May 2, 2019
by Lana Sanichar
Beep beep beep. You reach over and push the snooze button. Beep beep beep. This time you reach over and slap it. When you wake up half an hour later, you realize that you’re late for work! Panic sets in.
Running around the bathroom, you’re putting on one pant leg and brushing your teeth at the same time. You eventually get the tie on and run down the stairs reaching for an apple (an apple a day keeps the dentist away?) as you run out the door until…wait for it. You stop dead in your tracks realizing that…you’re RETIRED.
It can be a shock to many when that day comes if they haven’t fully prepared themselves for the eventuality of retirement.
Retirement can be a scary prospect for many people who are left wondering if they took the necessary steps to ensure their retirement goals. If you haven’t already, you should be asking yourself these questions:
• Did I put enough money aside for my retirement?
• Did I invest my money properly to meet my retirement goals?
• How will taxation and fees affect my retirement?
You’re a dentist. You own your own business. Translation: unlike other employees who may have pensions, who belong to unions, or work for corporations, you’re funding 30 years of your retirement on your own.
Regardless of how you have chosen to fund your retirement, whether by taking a salary, with dividends or the sale of your business, let’s talk about the three items that have the most impact on our investment portfolios:
2. Taxes and Fees
The Eighth Wonder of The World: TIME
Why is time one of the most powerful tools that has an overwhelming effect on your portfolio? The answer is complicated. But to try and put it simply – it opens your portfolio up to the power of compounding interest.
Albert Einstein said, “Compound interest is the eighth wonder of the world”. The power of compounding interest can be hard to comprehend because it is not a linear relationship but exponential. What looks like small gains in the early days lead to very big amounts longer down the road. Interest that is earned in year one is added to the initial investment amount, which then earns more interest. The investor accrues interest on the initial investment, any subsequent contributions, as well as the interest already earned from the previous year.
This continues to compound every year for as long as you are invested! So, it is always better to begin investing as soon as possible to achieve the maximum effect.
Besides illustrating the power of compounding, this also illustrates the importance of starting your investment career as early as you can.
Let’s say you (Table A, above) begin investing at 25 with an initial investment of $10,000 and you are also contributing $200 per month until age 65. Your friend (Table B, above) also decides to begin investing at age 45, with a $10,000 initial investment and contributes $400 per month into their investments until the age of 65. Although your friend has doubled his/her investment contributions, your investment is worth $846,841 and his is worth $256,388, which is three times more because of the power of time.
Upwards of 62% of Canadians are not aware that advisors actually charge a fee to manage their investment portfolios (https://www.theglobeandmail.com/globe-investor/funds-and-etfs/funds/investing-is-as-opaque-as-ever-for-canadians-studies-indicate/article37672353/). Fees and management expenses on actively managed funds can substantially erode a portfolio’s return by tens of thousands of dollars and depending on what amount you have invested, even hundreds of thousands of dollars. Think about that for a second and let it sink in: Over half of Canadians do not even realize that they are paying for something, let alone something that can potentially amount to six figures by the time they retire.
Some of the most common fees and expenses associated with investment portfolios include:
• Management Expense Ratio (MER)
• Sales Commissions like a Front-End Load/Back-End Load also known as Initial and Deferred Sales Charges
• Trailing Commissions
Table 1 (next page) assumes that the management expenses and fees are 2.5%. By year 35, when you are likely thinking about retiring, you could be paying upwards of a whopping $169K+ in fees. If the total value of the portfolio is $392,313.75 after compounding interest/returns at 8%, then cumulative fees over the 35-year period amount to approximately 43% of the portfolio, or $169,193.72.
We have discussed fees and management expenses, and we now understand how compound interest works. Let’s put it all together. Table 2 (right) illustrates how a 2.5% management fee can erode that same portfolio over a 35-year period.
Fees can have a material impact on the benefits of compounding interest simply because there is less money in the value of the investment and so, the amount of the interest accrued is not as great. If we look at Table 3 under the heading Year 35, the value of the investment before fees is $392,313 but becomes $223,120 after fees. Fees total 43% of the portfolio! If you were to consider dropping the management expenses to 1%, you would keep a further $87,210.18 in your portfolio. Even a 1.5% drop in fees and management expenses would significantly increase your resulting portfolio value.
Fees are the number one reason why investors choose to begin investing for themselves. For example, a MER of 2.5% is substantial when you consider the average cost of an ETF averages around 0.20%. So, there are other options that can reduce fees and increase the returns in your portfolio.
We all know and understand the saying …”nothing can be said to be certain, except death and taxes” coined by Benjamin Franklin in a 1789 letter. This remains true 250 years later.
Without knowing it, every investment decision that we make will affect how we are taxed by CRA. With so many types of investments to consider including but not limited to registered and non-registered accounts, insurance and other types of investments like homes, rentals and cottages, tax planning can be complicated. You may find yourself asking question like:
1. How do I invest in inside my RRSP vs TFSA to minimize taxes? What about my non-registered investment account?
2. How will the sale of my rental property be taxed?
3. How can I most efficiently invest the proceeds from the sale of my business so that I maximize returns but pay fewer fees and taxes?
While saving is paramount to a well-funded retirement, what remains after taxation occurs while trying to maximize government programs like OAS and CPP is what you should really focus on. The draw down, as you move into the end of your working life, can be a daunting experience and it is essential that you and the professionals that work with you like your advisor and your accountant, work out a comprehensive plan well in advance of retirement that allows you to increase returns while minimizing taxes in an effort to create a steady income stream that takes into account your short-term and long-term retirement goals.
Don’t Carry Your Eggs All In One Basket
Diversification is an investment strategy that aims to reduce the overall risk of a portfolio by spreading investments around in various asset classes so that exposure to any one asset class is limited so as to reduce volatility. Here are just a few asset classes to consider: Stocks; Exchange Traded Funds; Domestic Investments; International Investments; Bonds; Cash; and Guaranteed Investment Certificates.
It is impossible to time the markets and it is not likely that every asset class will go up or down at the same time. That being said, those that increase in value will usually offset those that do not. The goal with diversification is to smooth out the returns of the overall portfolio as a whole.
A sound retirement plan is crucial to a happy and well thought out retirement, and this means efficient planning well in advance of that eventual day. Whether you are a Do-It-Yourself investor, have a financial planner or maybe a little bit of both, here are a few things to think about:
• It is important to consider your goals when you are creating an investment portfolio. How much money you think you will need will determine a lot, including how much you save and which account you save it in.
• Your time horizon. The investment portfolio of a 30-year-old individual who is focused on higher returns will look much different than that belonging to a 60-year-old, whose retirement is looming and is more interested in protecting assets and maintaining government income while withdrawing income in a tax-efficient manner.
• Understand your ability to accept risk. All investments come with some degree of risk. Generally, the more risk you can accept, the more aggressive your portfolio will be. But if you’re keeping yourself up at night worrying about your investments, then a more conservative portfolio might be better for you!
About The Author
Lana Sanichar is the Editor-in-Chief of Canadian MoneySaver Magazine and Co-host of the MoneySaver Podcast.