The smart way to save for school

More than ever, RESPs are the best way to save for a child’s education. When we opened our first one in 1996, the only options were pooled “scholarship trusts,” where you had no control over how the money was invested. Two years later, the federal government started topping up contributions to all RESPs by 20% (see www.canlearn.ca for details), and the popularity of the plans exploded. Today just about every financial institution offers RESPs, and parents have the freedom to invest any way they like: in stocks, bonds, GICs and mutual funds. That means you can easily build your own Couch Potato portfolio inside an RESP account. Here’s how:

Forget about ETFs
Couch Potato investors love the low management fees and the huge variety of exchange-traded funds. But ETFs are a poor choice for small accounts (my usual cut-off is $50,000), especially if you’re adding money every month. “I don’t think ETFs are appropriate for RESPs because of the transaction costs, and because it’s difficult to automate the contributions,” says Mike Holman, author of The RESP Book and creator of the blog Money Smarts. “Index funds are a more logical choice.”

I found this out the hard way when I first moved my kids’ RESPs into self-managed accounts. I initially built my portfolios using ETFs, but I soon realized that every contribution would cost me $29. Now I use index mutual funds: their management fees are higher, but my overall costs are lower, because I can add money and rebalance the portfolio without paying commissions. With mutual funds it’s also easier to set up pre-authorized contributions that come out of my chequing account each month.

Keep things simple
Many serious index investors strive for higher returns by tapping into asset classes like emerging markets, real estate and commodities. But RESPs don’t need to be that complicated. You could start out with half your money in a Canadian bond fund and half in a Canadian equity fund (you may eventually need a money market fund, too). If you want more diversification, add U.S. and international equity funds. Anything else is overkill in such a small portfolio.

Holman recommends using the super-cheap TD e-Series Funds, which cover these major asset classes. (You can open a TD Mutual Funds RESP at any TD Canada Trust branch, but you’ll have to go online and convert it to a TD e-Series Funds account.) A balanced portfolio of e-Series funds will have a management expense ratio (MER) well under 0.50%. RBC and Altamira also offer index mutual funds with MERs between 0.52% and 0.70%.

If you want to keep things even simpler, consider the TD Balanced Index Fund. It holds a 50-50 mix of equities and fixed income and charges just 0.83%. While that MER is higher than the e-Series portfolio, the convenience of using just one fund may well be worth it. “For a lot of people, especially younger parents, this may be the first investment account they set up,” Holman points out. Costs are always important, but it’s not necessary to fight for every basis point when your account is small. “Your savings rate is going to have a bigger influence than anything else.”

Adjust your asset allocation
Most people understand they should ratchet down the risk level in their RRSPs as they approach retirement, gradually shifting from stocks to bonds and cash. In most cases you don’t need to change the asset allocation of your retirement portfolio more than once every several years. However, you need to make these adjustments more often in an RESP.

In general, I believe that RESP investments should be fairly conservative. Once your child is a preteen, you don’t have much time to make up the big losses that can occur in an all-equity portfolio. Even portfolios of half bonds and half stocks lost money in the early 2000s, and they saw double-digit plunges in 2008-09. Losing 15% or 20% of your savings when your child is in Grade 9 or 10 can put a serious dent in your plans.

Here’s my rule of thumb for RESP asset allocation. As long as your child is eight or younger, you can hold as much in equities as you can stomach. But by age nine, consider this formula: Subtract your child’s age from 18, then multiply that number by 10. That’s the maximum percentage of your RESP that should be in equities.

Since my oldest is 16 and just two years from university, her RESP is 80% in fixed income. My 13-year-old son’s, meanwhile, is currently at 50-50. “Towards the end, you really need to keep things as safe as possible,” Holman says. “You need to make sure that the money is going to be there when you need it.”

For more index investing ideas, visit Dan Bortolotti’s Canadian Couch Potato blog.