I recently received a question from Rachel, a reader here at Invest It Wisely, and with her permission I am publishing the question here so we can get feedback from fellow readers and bloggers.
Rachel is concerned about her mom’s retirement. Her mother is self-employed and has no other relatives to lean on other than Rachel and her brother. They have been pooling their money to help ensure their mom’s safe retirement, but they are unsure of what the next step should be. How can they safely and securely invest their money to assure a safe retirement for their mother?
Saving securely for the future
Canada is well-known for having some of the highest mutual fund fees in the world. Rates can be upwards of 3% when you go with a financial advisor, and you also need to watch out for back-loaded fees, which is an additional fee you get slapped with if you decide to transfer your funds before a certain time period has passed.
What are the alternatives?
- Real Estate?
The Canadian housing market is high, so I am not sure about real-estate. I do believe that stocks and commodities can be a good investment, if invested in a diversified manner and with a long time horizon in mind.
Index funds as the core
I personally believe that low-cost index funds are the best strategy for long-term growth. If you are an advanced investor or own your own mutual fund, you might be able to achieve more growth by following a different strategy, but it’s pretty hard to beat an index fund by trusting someone else to manage your money for you.
The evidence is simply not there. My fellow blogger and friend Andrew Hallam has tried to educate us on this point again and again; actively managed mutual funds tend to underperform for various reasons, including but not limited to the following:
- Taxation. Increased trading from mutual funds may decrease returns and increase your personal tax liability.
- Returns-chasing. Because active funds trade a lot more than passive indexed funds, they lose more of their capital to brokerage and trading fees.
- Survivorship bias. Mutual funds seem to perform better because you don’t read about the ones that no longer exist.
It comes down to simple mathematics: If an actively managed fund charges you 2% to 3%, and an index fund charges you 0.5% or less, and they invest in the same companies, then it’s going to be really tough for that active fund to outperform the index fund.
That 1%-2% difference compounds year after year. You can end up forking over a huge portion of your gains to your mutual fund company over a long enough period of time, simply by paying an additional 2% in fees every year! Unfortunately, as a Canadian, we don’t have access to the best low-cost index funds like Vanguard, but there are decent options out there.
One needs to be invested for the long-term
When you are investing in the markets, I do believe you need a time horizon of at least 20 years or longer to really see the fruit of your gains. Imagine someone that had started investing in the 1920s. They would have suffered immensely through the Great Depression and World War 2, but if they stayed strong and continued investing through these years, they would eventually have done well for themselves.
The important factor here is that these returns are realized to those who stick for investing in the long run. It takes up to 20+ years or more to really see the benefits of a long-term investment plan. You have to consistently invest every month, and you can’t give up hope when there is a big market crash. In fact, if you are still far from retirement, a market crash is good for you because you can buy more equity at a cheap price! You only really want the markets to be high when it’s time to start selling your shares.
Diversifying to reduce risk
A common rule of thumb is to invest your age as a % in bonds, and the rest toward equities. For example, if Rachel’s mother is currently 45 years old, then they would allocate their investments as follows:
If they invest $1,000 every month, then $450 should be put into the bonds, and $550 should be put into equity.
Over the course of time, changing valuations will affect your portfolio. For example, let’s say that over 5 years, stocks rise and bonds stay around the same. Then your ratios might look like this:
Rebalancing should be done at least once a year to bring ratios back into line. After five years, Rachel’s mother would be 50 and would want a 50/50 split. She should focus her future investments on bonds, and possibly sell some of her equity in order to buy bonds.
Why does this work?
You wouldn’t normally do this when dealing with individual companies. Imagine if you kept plowing more money into Enron as it fell. That would be a recipe for disaster.
However, when you deal with the overall market, the picture is different. The market as a whole is in relatively undervalued and overvalued states, depending on the bubble of the day. By rebalancing, you shift your money away from where assets are overvalued toward where they are undervalued. It is debatable whether this increases overall returns irrespective of risk, but there is a strong case to be made that this increases your returns for the same level of risk. Michael O’Higgins writes more about this in his book, Beating the Dow with Bonds: A High-Return, Low-Risk Strategy for Outperforming the Pros Even When Stocks Go South.
