RESPs – A Failing Grade?

RESPs are useful savings vehicles and neatly illustrate some of the challenges of investing over a fixed time horizon. On their own they are unlikely to meet future post secondary education costs.

A Registered Educations Saving Plan (RESP) is an effective way of saving for the cost of a child’s post secondary education. The maximum contribution allowed for each child within an RRSP is $50,000. The Government matches contributions with the Canada Education Savings Grants up to a maximum of $7,200 per child. The growth on the savings is tax deferred and the accumulated assets are withdrawn during the period the child is in post secondary education. A more detailed description of RESPs is available here.

How likely is it that an RESP started today would fully fund a child’s post secondary education costs? To answer that question we need to estimate future education costs and compare that with what might realistically be achieved by investing to maximize the advantages of an RESP. This was the subject of a recent white paper from which we highlight some key conclusions.

A 2013 study from BMO estimated the total current cost of post secondary education to be $60,000, including tuition and residence with meals and books¹. In the white paper we look at estimates of the rise in tuition costs and conclude that a conservative outlook is an increase to $68,127 (in today’s dollars).

To maximize the advantages of an RESP the best strategy is to start early to maximize the tax deferred growth and acquire the government grants as soon as possible. To keep comparisons simple we considered a single lump sum payment (rather than spread over 4 or more years of study). Our calculations considered a 20 year and 10 year savings period. In both cases, we spread out the contributions to maximize the Government grants at the earliest opportunity and continue making contributions until the $50,000 limit is reached.

Clear thinking about the objectives drives the investment strategy. For investors who attach a high importance to maximizing the potential final value they must shoulder the risk of a shortfall. Investors who want to avoid downside risk must be prepared to invest more to achieve the same outcome to compensate for the lower return.

We used PWL estimates of expected annual market returns for bond and equities of 3.70% and 7.22% (add PWL source here) respectively and constructed a range of portfolios with an equity allocation varying from 0% to 100%. For the bond portion of the portfolio all the bonds mature at the end of the 10 or 20 year period. Thus in the first year with a 20 year investment horizon we buy bonds that mature in 20 years, the following year we buy bonds that mature in 19 years etc.. This ensures that the bond portion of the portfolio has the same maturity as the liability, which means that the final maturity value is not impacted by changes in interest rates.

Figure 1 summarises the results from the study

The horizontal axis denotes the RESP equity allocation and the vertical axis is the cumulative value of the RESP at the end of the investment period. The dashed line represents the goal of $68,127. The 50th percentile is an average outcome such that 50% of outcomes would be above this value and 50% below. The 5th percentile is a measure of the confidence of success – 95% of outcomes should be above this line. A lower 5th percentile suggests a higher risk of significant losses. Curves are plotted for a saving period of 20 years and 10 years.

Figure 1: Projected Terminal RESP Values

Not surprisingly, the average ending value of the RESP increases with increasing allocation to equities. Starting contributions early is better than starting later. For the 20 year investment period, a 40% equity allocation is required to achieve the goal of full funding. Over a 10 year saving period the required equity allocation rises to 80%. But there is a catch. As the 5th percentile curves show, investing with a high proportion of equities increase the possibility of a low terminal value. Put simply, a high proportion of equities creates uncertainty with both extreme gains and extreme losses becoming more frequent.

In the white paper we also examine the impact of investment fees. When typical mutual fund fees are taken into account then even a 60% equity allocation over 20 years does not achieve the funding goal.

Certainly a conclusion from the study should not be to encourage very high equity allocations in RESPs but to show that investors currently preparing for their child’s education should consider the RESP as only part of the funding solution. The proper asset allocation within the RESP should be considered in the context of broader financial planning. Given that the RESP planning horizon is shorter than the retirement horizon for most parents, it can be argued that it would be unwise to pursue a more aggressive (higher equity allocation) strategy in the RESP than the investor is comfortable with for their retirement savings.

¹ Student tuition and debt on the rise: RESPs and beyond, BMO Wealth Institute (2013)