Description:
In this Episode, James Parkyn & François Doyon La Rochelle give a brief overview of how registered education savings plan works and what are the best strategies to tap into your RESP savings most efficiently.
They also drill down into the stock component of your portfolio and on how much global exposure you should have.
Links to share:
– The Debate About the 60/40 Balanced Portfolio and the Review of the RRIF Mandatory Withdrawal Rules — Capital Topics By James Parkyn & François Doyon La Rochelle
– Capital Topics episode 23: The High Cost of Investing in Hedge Funds – PWL Capital By James Parkyn, Raymond Kerzérho & François Doyon La Rochelle
– Canadian Home Bias: A Case for Global Equity Diversification | Vanguard Canada By Bilal Hasanjee – Vanguard
– Global equity investing: The benefits of diversification and sizing your allocation (vanguard.com) By Scott J. Donaldson, Harshdepp Ahluwalia, Giulio Renzi-Ricci, Victor Zhu & Alexander Aleksandrovich – Vanguard
–The Canadian Equity Market Isn’t as Canadian As it… | Morningstar By Dan Lefkovitz
Read The Script:
- INTRODUCTION:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #56!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.
In this episode, we will discuss the following points: For our first topic, we will review the basics of registered education saving plans (RESP) and withdrawal strategies. And for our next topic, we will discuss investors home market bias.
Enjoy!
- RESP Withdrawal Planning:
François Doyon La Rochelle: After a short break for the summer, and since it’s back-to-school season we thought that it would be a good idea to give you a brief overview of how the registered education savings plan (RESP) works and what are the best strategies to tap into your RESP savings most efficiently.
James Parkyn: Yes, François, we’re going to tackle the situation where after many years of diligently saving for your child’s post-secondary education, you are at the phase where your child needs to start withdrawing funds. From our experience with clients, the withdrawal rules are complicated. That’s why we decided to cover how RESP withdrawals work and how to get the most out of your RESP savings.
François Doyon La Rochelle: Correct and not knowing how withdrawals work adds to the stress of seeing our kids start a new phase in their lives. So, before we cover the withdrawal rules and strategies, let’s review briefly how the RESP works.
The RESP is a tax-advantaged savings account for a child’s post-secondary education. We normally recommend opening an RESP as soon as possible after the child is born. You must remember to apply for the social insurance number (SIN) as this is a requirement to make contributions.
James Parkyn: You can open an RESP later, but what you want is to get the magic of compound interest working as fast as possible on your contributions and the generous grants, you will be receiving from governments. Parents with young children have many competing priorities for their after-tax earnings, and because the contributions are not tax-deductible, it’s best to start early and not be caught with a large contribution catch-up. The more kids you have the bigger the challenge. I would like to remind our listeners in our podcast 23 we discussed the strategy of grandparents gifting money to their children for RESP contributions for their grandkids.
François Doyon La Rochelle: There are two main benefits to contributing to an RESP. The first is the tax-deferred growth, and the second which you just highlighted James is that you will receive government grants on your contributions. At the federal level, you will receive the Canada Education Savings Grant (CESG). The CESG is a 20% grant on your contribution, up to a maximum contribution of $2,500 each year. This means you are getting $500 in free money on your contribution.
James Parkyn: Other provinces also offer grants, here in Quebec you get an additional 10%. Assuming you make the maximum annual contribution of $2,500 you will receive a $500 grant from the federal government plus $250 from the Quebec government. These grants are deposited directly to the RESP. You can think of these grants as an immediate 20% to 30% return on your investment. There are also other types of grants for low-income families.
François Doyon La Rochelle: There is a lifetime contribution limit of $50,000 per beneficiary and a lifetime grant limit of $7,200 at the federal level and of $3,600 from the Quebec government. These grants are available until the end of the calendar year when the beneficiary turns 17. However, since the CESG was designed to encourage long-term savings for post-secondary education, don’t wait until the child is 16 or 17 to open and make a RESP contribution as you may not meet the requirements to receive the CESG.
