Retirement Planning: Choosing the right investment vehicle to help you reach your goals
Retirement Planning: Choosing the right investment vehicle to help you reach your goals
June, 2020
Focusing on your long-term goals and accepting some market volatility may lead to improved investment outcomes over time.
Focusing on your long-term goals and accepting some market volatility may lead to improved investment outcomes over time.
It is common for investors to be nervous with volatility in the markets. This is especially common in younger investors who are just starting their investment journey, or more seasoned investors who are approaching or are already retired. Many investors focus on avoiding the possibility for their investments to decline temporarily in value during corrections, an idea known as market risk. However, we must also be aware of a competing risk that offers just as large a threat to your overall financial health, and that is inflationary risk. In a nutshell, inflationary risk denotes the tendency for each dollar you save to be able to purchase slightly less each year it is held. In other words, if you were to stumble upon $50 in an old jacket that you had not worn in twenty years, you could purchase significantly less with that $50 today than when you earned it two decades ago. Therefore, a successful investor is one that balances the risk of market volatility with the long-term need for growth in your investments. Determining what the appropriate balance should be for you necessitates keeping an eye on your timeline.
It is common for investors to be nervous with volatility in the markets. This is especially common in younger investors who are just starting their investment journey, or more seasoned investors who are approaching or are already retired. Many investors focus on avoiding the possibility for their investments to decline temporarily in value during corrections, an idea known as market risk. However, we must also be aware of a competing risk that offers just as large a threat to your overall financial health, and that is inflationary risk. In a nutshell, inflationary risk denotes the tendency for each dollar you save to be able to purchase slightly less each year it is held. In other words, if you were to stumble upon $50 in an old jacket that you had not worn in twenty years, you could purchase significantly less with that $50 today than when you earned it two decades ago. Therefore, a successful investor is one that balances the risk of market volatility with the long-term need for growth in your investments. Determining what the appropriate balance should be for you necessitates keeping an eye on your timeline.
To illustrate the above point lets discuss an example of a young couple, 30 years of age, who would like to begin saving for retirement. The couple decides that they would like to have $65,000 of income for retirement (in today’s terms) and plans to contribute $12,000 per year, or $500 per month each, into their retirement fund. Lastly, the couple would like to retire and begin receiving CPP and OAS payments at the age of 65.
To illustrate the above point lets discuss an example of a young couple, 30 years of age, who would like to begin saving for retirement. The couple decides that they would like to have $65,000 of income for retirement (in today’s terms) and plans to contribute $12,000 per year, or $500 per month each, into their retirement fund. Lastly, the couple would like to retire and begin receiving CPP and OAS payments at the age of 65.
The first step in helping this young couple plan for their retirement is establishing a target amount that they will need to save for retirement. Note that the amount that they will need to sustain a level $65,000 income until at least age 100 decreases with each year that they work as this will be one less year that they need to draw an income from their investments. Also note that in order to maintain a lifestyle equivalent to what they would have with a $65,000 income by today’s standards, inflation will increase the actual income they need to withdraw with each passing year. The final factor we need to consider when anticipating how much the couple will require for retirement will be their choice of investment vehicles.
The first step in helping this young couple plan for their retirement is establishing a target amount that they will need to save for retirement. Note that the amount that they will need to sustain a level $65,000 income until at least age 100 decreases with each year that they work as this will be one less year that they need to draw an income from their investments. Also note that in order to maintain a lifestyle equivalent to what they would have with a $65,000 income by today’s standards, inflation will increase the actual income they need to withdraw with each passing year. The final factor we need to consider when anticipating how much the couple will require for retirement will be their choice of investment vehicles.
