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Background


I'm trying to figure out what is the best way to supplement my RRSP for retirement. In Canada, I can contribute roughly 18% of my annual income (up to an annual maximum of about $26,230.00) without having to pay tax on that income. When I withdraw it, I pay taxes at my marginal tax rate at the time of withdrawal, with the marginal rate likely being lower as I would be (hopefully) retired.

Since I can max out that contribution, I want to supplement that amount while legally minimizing my tax exposure. One such vehicle for that is a Tax Free Savings Account (TFSA), which allows me to deposit up to $5000.00 per year of already taxed income. The upside, is that any interest accrued in that account is free of any taxation (neither capital gains nor personal tax is applied to it). Also, since I haven't contributed to one before, I can currently invest $50,000.00 to make up for past years where I did not contribute to such an account.


Dilemma


I went to the bank to decide what kind of investments are available for the TFSA, and what kind of risks/benefits they provided. The choices seem like garbage, to be honest:

  • "High interest" savings account: 0.5% annual interest. If I put in $50,000.00, and invested the full $5000.00 per year, after 30 years I only gain a few thousands dollars in interest, and the real value of the amount has likely decreased due to inflation. The only benefit is no risk.
  • GIC: The best rates are 9% over 5 years, but the cash is locked in (not a problem in my case), but I have to put all the money up front, and can't "top up" the investment every year. Also, 2% per year is still low. No risk at least.
  • Mutual funds: The current funds I'm looking at are part of a "diversified portfolio" offered by the bank, which has had an 8% return over its entire lifetime. Correct me if I'm wrong, but that means that I'll never (likely) get more than 8% on top of whatever I invest.

Question


What has me a bit confused is the mutual funds. They seem to have no compounded interest effect, so over the entire lifetime of the investment (assuming 8% remains true, I know it won't in real life), I just get my investment back plus 8%.

Is there something I'm missing here? Is there an option other than hiring a stock broker that gives something better than 0.5% per year for long term investments that I can regularly "top up" instead of providing a giant lump sum up-front? I'm trying to find a relatively low-risk investment that will double my principle (ie: my growing annuity I deposit to my TFSA) by the time I retire.

Thank you.

  • Can you link to the specific funds you mention? – Nosrac Apr 19 '17 at 18:17
  • @DanielCarson Sure thing. – Cloud Apr 19 '17 at 20:06
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    Your premise is flawed - you can basically hold any type of investment (instead of things like real estate, or shares in a private company) within a TFSA. The banks don't package advertised products like that, but you can easily open a TFSA and use a brokerage account to buy individual stocks. – Grade 'Eh' Bacon Apr 19 '17 at 20:57
  • @Grade'Eh'Bacon Thank you for noting that. I didn't realize that additional types of investments could be utilized with a TFSA. – Cloud Apr 20 '17 at 17:35
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    9% over 5 years on GIC? I will kiss and hug the banker to give me that rate. – vimdude Apr 25 '17 at 12:52
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Typically mutual funds will report an annualized return. It's probably an average of 8% per year from the date of inception of the fund. That at least gives some basis of comparison if you're looking at funds of different ages (they will also often report annualized 1-, 3-, 5-, and 10- year returns, which are probably better basis of comparison since they will have experience the same market booms and busts...).

So yes, generally that 8% gets compounded yearly, on average. At that rate, you'd get your investment doubled in roughly 9 years... on average...

Of course, "past performance can't guarantee future results" and all that, and variation is often significant with returns that high. Might be 15% one year, -2% the next, etc., hence my emphasis on specifying "on average".

EDIT: Based on the Fund given in the comments:

So in your fund, the times less than a year (1 Mo, 3 Mo, 6 Mo, 1 Yr) is the actual relative change that of fund in that time period. Anything greater is averaged using CAGR approach.

For example. The most recent 3 year period (probably ending end of last month) had a 6.19% averaged return. 2014, 2015, and 2016 had individual returns of 8.05%, 2.47%, and 9.27%. Thus that total return over that three year period was 1.0805*1.0247*1.0927=1.21 = 21% return over three years. This is the same total growth that would be achieved if each year saw consistent 6.5% growth (1.065^3 = 1.21).

Not exactly the 6.19%, but remember we're looking at a slightly different time window. But it's pretty close and hopefully helps clarify how the calculation is done.

  • What is the tech/financial/expert/non-layman term for the "8% per year" average benefit? The way the banker explained it to me, it sounded like I would only get 8% back over the span of 30 years, which makes no sense that the return is independent of time. The fund info is here. – Cloud Apr 19 '17 at 20:02
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    @DevNull Perhaps you misunderstood the banker? Or are looking at a money market fund? 8% total over 30 years would be about a quarter of a percent return per year. The technical term I believe is Compound annual growth rate (CAGR) – pwcnorthrop Apr 19 '17 at 20:12
  • I followed up with my bank, and I did indeed misunderstand the banker. – Cloud Apr 20 '17 at 17:36
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You are not limited in these 3 choices.

You can also invest in ETFs, which are similar to mutual funds, but traded like stocks. Usually (at least in Canada), MERs for ETFs are smaller than for mutual funds.

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