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The High Cost of Free Money

Sometimes free isn't really free - and sometimes it's worse than free. This was made very apparent to me recently when I delved into the employee RRSP top-up program at a local company. In this case the company matches 10% of contributions made by employees to the plan, up to a limit of $1,500 per year. The catch is that the money may only be invested in the limited selection of funds provided by the plan's management company. A guaranteed return of 10% up front sounds like easy money - but is it worth it?

The slick, glossy literature provided by the management company assumes a guiding estimate of 6% annual growth for a reasonable, balanced combination of funds. This is in line with the long-term historical average which I use for my own planning. For the purpose of this investigation, I assumed that a balanced portfolio composed of a standard mix of Canadian, US and international equities and Canadian bonds would return an average of 6% per year over the long run.

To represent a reasonable self-managed RRSP outside of the company plan, I selected the Global Couch Potato provided by Dan Bortolotti on his wonderful blog Canadian Couch Potato. (Replicating something more akin to the Complete Couch Potato, which is what I use for my RRSP, was not feasible with the funds available in the employee plan.) The TD eSeries mutual fund variant of this model portfolio has a yearly cost of 0.44%. While it is possible to implement it with ETFs at a cost of about half that, it requires at least $50,000 or so in investment in order to be efficient. Sticking to the more accessible variant seemed more fair for this comparison.

I was able to replicate the asset mix of the Global Couch Potato using the menu of funds available in the employee plan. The broad index funds available are the cheapest, so it is very efficient compared to the alternatives. The portfolio representing this asset mix costs a mere 0.196% per year, which is notably cheaper than the self-managed portfolio. There is a 1.97% annual plan fee, however, so the total cost of the employee portfolio balloons to over 2%.

I assumed a contribution of $15,000, which maximizes the 10% top-up limited to $1,500, thereby giving the company plan maximum advantage. Where the self-managed portfolio began with $15,000, the employee plan had $16,500, ahead by 10% right out of the gate. Were the lower fees of the non-plan portfolio able to overcome the large head-start provided by the employer top-up?

As it turns out, the results were not even close. After 30 years of average annual growth at 6%, the simple, self-managed portfolio would be worth $79,806, while the employee plan portfolio would only be worth $51,012 - a difference of $28,795!

Such a result seems hard to believe on the surface. 2% does not feel like very much in terms of fees. Compared to 6% of expected growth, however, it represents about a third of the return for each year. Over a long period of time those costs compound significantly.

Even more striking is the realization that this is only the difference in return for a single year's contribution. Over many years and many contributions, this disparity quickly adds up to hundreds of thousands of dollars.

Suffice it to say, the employee RRSP plan is a disappointment. Despite the allure of instant return from free money, it bears a very significant long-term disadvantage. It is unfortunate that what should be an attractive and well-intentioned employee perk turns out to be such a costly burden. In this case, free money comes at a high price.