James Parkyn: It’s important to mention that if you can’t contribute the full $2,500 in a year to get the full government grants, the unused grant room is carried forward and can be used in future years. However, a word of caution here is that in any one year, only a maximum of $1,000 of grant can be received from the federal government and $500 Quebec government. So the maximum grant-eligible contribution for a given year is $5,000.
François Doyon La Rochelle: Now that we have covered the basics of RESPs on the contribution side, let’s look at how to withdraw the funds in the most tax-efficient way when the child goes to post-secondary school.
James Parkyn: Our listeners need to know that withdrawing funds from an RESP tax efficiently involves a fair bit of careful planning. You need to make sure you understand the RESP maximum withdrawal rules and you need to understand the tax situation of the beneficiary over the number of years you plan to withdraw. In the end, you want to avoid the beneficiary having to pay higher income taxes than necessary. You also want to make sure to optimize the withdrawal of grants for each beneficiary before they complete their studies otherwise you may have to pay back the government grants.
François Doyon La Rochelle: First off, you need to understand that the amount accumulated in the RESP for each beneficiary belongs to three different buckets.
The first bucket is your contributions, so this is the money you have put into the plan. The second bucket is the grants, whether federal or in some cases provincial grants. The last bucket and the third bucket are called the accumulated income. This bucket is the tax-deferred growth on the contributions and the grants, which is composed of capital gains, dividends, and interests.
James Parkyn: Since these buckets are taxed differently, what we do for our clients is build a spreadsheet for each beneficiary to track how much money they have in each bucket. This allows us to develop a tax-optimized withdrawal strategy.
François Doyon La Rochelle: Now to start withdrawing funds from an RESP, the child must present proof of enrollment in a qualifying full or part-time educational program in a university, college, or other designated educational institution.
James Parkyn: However, before you start withdrawing funds you need to discuss with your child to figure out how many years he intends to pursue his studies and estimate the total annual costs to complete their degree. You will also want to discuss the estimated income your child will be earning each year through work and internship programs.
François Doyon La Rochelle: That’s a good point James, when you take money out of the RESP there are two types of withdrawals. There is the Post-Secondary Education withdrawal (PSE) which is essentially a withdrawal of your contributions that is not taxable. There are Educational Assistance Payments (EAP) which are composed of grants, capital gains, dividends, and interests that have accrued over the years and are taxable in the hands of the beneficiary (the student). The T4A slip will be sent by the financial institution to the student for the EAP withdrawals.
James Parkyn: Since Educational Assistance Payments (EAP) are taxed as income to the student, in the year of withdrawal, it will be important to know before withdrawing how much taxable income the student expects to earn. In the early years, generally, the beneficiary’s income will likely be low, therefore it makes sense to prioritize EAP withdrawals. However, as time passes, the student’s income may increase because of higher-paying summer jobs and internship programs. Therefore, increasing the likelihood that taxes will be payable on EAP withdrawals. Then, you could consider a mix of PSE withdrawals (your contributions) and EAP withdrawals.
François Doyon La Rochelle: Once enrolled in post-secondary education, there are no limitations on the withdrawal amounts of PSE, however, there are limits on the EAP withdrawals during the first 13 weeks. The limit for full-time students is now $8,000. It was raised in the last federal budget from $5,000. For part-time students, the limit was raised to $4,000 from $2,500.
James Parkyn: After the first 13 weeks, there is no restriction on how much you can withdraw from EAP. Also, make sure your withdrawal plan depletes all EAP before the beneficiary student finishes his studies. However, keep these annual withdrawals below the EAP threshold limit which is $26,860 for 2023. Otherwise, you may need to show receipts and proof of expenses.
