Just a little schooling can help you achieve a higher grade of investment returns in a registered education savings plan.
RESPs are a tax-deferred way for parents and others to save for a child's college or university costs, including tuition, books and residence or other accommodations. RESP basics, including how to contribute using money from the new Canada Child Benefit, were covered in a recent Portfolio Strategy column that you can read by typing this URL into your browser – tgam.ca/EQCE. Now, let's look at some RESP investing basics for do-it-yourself investors.
We'll go with exchange-traded funds for this tutorial because they're simple to use, cheap to own and likely to produce returns that compare well with mutual funds and portfolios of hand-picked stocks, bonds and guaranteed investment certificates.
Here's a demonstration of how simple ETFs are to use. Justin Bender, a portfolio manager with PWL Capital, says you can build an effective portfolio with just three funds. As an example, he highlighted:
- Vanguard FTSE Canada All Cap Index ETF (VCN)
- iShares Core MSCI All Country World ex Canada Index ETF (XAW)
- BMO Aggregate Bond Index ETF (ZAG)
Mr. Bender says similar ETFs may work fine, but he likes these funds for their combination of diversification and low fees. While you're investing in only two stock market ETFs, you're getting exposure to something like 7,500 companies in Canada, the United States and around the world. Using his suggested asset mix of 40 per cent bonds, 40 per cent international global stocks and 20 per cent Canadian stocks, this trio would have a very cheap weighted average management expense ratio of 0.14 per cent.
Ideally, you start an RESP for children as soon as possible after they're born (the child must have a social insurance number to set up the account). Students don't typically attend college or university until they're at least 18 or 19, which in theory leaves enough time to invest a start-up RESP very aggressively.
Yet Mr. Bender isn't keen on the idea of having 100 per cent of a newly created RESP in stocks. "You're taking all this risk, but the portfolio is so small it really doesn't have that much of an impact," he said.
In fact, there's a strong chance that you'll do worse with an all-stocks RESP than you would with Mr. Bender's suggested mix of 60 per cent stocks and 40 per cent bonds. He looked at rolling 10-year periods between 1988 and 2015 and found that an all-stock portfolio beat the balanced 60-40 mix only about 45 per cent of the time. "Although this analysis is backward-looking, it should remind investors that taking more risk is no guarantee of higher return," he said in an e-mail summary of his analysis.
And what if an all-stock portfolio performs well, say by earning an average annual return of 7 per cent after fees? Mr. Bender estimated you could earn an extra $6,081 over a balanced portfolio with an annualized return of 5 per cent. If stocks behaved as they did during the worst 10-year period in recent years, the balanced portfolio would outperform the all-stocks version by almost $6,370.
For the all-stock RESP, this comparison assumes you invested exclusively in stocks for the first 10 years of a child's life and then began a gradual retreat from stocks that leaves you with 90 per cent bonds in the 14th year and then 100 per cent safe investments thereafter. In the balanced portfolio, the assumption is that you use the 60-40 mix of stocks and bonds for 10 years and then similarly reduce risk.
There are three levels of fees to consider if you're managing an ETF portfolio at an online brokerage in an RESP or any other account. In addition to the fees charged by the ETFs themselves, there are trading commissions and account administration charges. Mr. Bender scouted the country's online brokerage firms and came up with CIBC Investor's Edge as an option with zero in account fees for small RESPs and a comparatively low online stock-trading commission of a flat $6.95 per buy or sell order.
Mr. Bender suggests making just three trades a year to run your RESP portfolio – add enough money to each of the three ETF positions to bring you back to your target asset mix. Even with CIBC's cheap commissions, the cost of managing these investments would be a hefty 0.84 per cent in the first year (costs fall every year thereafter as the portfolio grows). This math is based on the 0.14 per cent MER for the ETFs and an additional 0.7 per cent for the three $6.95 stock trades to invest $2,500 in contributions and $500 in money received through the Canada Education Savings Grant. (CESG is paid by the federal government as 20 per cent of contributions to a maximum of $2,500.)
Grant money is usually paid within weeks of making an RESP contribution. To keep things simple and contain trading costs, Mr. Bender suggests you wait until the grant money arrives and invest the total $3,000 at one time.
Another example of Mr. Bender's conservative approach to RESP investing is his suggestion to start reducing risk well before a child reaches high school. By age 15, he suggests the portfolio be 100 per cent GICs and investment savings accounts.
If you got a late start on RESP saving, you could continue to have a modest amount of stock market exposure for longer. Mind the risk of a stock market crash that decimates the RESP just ahead of your child's high school graduation. Remember, it's possible for the stock markets to be down over periods as long as five years.
Another situation where you might leave stocks in the RESP for longer is if you have a family plan with kids of different ages as beneficiaries. You could start to reduce risk for a portion of the RESP to cover an older child's costs while leaving a younger child's money in a more aggressive mix.
A thought for managing the RESP as it's being drawn down during the college or university years: Create a ladder of GICs that mature late in the summer of each year of the program your child is in. Keep several thousand in a high interest account as well to cover extra costs that may arise.
Care and feeding of an RESP portfolio of Exchange-Traded Funds
Portfolio manager Justin Bender of PWL Capital suggest this approach for managing ETFs in a registered education savings plan
Use this mix for starting up the RESP after your child is born and then keep using it through Year Nine
|20% Vanguard FTSE Canada All Cap Index ETF (VCN)||0.06%||Shares of Canadian large, medium and small companies|
|40% iShares Core MSCI All Country World ex Canada Index ETF (XAW)||0.21%||Shares of large, medium and small companies in 22 developed market and 23 emerging markets outside Canada|
|40% BMO Aggregate Bond Index ETF (ZAG)||0.11%||Government and investment-grade corporate bonds|
|Weighted Portfolio Average||0.14%|
Next, start gradually reducing your exposure to the stock market
|Year 10||50% Stocks / 50% Bonds||(50% ZAG/33% XAW/17% VCN)|
|Year 11||40% Stocks / 60% Bonds||(60% ZAG/27% XAW/13% VCN)|
|Year 12||30% Stocks / 70% Bonds||(70% ZAG/20% XAW/10% VCN)|
|Year 13||20% Stocks / 80% Bonds||(80% ZAG/13% XAW/7% VCN)|
|Year 14||10% Stocks / 90% Bonds||(90% ZAG/7% XAW/3% VCN)|
Finally, flush out stock market risk entirely to protect the RESP
Year 15-18 and beyond: 100% GICs, investment savings accounts
How the cost of managing an RESP portfolio of ETFs falls over time
Here's how costs fall rapidly in the first few years. It's assumed here that you contribute $2,500 per year to an RESP and receive the maximum $500 in Canada Education Savings Grant money. Market-related changes to the value of the portfolio are not considered here.
|Year||Trading Costs*||Product Fees||Total Annual Fees|
|0||0.7% ($6.95 x 3 trades/$3,000)||0.0014||0.0084|
|1||0.35% ($6.95 x 3 trades/$6,000)||0.0014||0.0049|
|2||0.23% ($6.95 x 3 trades/$9,000)||0.0014||0.0037|
|3||0.17% ($6.95 x 3 trades/$12,000)||0.0014||0.0031|
|and so on…|
*the commission schedule at CIBC Investor's Edge is used here
Source: Justin Bender, PWL Capital