I recently received a reader question about how to effectively use GIC’s with RESP withdrawals.
I have a question in regards to moving funds towards GIC’s. My son turns 17 later this month and his RESP portfolio has $70k. This month I would like to start moving funds into Money Market Fund and GICs. While Money Market is pretty straightforward, I am not exactly sure how to incorporate the GIC’s at this stage of the RESP journey. Can you please provide some advice on his? Thanks for the great posts!
For those of you new to these acronyms, a GIC stands for Guaranteed Income Certificate and will provide you a slightly higher interest rate than savings accounts, but with the condition that you keep the money locked in for a specific time period. Some GICs will allow you to withdraw early but will come with a penalty.
An RESP stands for Registered Education Savings Program (my article with RESP details) and is a way for parents to invest in their children’s future education. Contributions are after-tax (ie. no tax refund), but the account grows tax-free. While withdrawals are taxable, they can be taxed in the student’s hands. So essentially, providing the student has little income while they are in post-secondary, the withdrawals will face very little tax.
The icing on the cake is receiving the government matching grants on contributions. Essentially, the government will top up your contribution by 20% to a maximum of $500. Doing the math, that means contributing $2,500 into an RESP will result in receiving the maximum $500 grant from the government.
Related: Low-Cost Discount Brokers for RESPs
Asset Allocation and Reducing Withdrawal Risk
Investing within an RESP is similar to investing within an RRSP, but with a compressed timeline. With a traditional RRSP timeline, you have 40+ years to invest and compound, then another 30 years of decumulation. The longer timelines allow for some flexibility if mistakes are made.
A traditional RESP, on the other hand, only allows for 17 years of portfolio compounding, then only 4-5 years of decumulation to pay for tuition (if you have a family RESP, any excess can be used by a sibling and stretched out longer). The relatively short timelines leave little wiggle room, which means a major market correction combined with large withdrawals could simply mean not having enough money in the RESP to complete a degree (see my article on the sequence of returns).
In saying that, it’s a high priority to protect against market volatility while the student is in post-secondary. To do that, the main idea is to reduce or remove market exposure.
Here are a few ways to obtain a return without equity exposure.
- Go to Bonds – While bonds are known to be less volatile than equities, they can still bounce around. For example, popular iShares XBB fell 7.7% from June 2016 to the end of 2018. On a $50,000 RESP balance (like for my daughter), that would $3,850 less to spend on tuition and books. However, since then, XBB has recovered 6.7% which is fine during the accumulation phase, but the drop would have hurt during withdrawal time.
- Go to Cash – To be 100% safe from volatility, the best bet would be to go to cash. While cash earns very little, this can be offset by small interest offered by money market funds, or if you are willing to lock in your money for a higher interest rate, the use of GICs and/or stacking them to create a GIC ladder. More on this in the section below.
- Combination of Cash and Bonds – If you would like to take a little more risk to try to squeeze out the extra return, consider a combination of cash and bonds. The more comfortable you are with risk, the higher your bond allocation. Personally, if I need to withdraw money from the account over the next 4-5 years, then I’m going to cash.
Using a GIC Ladder
As mentioned above, one of the surest ways to ensure that the money will be there when you need it is to go to cash. While cash will not grow like the market over the long-term, there are ways to maximize short-term cash savings.
When the student starts post-secondary, the RESP will need to last as long as possible, hopefully for the term of the degree (4-5 years). Since money is needed annually, it would make sense to have cash available in 4-5 tranches. This is where a GIC ladder can come in handy.
A GIC ladder is where you split your capital into equal portions and invest in GICs with variable terms/maturities (from short to long term). As each term expires, the released cash is used or re-invested into a longer term.
- 1 year: 2.55%
- 2 year: 2.65%
- 3 year: 2.70%
- 4 year: 2.75%
- 5 year: 2.90%
Say that you have a $40,000 in cash that is ready to be deployed towards post-secondary education (or other education that qualifies), and each year requires $10,000. Assuming a 4-year degree, the initial $10k will need to stay liquid to pay for initial expenses. However, the remaining $30k can be put into GICs to maximize the return with minimal risk.
The GIC ladder would look like:
- 1-year GIC: $10,000 ($10,255 value at maturity)
- 2-year GIC: $10,000 ($10,537.02 value at maturity)
- 3-year GIC: $10,000 ($10,832.07 value at maturity)
While not a huge gain, this example resulted in an extra $1,625.09 which is perhaps enough for a few sets of textbooks. Not a bad return for minimal effort and risk.
Since spending an RESP balance usually occurs over a short 4-5 year time frame, it’s important to keep the volatility of the portfolio to a minimum (market drop early in the withdrawal phase could be disastrous). Volatility can be mitigated by going to cash during this phase. However, going to cash doesn’t necessarily mean a 0% return over the next 4 years. Creating a simple GIC ladder can result in maximizing your cash (see example above) while ensuring that the money will be there when you need it.If you would like to read more articles like this, you can sign up for my free weekly money tips newsletter below (we will never spam you).