For all individuals, the choice of investment vehicle holding your retirement funds after you retire is extremely important. Ideally, you do not want an investment that will be subject to large variability in the markets, but you also need to choose an investment vehicle with enough upside potential to sustain your anticipated needs. As you can see in figure one, the choice of a high-interest savings account (at today’s rates, approximately 0.3% interest per year) would necessitate a much larger retirement fund than if the couple chose a series of 5-year GICs (about 1.8% annual return at today’s rates). However, if the couple were to accept some market variability by investing in a conservative fixed income focused mutual fund (yielding an average 4% annual return) the couple would need to save significantly less than either of the above options. Please note that the above applies to all individuals, and a similar graph with the same relative shapes could be generated for individuals of any age.
For all individuals, the choice of investment vehicle holding your retirement funds after you retire is extremely important. Ideally, you do not want an investment that will be subject to large variability in the markets, but you also need to choose an investment vehicle with enough upside potential to sustain your anticipated needs. As you can see in figure one, the choice of a high-interest savings account (at today’s rates, approximately 0.3% interest per year) would necessitate a much larger retirement fund than if the couple chose a series of 5-year GICs (about 1.8% annual return at today’s rates). However, if the couple were to accept some market variability by investing in a conservative fixed income focused mutual fund (yielding an average 4% annual return) the couple would need to save significantly less than either of the above options. Please note that the above applies to all individuals, and a similar graph with the same relative shapes could be generated for individuals of any age.
Now that the first step is completed and we have a retirement savings target for each investment vehicle, we can now assess the couple’s options for the growth phase of their retirement funds. Figure 2 shows the couples overall portfolio growth if they choose to save for retirement in either a High Interest Savings Account (HI) or a series of 5 year GICs (GIC). In either case this is graphed against the target for retirement pools for each investment type we established in figure 1. The point at which the growing retirement savings graph crosses its decreasing Target Portfolio is the point at which this couple could afford to retire while sustaining their current lifestyle until age 100. If the couple were to save for retirement solely in a high interest savings account, they would not be able to afford to retire while maintaining their current lifestyle until 94 years of age. Alternatively, investing in 5-year GICs (GIC) would allow the couple to retire slightly earlier at approximately 89. While both investment options provide safety, unfortunately neither would allow this couple to achieve their stated goal to retire in their mid-sixties.
Now that the first step is completed and we have a retirement savings target for each investment vehicle, we can now assess the couple’s options for the growth phase of their retirement funds. Figure 2 shows the couples overall portfolio growth if they choose to save for retirement in either a High Interest Savings Account (HI) or a series of 5 year GICs (GIC). In either case this is graphed against the target for retirement pools for each investment type we established in figure 1. The point at which the growing retirement savings graph crosses its decreasing Target Portfolio is the point at which this couple could afford to retire while sustaining their current lifestyle until age 100. If the couple were to save for retirement solely in a high interest savings account, they would not be able to afford to retire while maintaining their current lifestyle until 94 years of age. Alternatively, investing in 5-year GICs (GIC) would allow the couple to retire slightly earlier at approximately 89. While both investment options provide safety, unfortunately neither would allow this couple to achieve their stated goal to retire in their mid-sixties.
With the capital guaranteed options above not providing a large enough growth potential for this couple to reach their goals, they may want to consider accepting some market risk that would provide a larger growth potential over the long term. For the next example we can examine how three different market investments may perform over the long term: a portfolio primarily composed of conservative fixed income (FI) investments with a 4% average annual return (AAR), a portfolio with a balanced mix of fixed income and equities (Bal) that would have slightly higher variability but also higher growth potential (6% average return), or a portfolio based around equities (Eq) that would have the largest exposure to market variability but also the largest growth potential over their 30 year time horizon (8% average return). The graph in figure 3 shows similar curves as above, but now matched against only one curve assuming the couple will invest in a conservative fixed income mutual fund once they retire.
With the capital guaranteed options above not providing a large enough growth potential for this couple to reach their goals, they may want to consider accepting some market risk that would provide a larger growth potential over the long term. For the next example we can examine how three different market investments may perform over the long term: a portfolio primarily composed of conservative fixed income (FI) investments with a 4% average annual return (AAR), a portfolio with a balanced mix of fixed income and equities (Bal) that would have slightly higher variability but also higher growth potential (6% average return), or a portfolio based around equities (Eq) that would have the largest exposure to market variability but also the largest growth potential over their 30 year time horizon (8% average return). The graph in figure 3 shows similar curves as above, but now matched against only one curve assuming the couple will invest in a conservative fixed income mutual fund once they retire.