What can Canadians invest in?
The picture is slowly improving for Canadians. Your financial advisor probably won’t tell you about these options, but the landscape is improving.
Here are some funds you can look at that have decent management expense ratios:
If you were doing 40% bonds and 60% equity, you could allocate an investment of $1,000 a month as follows:
$300 –> Canadian Index Fund
$300 –> International Index Fund
$400 –> Canadian Bond Index Fund.
Retirement tax planning
There are three main choices for Canadians:
- RRSPs (Registered Retirement Savings Plans): Get a tax refund now, pay income taxes later.
- TFSAs (Tax Free Savings Accounts): Pay taxes now, pay no taxes later.
- Unregistered: Pay taxes now, pay capital gains or dividend income later.
My Own Advisor goes into more detail in his post “I’ll maximize my TFSA first, thanks“.
The investment decision will depend on Rachel’s mother’s income position:
- What tax bracket is she in now?
- What tax bracket does she expect to be in when she retires?
Readers, I’m unclear of what the tax impact would be if Rachel and her brother are providing the funds for her mother’s retirement. What are your thoughts on this?
How do you calculate how much income your mom can get on her investments?
I used this compound interest calculator to come up with a reasonable estimation: http://www.
Let’s say they invest $1,000 a month for 25 years out, compounded at 5%. After 25 years they will have $597,991 (actual results will vary, but let’s say this is the middle range).
I then recommend withdrawing no more than 3% to 4% per year. This is what I call an “infinite” portfolio. This means that her mother could safely withdraw $18,000 – $24,000 a year in retirement income for the rest of her life, if her and her brother save $1,000 a month. If they save $500 a month, her mother will end up with $298,995 which would be good for $9,000 – $12,000.
Keep in mind that these are real figures, so inflation is already taken into account. Her mom will also be eligible for OAS and CPP on top of this. If she gets an additional $6,000 a year in OAS and $6,000 a year in CPP, and her children saved $1,000 a month for her, then she could enjoy an inflation-adjusted income of $30,000 – $36,000 in retirement, and even if the government partially or fully reneges on these promises, she will not be totally left in the lurch. This is not a huge income, but it’s more than enough to live comfortably. With the infinite portfolio strategy, her income will also rise in real terms, year after year, over the long run.
What about if you’re close to retirement?
The closer her mom is to retirement, the more variance there will be. To help compensate for this variance, the proportion of funds in bonds will increase, but this may also have the impact of lowering returns. A strategy of laddered GICs and CDs can be used, depending on the CD rates and GIC rates. If they only have 10 years to retirement, they might end up with a portfolio amount between $140,000 and $175,000 by retirement time. With the infinite portfolio strategy, they would be able to safely withdraw $4,000 to $7,000 per year. This doesn’t seem like much, but it’s actually still a very big help because it’s almost like getting an extra OAS or CPP cheque! In addition, even with the withdrawals, should they continue contributing to the fund in her mom’s retirement, her income will still rise in real terms.
By the time she’s in her mid 70s, the portfolio balance could be between $280,000 and $375,000. This would allow withdrawals in a range of $8,000 – $15,000. With the addition of OAS and CPP, as well as additional cash from the sale of her primary home, this would be enough to afford a decent retirement home, should the day come when she can no longer be fully independent.
Please keep in mind all figures here are in real-terms, so they are already adjusted for inflation. In addition, there is always the chance of variance and reduced returns. That is why I like an infinite portfolio strategy, because if you plan to live on the lower income ranges, you can survive through these periods of low returns. If things go better, then the extra income is just a blessing.
If Rachel’s mother’s health and inclinations allow, she might want to become a landlord during the first few years of her retirement. The housing market in Canada is currently high, but things might change in 10 years. There might be some really good rental options, and saving money now will help give her the flexibility to take advantage of that opportunity.
I think it’s very commendable and honourable that Rachel and her brother want to help their mom save for their retirement. Dear reader, what would you recommend? Please help a fellow reader out, and let us know what your strategy would be. We would appreciate it very much.
P.S. Happy Spring!