Taking risk in an RESP

My column in the November issue of MoneySense offers suggestions for parents who want to use the Couch Potato strategy in a Registered Education Savings Plan (RESP).

Investing in an RESP presents some added challenges compared with a retirement account. First, the time horizon is usually shorter: even if you start contributing to an RESP when your child is born (and most parents don’t), you’ll start tapping the funds in no more than 18 years. The account size is also much smaller. You’re not allowed to contribute more than $50,000 to an RESP, and most parents won’t ever hit that maximum. We’re hoping your nest egg is bigger than that when you retire.

For these reasons, I suggest that RESP investors use index funds rather than ETFs: something simple like the Global Couch Potato (assembled with TD e-Series funds) is all the diversification you need. That advice is echoed by Mike Holman, Money Smarts blogger and author of The RESP Book, whom I interviewed for the column.

There is one other idea in the article that I’d like to expand on. As your child approaches university age, it’s important to gradually decrease the risk in her RESP. You can invest in stocks when she’s a toddler, but by the time your child is 18, all of your RESP money should be in fixed income and cash, so you’re certain it will be there when you need it. Imagine if your teen was getting ready for Frosh Week in September 2008 and her education savings were in an all-equity fund. You could have lost half of your RESP and put your kid’s university plans in jeopardy.

Adjusting your RESP asset allocation

Here’s my strategy for dialing down the risk in an RESP. Until your child is nine years old, you can keep as much of her RESP in equities as you want. For example, Mike Holman’s children are two and four years old, so his RESPs are 100% stocks for now.

After that, consider this formula: Subtract your child’s age from 18, then multiply by 10. That’s the maximum percentage of an RESP that should be in equities. My 13-year-old’s account is split 50-50, while my 16-year-old’s is only about 20% stocks. Here’s a year-by-year breakdown:

I stress that these are maximum stock allocations. Depending how early you start and how much you’re able to save, you may not need to take any equity risk at all. Thanks to the generous 20% government grant on RESP contributions, $200 a month starting when your child is six will grow to $50,000 by the time she’s 18 if you earn a modest 5% annually. That may not be achievable with an all-bond portfolio today, but it has been in the past and will likely be possible again in the future as interest rates rise.