The fixed income portfolio will minimize market variability, but may also give the couple fairly modest average returns. With an average 4% average return, the couple would meet their retirement objective at 77 years of age, clearly better than the capital guaranteed options above, but still not meeting their goals. However, holding a mix of fixed income and equities in the balanced portfolio may allow this couple to retire as young as 68 while meeting their needs for a sustainable income, much closer to their stated goal of retiring at 65. Lastly, if the couple were to invest in an equity weighted portfolio earning an average of 8%, they could possibly retire as early as 62; providing some flexibility for this young couple.
The fixed income portfolio will minimize market variability, but may also give the couple fairly modest average returns. With an average 4% average return, the couple would meet their retirement objective at 77 years of age, clearly better than the capital guaranteed options above, but still not meeting their goals. However, holding a mix of fixed income and equities in the balanced portfolio may allow this couple to retire as young as 68 while meeting their needs for a sustainable income, much closer to their stated goal of retiring at 65. Lastly, if the couple were to invest in an equity weighted portfolio earning an average of 8%, they could possibly retire as early as 62; providing some flexibility for this young couple.
One could certainly ask how the above compares to what we might see in real-life market growth over time? In figure 4 you will see real world historical growth charts for four different top quartile mutual funds that we commonly recommend, and a fifth GIC curve using current interest rates. Over the last market cycle, despite eight different market corrections of 10% or more (shaded bars in figure 4), a pattern emerges whereby the more market volatility you are willing to accept, the more your investments would have grown, with the highest risk growth equity fund on top, the lowest risk fixed income fund growing the less than other funds, and the “secure” GIC growing least of all.
One could certainly ask how the above compares to what we might see in real-life market growth over time? In figure 4 you will see real world historical growth charts for four different top quartile mutual funds that we commonly recommend, and a fifth GIC curve using current interest rates. Over the last market cycle, despite eight different market corrections of 10% or more (shaded bars in figure 4), a pattern emerges whereby the more market volatility you are willing to accept, the more your investments would have grown, with the highest risk growth equity fund on top, the lowest risk fixed income fund growing the less than other funds, and the “secure” GIC growing least of all.
For many investors it is therefore beneficial to accept some market risk and incorporate some mix of equities and fixed income that may provide a better growth potential than a strict capital protection approach, even during market corrections. This demonstrates one of the most important rules of investing: starting to save early and focusing on your long-term goals instead of short-term market fluctuations will generally lead to improved investment outcomes. We would even recommend against checking your investment account too often. Many investment professionals recommend checking your portfolio at most once a month, or even once a quarter1. Checking your account too often can lead many investors to feel increased anxiety when they see day-to-day market variability, and this may motivate them to alter their investment mix at suboptimal moments in time. Rather, if you get in the habit of checking your account at 2-3 month intervals and focus on progress since inception you will be more likely to see what’s most important—steady growth of your investments over time as you work toward your goals.
For many investors it is therefore beneficial to accept some market risk and incorporate some mix of equities and fixed income that may provide a better growth potential than a strict capital protection approach, even during market corrections. This demonstrates one of the most important rules of investing: starting to save early and focusing on your long-term goals instead of short-term market fluctuations will generally lead to improved investment outcomes. We would even recommend against checking your investment account too often. Many investment professionals recommend checking your portfolio at most once a month, or even once a quarter1. Checking your account too often can lead many investors to feel increased anxiety when they see day-to-day market variability, and this may motivate them to alter their investment mix at suboptimal moments in time. Rather, if you get in the habit of checking your account at 2-3 month intervals and focus on progress since inception you will be more likely to see what’s most important—steady growth of your investments over time as you work toward your goals.
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