TD study cites debt as barrier to saving

While Canadians continue to under-fund their RRSPs, a new study suggests its not a lack of understanding the importance of retirement planning, but rather a habit of linear thinking that is forcing them to make an “either/or” decision: save or pay down debt.

The sixth annual TD Waterhouse Investor Poll cites StatsCan data revealing that during the 2005 tax year, 93% of the total RRSP room available to Canadians was left unused. This gross neglect to save has accompanied a sharp increase in Canadians’ personal debt load, the median of which has risen 38% since 1999, from $32,300 to $44,500.

A CIBC Capital Markets study released on Tuesday points to a direct correlation — RRSP contributions fell below 6% in 2005, more than a full percentage point lower than the level seen in 1999.

It come as no surprise then that when TD surveyed 1,000 random Canadian investors, it found this escalating debt load to be a major reason why many are skipping RRSP contributions.

Thirty-five per cent of respondents said they will focus more on investing once their earnings increase or their debts decrease. Twenty-six per cent cite high expenses and debts as the primary obstacle to saving for retirement, while 23% blame insufficient take-home pay.

Only 32% of poll respondents contribute the maximum allowable amount to their RRSP.

TD suggests these stats show Canadians need to stop thinking linearly about debt and retirement savings. In fact, the company says that investors with debt should consider carrying it longer in order to make regular RRSP payments.

Based on its growth estimates of RRSPs, TD illustrates the scenario of two people with the same debt load of $12,000 at 12% interest. If one, Ms. Hare pays off debt first and then saves, and the other, Mr. Tortoise, carries debt longer and contributes to an RRSP earlier, Mr. Tortoise will much more money for retirement, even after he subtracts the larger total he payed in interest.

Are the study’s conclusions correct? Should advisors tell their debt-ridden clients to invest at all costs?

Moshe Milevsky, a professor of finance at York’s Shulich School who specializes in financial risk management, says TD’s proposal is somewhat simplistic, but he agrees with the general premise, emphasizing that investors need to evaluate what kind of debt they are carrying and whether it helps them establish net growth for their retirement assets.

“There is ‘good debt’ and ‘bad debt,’ just like cholesterol. The good debt is at low interest rates and tax deductible. The bad debt is at very high rates, unsecured loans and non-tax-deductible,” Milevsky said.

“I think the bad debt should be eliminated as soon as possible, top priority and well before you start thinking about retirement planning. Good debt is beneficial, especially when used to purchase assets that grow over time. There is nothing wrong with having this type of debt, even at very advanced ages and well into retirement.”

Rick Robertson, a professor of finance with the Ivey School of Business at the University of Western Ontario, expands on the good debt/bad debt scenario, adding that there are mathematical and human variables to every situation.

For example, he points out, if you have a 12% loan that isn’t tax deductible, and your rate of return on the RRSP is only 7%, depending on the actual tax deduction you get on your RRSP, you may still not be offsetting the interest on the loan. In this case, you would be better off paying down the debt.

He also points out that if Ms. Hare invested the money she saved in interest payments into an RRSP, she might very well have more in it than Mr. Tortoise upon retirement. Robertson says that, generally, when people are out of debt, they consume, not save, so TD’s assumptions are probably correct, but that the problem with many Canadian investors is not choosing to pay debt instead of saving — it’s their consumption habits.

“If you have a big debt, it’s probably because you consumed a large amount early on. Because you did, it’s going to limit your ability to consume later on. Once you incurred the debt, the odds are it makes good sense to pay off the debt,” Robertson says.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(02/07/07)

Mark Noble