save up to a maximum of $4 K per year.

Under the Canada Education Savings Grant (CESG), the maximum grant is $400 per year per beneficiary, meaning that the grant covers the first $2,000 of annual contributions per beneficiary (20% of $2,000 equals $400). Under this option the tool suggests you save up to a maximum of $2 K per year.

To conclude, although online tools allow for quick on the fly "guesstimates", conduct your due diligence before deciding on how much to set aside. By inflating assumptions, these online calculators may suggest higher than necessary monthly RESP contributions.