François Doyon La Rochelle: You want to prioritize EAP withdrawals first because if the child quits school or there are still grants and accumulated income in the account six months after he finishes school you may lose out on some benefits of the RESP. On the other hand, withdrawing contributions is not an issue, as that money belongs to you, the subscriber.
James Parkyn: Yes, François, if the child quits or finishes school and there are still grants and accumulated income in the account it gets complicated but there are still a few options. One, since you can keep an RESP open for 35 years you can wait to close the account to see if the beneficiary might return to school later.
Second, if you are certain that the beneficiary will not be returning to school you can transfer the grants and accumulated income to a brother or sister that is under the age of 21. The maximum CESG grant of $7,200 per child nonetheless continues to apply therefore the transfer of grants can’t bring the sibling’s total withdrawal of grants above $7,200. If there are any excess grants, they will need to be returned to the government.
François Doyon La Rochelle: If there are no siblings, the grants must be returned to the government. For the accumulated income portion, if the RESP has been open for at least 10 years, there are a couple of options. You can withdraw what is called an accumulated income payment (AIP).So this wraps up the review of what happened in the Markets during the first half of the year.
James Parkyn: Yes, but you will want to avoid withdrawing the AIP since these payments are taxable to the subscriber at their marginal tax rate plus an additional 20% penalty tax.
François Doyon La Rochelle: Indeed, a better option if you have an RRSP contribution room is you transfer up to a lifetime maximum of $50,000 to your RRSP or a spousal RRSP and claim a deduction. While this accumulated income payment (AIP) is reported as taxable income, it’s fully offset by your RRSP deduction. If you don’t have the RRSP room, you could delay withdrawing the funds until you have the room. Remember you have 35 years before you need to close out the account. Also, you could transfer the AIP to a registered disability savings plan (RDSP) if you have a disabled child.
James Parkyn: There are a lot of rules when it comes to RESPs and it can get quite complicated. For any special situation, it may be best to discuss it with your advisor.
François Doyon La Rochelle: I agree James, I think we covered the basics, but I have two small things to add. First, when you get close to the time you will need to withdraw funds from the RESP think of reducing the risk level on your investments to protect the funds. Second, all the funds withdrawn from the RESP don’t have to be spent on school-related expenses if not needed. By that time the beneficiaries will have become young adults and the excess funds could be put to work in their TFSAs or FHSAs for retirement or the purchase of a home.
- Portfolio Home Market Bias :
Francois Doyon La Rochelle: As our regular Listeners know, we are in a new higher Interest rate world. This new investing landscape is top of mind for all investors. In Podcast #53 we tackled the Topic of the 60% Stocks/40% Bonds Portfolio as the starting point for setting your long-term asset allocation. In today’s main topic, we will drill down into the Stock component of your Portfolio, specifically how much global exposure you should have. So, James, what are your thoughts on this topic?
James Parkyn: So, Francois, the decision to invest globally is the first step. The next step is to determine an appropriate allocation. The standard allocation approach for global stocks is to invest proportionally according to market capitalization which is the weight of the aggregate value of the stocks in each country. This method assumes that markets are efficient and that asset prices reflect all available information and expectations of the investors.
François Doyon La Rochelle: In practice, most investors around the developed world exhibit a strong home bias and overweight domestic equities relative to their global market capitalization weight. Recent numbers indicate that Canada represents only 3.4% of the Global Capital markets. How do Canadians invest?
James Parkyn: Vanguard published a paper on Canadian Home Bias this summer titled “A Case for Global Diversification” quoting International Monetary Fund data. The paper, states that Canadian investors allocated 52.2% of their total equity allocation to Canadian stocks, which is overweight 15x the actual weight of 3.4%.
François Doyon La Rochelle: Despite the benefits of diversifying a portfolio globally, home bias has been strong among Canadian investors. Is that true for Investors outside Canada?
