What many people don’t realize about a RESP (and RRSPs for that matter) is that it is a plan and not an actual investment product that you buy. RESPs were initiated by the government to provide people with a tax free incentive to grow investments that are earmarked for their children’s education. That’s all a Registered Education Savings Plan actually is! You can still do everything inside an RESP that you can do outside of it. The only differences occur in that all the dividends, interest and capital gains are tax free (just like in an RRSP) until they are withdrawn, and then the obvious withdrawal rules apply.
Every year the banks make a killing off of people who have been told that, “You need to buy some RRSPs and RESPs to prepare for your future and your child’s future.” Does it actually make any sense to say that you need to buy registered retirement savings plans? Obviously not, usually when the banks tell you that they will buy the amount you want in “RRSPs” what they are actually doing is investing your money in their in-house batch of mutual funds. These mutual funds are often packed absolutely full of fees and make banks very very wealthy. For most middle class people, they believe that this is all there is to investing.
RESP – The Actual Truth
The fact is that you can own all kinds of investments in your RESP (and RRSP accounts as well for that matter). Don’t just let the bank take your money and suck you dry with various user fees that occur on the front end and back end of mutual funds. Get educated about what your RESP portfolio should look like.
When I begin saving for my child’s education, and what I would recommend to others, is to start investing when the child is young. This gives you a long time frame to work with. When you have a longer time frame you can afford to take more risks with your investments because your time horizon is so long. Remember the more risk the more return. The stock market has returned about 10% per year since its inception. Today some forecasters claim that we should not expect returns like this (others claim it is just fine), but nearly everyone agrees that 8% should be a fairly safe number to use when calculating future gains. When you compare this to the 4% you will likely average in bonds (you couldn’t even find this right now) or the 2% your money could gain in a high interest savings account, this adds up to quite a difference. To help visualize, let’s take a look at 3 scenarios:
Scenario A: We invest $2500 per year, +$500 (20% CESG match) at 8% interest. In 18 years we would have $121,000+
Scenario B: Same conditions, but we put the money in bonds at 4% interest. In 18 yearrs we’d have about $80,000
Scenario C: Again, same conditions using the 2% high interest savings account: $65,500
We can take a few conclusions from these scenarios. The most obvious conclusion is that taking advantage of the government’s match and investing consistently is going to yield some pretty great results no matter what the rate is. We also learned just how powerful that compound interest can be; however, to expect parents to keep their money in a volatile stock market as their child edges closer to needing the money is not smart, nor realistic.
The Realistic RESP Solution
My preferred solution, and one I have seen successfully executed in a few different portfolios is to start the account early, and invest in very basic index funds that will track the whole market. This is not the same as throwing your money into 1 or 2 stocks and praying. The index will reflect the market as whole. In case you didn’t realize it because of all the crazy media, those people that put there money into basic index funds when the market crashed in 2008 would have roughly doubled their money already, and people are saying the recovery has barely started! But index funds can still go down when the market shifts; therefore, I would probably gradually start shifting my money into bonds around the 7 year mark. Analysts claim that a good rule of thumb is don’t have any money in the stock market if you’ll need it within 5 years. I’d probably expand on the measure of caution when dealing with my child’s education funds. The other thing I would look at is that I don’t think my children need that much help from me to go to school. If I could give them 8-10K a year (which was roughly the same as I got when taking inflation into consideration) I would be happy about helping them out, but still letting them work hard enough to understand the value of the education. Much like my parents did for me.
Here is what my proposed ideal RESP plan would look like using conservative interest rates.
Year 1-6: Invest $2,500 per year, get the government kick in. After 6 years I would be sitting with $23,768 (assuming the index funds return 8% which is again, a conservative estimate)
Year 6-11: Watch my money grow at 8%, at the end of year 11 we’re at about $35,000.
Years 11-18: At this point I would begin to switch over and get the money into bonds so I knew the money would be there. The money won’t all be going into bonds at once, so we’ll assume a 5% interest rate.
This brings my grand total to just under $50,000. Not bad when you consider I would have only invested 12,500 of my own money. This is the power of compound interest within a tax free account. Don’t be afraid of some ‘riskier’ investments if your child won’t be going to school for 10+ years, just remember to stay away from those mutual funds that will take over 2% of your money and cut into that compounding affect that you see below. Basic index funds are the best way of beating this that I have seen. Ask your financial advisor about them today.
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Check out the great RESP book by Mike Holman from Money Smarts Blog