February 2009

Turning your RRSP into an income pipeline:
A better way to think about money and risk

By Don Eberley

“I came from a real tough neighbourhood. I put my hand in some cement
and felt another hand.”

- Rodney Dangerfield

The stock market in 2008 was a tough neighbourhood indeed. Residents watched in horror as their investments and retirement dreams became buried in cement. Sure, everyone was stuck in the cement together, but this offered little comfort.

One way around this stress is to turn your RRSP into an income pipeline, and change the way you think about money and risk.

Forget some of what you ever learned about investing

We tend to think of an RRSP as a "pool" of money that must get bigger every year. If it gets smaller, even temporarily, we call that "risk". We try to manage this "risk" through Asset Allocation; investing in a combination of stocks and bonds to reduce volatility. Sound familiar?

Unfortunately, this is a toxic way of thinking about investing. The reasons are simple.

(1) Temporary market fluctuations are not "risk". They are a perfectly normal event for which we can plan ahead. Risk is an uncontrollable, permanent loss of wealth caused by things like death, taxes, inflation, Nortel or Bernie Madoff. These are the things we should be concerned about; not market fluctuation.

(2) Traditional Asset Allocation has some serious drawbacks. At today's low interest rates, adding bonds to a long-term growth portfolio is like adding water to a car's gas tank. All it does is make the engine sputter. And including stocks in the money we're about to spend is also a bad idea, since it can result in selling at a loss which erodes our capital more quickly. Proper asset allocation is not about mixing stocks and bonds together for emotional comfort, it is about using them separately for financial effectiveness.

The RRSP income pipeline solution: A smarter approach

In an income pipeline, money flows from stocks into bonds as needed. Each asset class is used separately, according to its intended purpose, rather than being combined together with the others. Stocks are used for building wealth over the long-term, and bonds are used to protect this wealth when it is almost time to spend it.

Example: If Catherine makes an RRSP contribution in 2010 that will not be withdrawn until 2030, she might initially invest all of it in stocks for maximum long-term growth potential and inflation protection. Ten years later, around 2020, she starts looking for opportunities to lock in profits and shift the money into bonds. By 2025 the money is entirely invested in bonds for safety, and by 2030 it is ready to flow into her bank account for spending.

At all times during retirement, Catherine maintains a "safety cushion" of several years' income in her pipeline. She can sleep at night even when the stock market is down, because all of her current income is coming from bonds. She can wait out virtually any decline, thus avoiding the losses that other investors will lock in. This makes her a better - and potentially richer - investor.

Use a TFSA to plug leaks

One problem with RRSP pipelines (and pools for that matter) is that they leak. Because every withdrawal is fully taxable as income, you could lose up to 46% of your gross RRSP revenue to tax “leakage”.

One solution is to take those tax refunds you get every April as a result of making RRSP contributions, and invest them inside a Tax-Free Savings Account. The TFSA will help cover RRSP-related taxes during retirement, giving you a tighter, more leak-free pipeline.

How do you convert an existing RRSP pool into a pipeline?

First of all, if you're not planning to retire within the next ten years, there is no rush. Your entire RRSP can remain the way it is, with up to 100% equities if you have the stomach for it.

As retirement approaches, we evaluate your total package of pensions, benefits and investments, and project how much income will likely come from RRSPs over the next 5 to 10 years. We make sure that this money is invested in a low-risk bond fund, GIC, daily interest savings option, or exists as part of a balanced fund.

If there isn't enough money set aside in this manner, we evaluate how many remaining contributions might be available for buying bonds. We also watch for selling opportunities among your growth funds. Somewhere in the middle we should be able to find the money, but it does illustrate the importance of planning ahead.

When the big day arrives and you start needing regular income, we set up automatic payments to your bank account. We also conduct periodic reviews - at least once a year - to make sure money is flowing through the pipeline so you'll never be caught short.

To discuss building an income pipeline in your RRSP, please drop me a line. In the meantime, watch out for that wet cement!