James Parkyn: Vanguard’s Paper has a nice chart that shows Home Market Bias is a globally observed phenomenon. Americans have a 79.4% home market bias Vs. a global weight of 65.5% whereas UK Investors have a much lower 26.3% home market bias Vs a global weight of 4.2%. In Developed Europe, it is 53.6% Vs a global weight of 18.2%.
François Doyon La Rochelle: Based on this chart, we can say that Investors in most countries significantly overweight their domestic allocation to stocks compared to their country’s market-capitalization weight in a globally diversified equity index. While market-cap weight is a valuable starting point, I believe that several other critical factors should be considered when deciding your exposure to international equities. Investors should carefully weigh the trade-offs, such as volatility reduction, expected returns, implementation cost, tax considerations, and their own goals and ability to take on risks.
James Parkyn: One way to evaluate the expected diversification benefits of international equities is to analyze the impact on portfolio volatility as incremental allocations of international equities are added to a domestic equity portfolio.
Vanguard also produced a US paper in 2021 titled “Global Equity Investing: The benefits of diversification and Sizing Your Allocation” based on market data ending on September 30, 2020. In this paper, they stated that “In each market we examined, our analysis indicated that volatility was reduced most with an allocation to international equities of between 35% and 55%. While this observation may help investors determine the appropriate mix of domestic and international equities, volatility reduction is not the only factor to consider.” For our listeners, this paper was written for American-based investors.
The Vanguard Canadian paper from July 2023 shows that the reduction in portfolio volatility for a Canadian investor declines as the allocation to international equities increases up to 70% and then begins to taper off gradually. The paper concludes: “Looking at the data, the optimal asset allocation for Canadian investors is a 30% allocation to Canadian equities and a 70% allocation to international equities because it has been shown to minimize the long-term volatility of their portfolio.”
François Doyon La Rochelle: Our equity model portfolio devotes 20% to Canada, 50% to the U.S. market, and 30% to international markets which includes emerging markets. If we remove our home bias of 20% to Canada, the remaining 80% is invested to reflect roughly the global market cap weights.
James Parkyn: I would add to that, the Canadian market has historically been more volatile than the global market without a proportionate increase in return. That’s a bad deal for investors and the obvious reason why you would want to add a substantial quantity of global stocks to your portfolio mix.
François Doyon La Rochelle: Modern portfolio theory dictates that the broadest possible diversification will be the most efficient for reducing risk. Therefore, in theory, your portfolio would replicate the geographic weightings of the global stock market.
James Parkyn: On a positive note, Vanguard’s research shows that Canadian and other developed countries’ investors may have realized the benefits of international diversification as shown by the declining preference for domestic equities from 2012 to 2022.
François Doyon La Rochelle: Vanguard also highlights that global pension assets over the last two decades reveal a notable decrease in the degree of home bias in equities. Specifically, the average weight of domestic equities has declined from 67.1% in 2002 to 37.7% in 2022 across Australia, Canada, Japan, Netherlands, Switzerland, and the UK. In the last decade, the data shows that the United States has had the largest allocation to domestic equities, whereas Canada, Japan, and Switzerland have had the lowest allocation.
James Parkyn: Look no further than Canada’s big pension funds to see how the most sophisticated pension investors allocate the assets they manage globally. CPP Investments, which manages the $570-billion Canadian Pension Plan Fund, doesn’t disclose the geographical distribution of its $135-billion public equity portfolio. However, as of March 31, only 14% of its total net assets were invested in Canada. The Caisse de dépôt et placement du Québec, manager of the Quebec Pension Plan, had 21% of its public market equities portion of $402 billion in net assets invested in Canada at the end of 2022.
François Doyon La Rochelle: There are several reasons why an investor might prefer to buy domestic stocks, but it usually comes down to simple familiarity. The companies that make up your local stock market you hear about in the news daily. Home bias is nevertheless a serious impediment to portfolio diversification, which is the key to reducing risk. This is very much the case in Canada, where a handful of companies and just three sectors dominate the equity market.
