Monday, August 30, 2010

More Realistic RRSP Contribution Expectations

Last week’s post Unrealistic RRSP Contribution Expectations generated quite a few comments. We explored the issue quite thoroughly, and it makes sense to lay out a more realistic plan.

The main problem with examples that assume constant contributions for a lifetime is that they ignore inflation. It makes little sense to assume that the typical young person will make considerably larger contributions (taking into account inflation) than that same person will make later in life. There may be a few people who will follow such a path, but the majority will make large contributions in mid-life.

So, let’s try a different scenario. As some commenters suggested, let’s assume that the contributions increase in size with inflation. Let’s say that a 25-year old starts contributing \$500 per month and increases this amount with inflation for 40 years. As before, we’ll assume that inflation is 4% and investment returns are 8%.

The total in the RRSP after 40 years will be about \$2.7 million, but it will only have purchasing power of about \$560,000 in today’s dollars. The question now is what will happen if we wait until age 35 to begin contributing? The final total in today’s dollars would be about \$330,000. So, the first of 4 decades of contributions accounts for a little over 40% of the total.

Even if the contributions from age 25 to 35 are half-sized, the final RRSP holdings of about \$445,000 are substantially higher than the \$330,000 that would result from making no contributions in the first decade. So, saving when you are young makes a difference.

1. I like your analytical rigor. I wonder why your final conclusion is almost exactly the same as the "unrealistic" version.

2. @Patrick
Due to the "magic" of compounded interest, you will always be better off to start investing earlier rather than later. I think Michael James was simply trying to point out that the benefit might not be as large as the traditional method of analysis would lead you to believe.

The real difference between the method that takes into account inflation and the method that does not is that you use a real rate of return instead of a nominal rate of return (i.e. you subtract the expected inflation from the expected return). As a result, you plug a smaller expected gain into your calculations, which shows less benefit to earlier contributions.

On the one hand, someone might use this as an argument to say they don't need to worry about saving when they're young.

But on the other hand, if they hadn't considered the power of inflation to erode the value of their saved money, they might now suddenly realize they have to save much more money to achieve their savings goals.

For example (using the same 8% nominal returns; 4% inflation numbers here), if someone thought they needed 1.7M dollars in today's dollars and figured \$500/month from age 25 was going to cut it, they'd be in for a surprise. After you take inflation into account, they would realize they need to save about \$1500/month -- 3 times the original amount to end up with the spending power they thought they'd have. And on top of that, they need to keep increasing that contribution at the rate of inflation.

By delaying until they are 35, they now need to contribute about \$2500/month to reach their goal -- 5 times the originally determined contribution level. This can be a real kick in the pants to start saving earlier rather than later.

Even saving just the original \$500/month for the first 10 years knocks down the needed contribution level from age 35 onwards from over \$2500/month to under \$2200/month. So \$500/month for 10 years could save you around \$350/month for 30 years.

I think the moral of the story is that any financial plan that considers expected rates of returns without also considering expected inflation rates is likely seriously flawed.

3. @Patrick: Perhaps the corollaries would be different. The original (flawed) version stresses the importance of saving when young, but overstates it badly. This sends the message that if you haven't saved a substantial amount before age 35, you might as well give up. In the more realistic version, saving early still matters, but there is still reason to save even if you don't start young.

@Returns Reaper: Well said.

4. I always wondered why the online retirement calculators were so simplistic in their inputs...like someone will actually save exactly \$500/month from 20 - 65.

Wouldn't a more realistic approach be to save a percentage of income, and then build in some assumptions on salary increases over time?

I think it's pretty realistic to assume that people can save 10% - 15% of their income, regardless of age. Then there's no pressure on someone in their early twenties trying to sock away \$500/month to meet some magic formula. Their savings will grow as their income grows over time.

5. @Echo: Saving a percentage of income is a more realistic approach. Getting too caught up in an absolute figure might be too much pressure when your income is low.

6. Melanie Reformed SpenderAugust 31, 2010 at 7:46 PM

It's especially unrealistic for someone paying off student loans. I have been contributing to RRSPs since starting my career at 24, but the contributions are minimal compared to the amount I'm putting to my loans. Once they are paid off, I'll be allotting a lot more to the RRSPs.

I've also been increasing my contribution amount by about 10% every year. I thought this was standard practice.

7. @Melanie: Your situation is a good illustration of why even frugal young people can have trouble saving large amounts for retirement. Good luck with continuing to increase your saving amount each year.