|Contributed by: martingale |
Why don't most people save as much as they should? Canadians can contribute up to 18% of their income to their RRSP in exchange for a generous income tax deducation--essentially, free money. Yet most fail to take advantage: In 2003 the median RRSP contributor earned $43,000 but their median RRSP contribution was just $2600, which is only 6%. Overall, only 34% of those eligible to contribute to an RRSP actually did so. When RRSP room left over from previous years is included the result is dismal: Canadians used up barely 9% of the available RRSP contribution room, leaving 91% of it unused. These numbers are astounding--Canadians left an enormous amount of free money on the table! In this article I'll explain the psychology behind why most fail to max out their RRSP contributions, and what you can do to make sure that you do contribute enough to your RRSP.
The same sorry story plays out around the world--most nations have generous retirement savings plans which go unused by their citizens. It is not that individuals do not want to save for their future, but rather, at any given moment they are faced by an array of current expenses, while retirement seems to be years away--with so much time to save, and more immediate concerns, people decide that setting up a savings plan can wait. Worse, some apply the same logic to debts that they really ought to pay off.
In reality, people wait until it is almost too late, and then suffer economic hardships in an attempt to catch up with their RRSP savings in the latter half of their working life. Worse, some never make it, and wind up living on insufficient government subsidies in their old age. We are fortunate to live in a state which provides at least a minimal income to those who failed to save for themselves, but getting by just on CPP/OAS is not much fun. It is worth-while sitting down and working out how much you need to save to retire just to scare yourself into action.
The generous 18% RRSP tax deducation carrot and the scary stick of potentially having to eat dogfood in your retirement ought to be enough to convince you to conribute the maximum to your RRSP, but often it is not. The problem, really, is that you are human.
There is an anomoly in the way people percieve value. We are hardwired to be biased in favour of short-term benefits. According to Richard Thaler, professor of economics at the University of Chicago, if you offer someone the choice of $1000 this year or $1100 next year most people will take the cash up front. But offer them a choice between $1000 in 20 years or $1100 in 21 years and most people will wait the extra year to get the higher amount. Why is that? Financially, economically, the two cases should be treated the same: They both offer you the option of waiting one extra year to earn a 10% higher return. However, people's observed behavior implies that they actually use an internal interest rate greater than 10% for this year, but less than 10% for a one year period 20 years away. Interest rates ought to be the same over time, so that's irrational--yet, it's how people actually operate.
One solution to this problem might be better education. Were more people aware of the biases hardwired into their own fallible human nature they might compensate. Aware of this irrationality, a thoughtful investor would overcome such biases and force themselves to save the proper amount. I would hazard a guess that those of you who have taken the time to read Efficient Market Canada have already gone part of that distance, and are a little less likely than most to leave so much money on the table.
Nevertheless, I would still guess that a significant number of you do not save as much as you should, and that in fact many of you continue to leave money on the table by contributing less than 18% per year to your RRSP's. Perhaps some of you have used just 12-13% out of your RRSP room. Of course, you had a good reason--you had to pay that mortgage down, your car payment has to come first, and certainly you have to live a little: It was so much more enjoyable vacationing in Europe than a cheaper vacation closer to home would have been. That piddly 5-6% of additional savings isn't worth giving up the good things in life, is it?
Or isn't it? What is the impact of that 5-6% over the long-term? If you estimate that you can reach your retirment goals in 25 years, that extra 5-6% would have put you there in just 20. Is it really worth more to you to have that bigger house, flashier car, and fancier vacation, when the cost is understood to be five full years of your life? Five years is the sort of punishment we inflict on people who commit armed robbery--would you risk five years in jail for that house, car, and vacation? Ask yourself again whether you have not fallen victim to the kind of thinking just described--discounting more heavily those things that are far off in the future, and over-weighting the here and now. If I offered you the chance to take the next five years off as an extended vacation, in exchange for that, how much more would you promise to contribute to our RRSP after you got back?
The best way to avoid falling into this trap is to make saving the default. Rather than having to decide to contribute, you should arrange things such that your RRSP contributions happen automatically. If it takes an effort for you to contribute to your RRSP, often you will not. If it takes an effort for you not to contribute, then you will more often--you will only shut down the automatic RRSP contribution for a good reason, or a financial emergency. Setting up an automatic RRSP contribution will help you avoid being blinded by the here and now at the expense of the future. It may also help you to fill out Form T1213, Request to Reduce Tax Deducations at Source. Have all that extra money transfered automatically to your RRSP!
In the end most of us are too lax and too prone to procrastination when it comes to saving. One of the best things that you can do, therefore, is to set up a pre-authorized contribution plan so that money is automatically deducted from your account each and every month. Your discount broker will have a Pre-Authorized Contribution form on their website. Download it, fill it out, and mail it in. Alternately, you may be able to set up an automatic EFT using your brokerage's website. Do it now.
If you feel you do not have the money to do it now, try and arrange for the PAC to start in the future. Trick yourself: Your human weakness, your propensity to discount the future in favour of today, can work to your advantage here. I bet you can convince yourself to set a fairly high automatic contribution rate if you set it up so that the first payment comes out of your account next month, or the month after that. That's a long ways off, right? You have lots of time to get your financial house in order before that RRSP contribution comes out.
 Statistics Canada
 The Economist