James Parkyn: Vanguard reports that the top 10 holdings in Canada represent nearly 37% of the Canadian stock index. By contrast, the top 10 holdings make up 16% of the global stock market. When it comes to sector concentration, Canada is heavily overweighted in financial services (+16.4%), energy (+12.1%), and materials (+7.2%) relative to the global market weights, and underweight in information technology (-13.0%), health care (-11.7%) and consumer discretionary (-7.3%).
François Doyon La Rochelle: Morningstar also published a Report recently titled “The Canadian Equity Market Isn’t as Canadian As it Once Was.” According to Morningstar Indexes’ annual study, only 48% of the revenues from the Canadian equity market are sourced domestically.
James Parkyn: Also, according to Morningstar, Canadian companies, like many in other developed equity markets, have globalized their revenue sources. Canada is similar to the U.S., Japan, Australia, and most of Western Europe in having become less domestic. So, despite the pandemic and geopolitics, globalization does not seem to be reversing.
François Doyon La Rochelle: Morningstar adds, and I quote “In emerging markets, China foremost among them, tend to be more domestic in their revenue sources. Two outliers among emerging markets are South Korea and Taiwan, which source most of their revenues internationally. These are technology-heavy markets. South Korea’s international revenues are largely driven by Samsung Electronics, a global leader in smartphones, semiconductors, TVs, and more. The Morningstar Taiwan Index is dominated by Taiwan Semiconductor, the world’s largest contract chip manufacturer.”
James Parkyn: So, what we can take from this François is in my view,
that increasingly globalized revenue sources, especially among developed markets, can explain parallel rising correlations among equity markets.
François Doyon La Rochelle: But on the other hand, can multinational corporations provide enough global diversification as an alternative to buying global equities?
James Parkyn: That is a common question about exposure to stocks outside an investor’s home market. The thinking goes that, because many large domestic firms generate a significant portion of their revenue from foreign operations, the diversification benefits of global investing are already reflected in their prices and performance. But we don’t accept this thinking, particularly for Canadian investors as we mentioned earlier, our stock market is considered a three-sector bet with high levels of concentration.
François Doyon La Rochelle: I agree James for several reasons. First, simply focusing on domestic companies means an investor has no stake in leading global companies that are domiciled outside their home market. Second, the history of capital markets tends to demonstrate that exposure to foreign currencies helps reduce portfolio volatility. Finally, as you mentioned James, a portfolio composed only of domestic companies will likely have less well-diversified sector exposures than a globally diversified stock portfolio.
James Parkyn: You brought up a good point François about currency exposure. Investments in foreign markets are exposed to fluctuations in foreign exchange rates. Currency has no intrinsic return—there is no yield, no coupon, and no earnings growth. Therefore, long-term, currency exposure affects only return volatility. When we build portfolios, The currency hedge decision is based on several factors including currency contribution to portfolio volatility, currency correlation with the underlying asset, and investor risk tolerance.
François Doyon La Rochelle: Currency volatility can be a major driver of risk for fixed-income return volatility. That’s why we favor currency-hedge globally diversified fixed-income funds or ETFs. On the other hand, for international equities, currency volatility can have diversification benefits, especially over the long term.
James Parkyn: I will wrap this topic up by concluding that Canadian Investors should consider allocating a significant part of their portfolios to international equities. In determining how much to allocate between domestic, US, and international equities, a helpful starting point for investors is global market-cap weight. In practice, we suggest investors consider an allocation below this starting point based on their sensitivity to several considerations, including volatility reduction, implementation costs, favorable tax considerations, currency effects, regulation, and preferences.
François Doyon La Rochelle: Thanks, James, I think that covers the topic. I hope our listeners found this interesting.
- Conclusion :
François Doyon La Rochelle: Thank you, James Parkyn for sharing your expertise and your knowledge.
James Parkyn: You are welcome, Francois.
François Doyon La Rochelle: That’s it for episode #56 of Capital Topics!
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