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Which is better: RRSPs or public pensions?

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Every year at this time, the marketing arms of Canada's mutual funds go into high gear exhorting Canadians to dig deep to pour money into their RRSP investments in time to beat the end-of-February tax deadline.

While it may be the officially supported time to think about adding to the pool of assets managed by Canada's private retirement savings industry, it is also an opportunity to reflect on the overwhelming advantages of our public pension system.

To put it bluntly and directly, public pensions -- the Canada Pension Plan (CPP) and the proposed Ontario Registered Pension Plan (ORPP) -- are better than RRSPs because they are more efficient in delivering retirement incomes than any individual retirement saving option.

How much more efficient?

We get a pretty clear idea from the test that the ORPP is going to apply to determine whether or not a Defined Contribution (DC) plan delivers a benefit that is equivalent to the benefit provided by the ORPP at a total contribution rate of 3.8 per cent of income.

Based on detailed actuarial studies, the government determined that to deliver a benefit equivalent to that delivered by the ORPP, a DC plan would require a contribution rate of 8 per cent of pay -- more than twice the contribution going into the ORPP.

In other words, retirement savings through the ORPP are more than twice as efficient as retirement savings through a DC plan.

Why is that the case? It all comes down to cost, investment returns and risk.

Investment management costs are lower for large investment funds that can manage their money internally or get the best pricing from external managers than they are for smaller funds.

Investment returns are higher for large defined benefit plans than they are for DC plans:

  • They are larger and therefore have a more attractive investment opportunity set;
  • They spread investment risk over large numbers of people and among generations;
  • They can afford to take the longer-term view that generates higher investment returns;
  • And whereas an individual saver can only deal with the risk of outliving your retirement savings (longevity risk) by buying expensive annuities, a defined benefit pension plan can pool longevity risk over a large group of people.

A study I did a couple of years ago drilled into the issue to quantify the difference.

Looking just at fees, mutual fund fees on a 60 per cent equity, 40 per cent bond investment portfolio would average 2.07 per cent of assets annually compared with fees for exchange-traded funds for the same portfolio of 0.23 per cent -- a difference of 1.84 per cent.

While 1.84 per cent may not sound like much, over a lifetime of saving it comes to a pretty healthy sum. I found that for an individual who saved consistently throughout his or her working life and paid average Canadian mutual fund fees, 36 per cent of that person's retirement savings would go to the mutual fund manager.

And that's after paying fees for market access through an exchange-traded fund.

There may well be actual Canadians who retire in the kind of comfort, independence and luxury depicted in the advertisements touting the benefits of RRSP savings. But they are much more likely to be mutual fund managers than their clients.

So far, we've only considered fees. Returns are another big issue. Although there hasn't been a systematic study of RRSP vs. pension fund returns in Canada, separate U.S. studies have shown that Defined Benefit (DB) plans outperformed DC plans by 1.5 per cent per year over a 20-year period and that DC plans outperform individual retirement accounts by 1.8 per cent per year.

Add into the picture the fact that Canadian mutual fund fees are more than double the corresponding fees in the United States and you get an expected difference in returns after investment management costs of roughly 4.3 per cent per year for a large DB plan compared to an individual RRSP.

A difference in returns of that magnitude has a significant impact: 2.7 times more money -- that's how much you can expect to generate over your working lifetime, saving the same amount of money, with a DB pension plan instead of an RRSP.

And we haven't even taken into account the cost of managing longevity risk. That adds even more to the differential because the cost of managing that risk as an individual is far greater than the cost of pooling that risk in a large group in a pension plan.

Individual retirement saving isn't just inefficient relative to public plans in providing for retirement income security, it is grossly inefficient. Hopelessly inefficient.

So my best advice to Canadians pondering what to do at RRSP time is to ensure their federal government is doing everything in its power to improve the efficiency and effectiveness of Canada's retirement income system by expanding the Canada Pension Plan.

In the long run, expanding the CPP is going to contribute a lot more towards your retirement income security than any amount you put into your RRSP this year.

And if the federal government isn't doing it, then the Ontario government's planned Ontario Retirement Pension Plan is the second-best option.

Economist Hugh Mackenzie is a CCPA research associate. Follow him on Twitter @mackhugh.

Photo: Allan Lorde/flickr

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