The new rules of saving

Forget buy and hold. Saving enough to retire today takes a more active approach and a few new tools.

(Photo: Carl Pendle/Getty)

When Warren Mackenzie listens to his baby boomer clients, the same archaic strategies around saving for retirement come up. Despite the financial crisis and its aftermath, their knowledge of investing is stuck in the past. “People have largely been shaped by what happened in the 1980s and ’90s, where everyone expected 10% returns,” says the president of Toronto’s Weigh House Investor Services and author of New Rules for Retirement. That, he says, is a big problem. These days, people are lucky if they get a 6% return. If Canadians don’t adjust their expectations and their investing tactics to account for slower growth and a longer life, their retirement savings will fall short. “People need to be more careful,” he says. Investors must throw out a few ingrained ideas, like buy and hold and de-risking in old age, and adopt some new strategies if they want to live comfortably into their 90s.

1. Be prepared to sell
Buy-and-hold investing gained in popularity in the 1990s, when stock markets were soaring. That decade, the S&P/TSX composite index climbed a whopping 112%. It made no difference if you reviewed your investments or not; everything went up. However, buy and hold, says Mackenzie, “is not a valid thing at all” in the years since. He points to Japan, where the Nikkei index hit about 40,000 points in the 1990s; today’s it’s 9,500. “Imagine being a retiree in Japan and buying and holding,” he says.

Instead of buying funds and leaving them alone, many investment experts now recommend taking a more active approach to a portfolio. Ken Solow, chief investment officer at Columbia, Md.–based Pinnacle Advisory Group, and author of Buy and Hold is Dead (Again), says simply rebalancing a portfolio once a year can add 50 to 80 basis points of extra return to investments.

But to get more value out of your portfolio, investors need to take a step further and buy and sell more frequently. “We call it tactical asset allocation,” says Solow. “You’re making changes to asset allocation based on what you see in the world.”

He recommends following three steps. The first is the market cycle. Form an opinion on whether the market is expanding or contracting. “If you can get where we are in a market cycle, then it will help you manage risk a whole lot better than just diversifying,” he says. If you think the economy is contracting, buy non-cyclical sectors such as consumer staples. If you think stocks will outperform, buy riskier assets.

Then look at whether or not the market is overextended, he says. Ask yourself if there’s been a run-up in equity markets. If so, it may be time to sell some stocks and shift money into cash or bonds. Finally, look at metrics such as price-to-earnings, price-to-sales and dividend yields to see if markets are cheap or expensive. (Buy what’s cheap; sell what’s expensive.) Put everything together and determine where the balance of your money should go.

2. TFSA vs. RRSP
Investors have been told, over and over again, to put as much money as they can in registered retirement savings plans. That was wise advice years ago, when people made less money and stopped working at 65. But these days, says Mackenzie, many people may be better off saving in a tax-free savings account instead.

The appeal of RRSPs is that you’re only taxed when you withdraw. And by that time, you’ll no longer be working, the thinking goes, so you’ll be taxed at a lower bracket. At 71, Canadians are forced to withdraw money from their registered account. If they’ve saved up a large nest egg, or are still bringing in income—either through a job or pension—they could be forced to pay the top marginal tax rate (46% in Ontario, for example). Not only that, their Old Age Security payments will be clawed back.

Using a TFSA won’t give you a tax break when you add money to the account, but the investments still grow tax-free. This strategy arrives too late for today’s boomers, unfortunately. You can only put a maximum $15,000 into a TFSA now (2011 being the third year of the program), but every year that room increases by $5,000. A 30-year-old today, therefore, will have $175,000 of room by age 65, and can withdraw whatever that grows to without declaring the income on it or worrying about OAS clawbacks. It makes sense to max out your TFSA before you do your RRSP room, therefore, if you think you’ll retire rich. “The problem is that people never know for sure,” says Ted Rechtshaffen, president of Toronto’s TriDelta Financial.

3. The three-basket portfolio
If investing mostly in equities makes you nervous, consider Serge Pépin’s approach. The head of BMO Investments also thinks the 60/40 ratio is outdated. Instead, he suggests separating your portfolio into three parts that feed into each other. Put 20% or 30% of your money into GICs or government bonds to fund your immediate needs, like paying a mortgage and buying food. Then invest anywhere between 10% and 80% in conservative, dividend-paying stocks. This is the “capital preservation” basket, says Pépin. Put the income you generate from the second basket into the GIC account, so your first basket is constantly replenished.

Finally, deposit the rest into growth-oriented stocks. “These are pure equity plays,” he explains. It could mean going into a Canadian equity growth mandate, buying emerging markets, or playing with even riskier assets. Ultimately, you’ll move gains from basket three to buy more stocks in basket two, which then gives you more dividend income to add to your immediate-needs bucket.

4. More ways to trim taxes
One key to wealth creation, regardless of asset class or investing strategy, is mitigating taxes. Usually, when investors move money out of one non-registered fund and into another, they have to pay capital gains. To alleviate that problem, fund companies created a “corporate class” structure, which lets people move between funds without triggering gains. Almost all mutual fund companies offer this option, and most of the same funds can be bought inside or outside a corporate class arrangement.

According to Mackenzie Investments, if you invested $100,000 in a corporate class fund that earned 6% a year, you would have $370,268 after 25 years, assuming it’s taxed annually at the top marginal rate. If you held an interest-paying investment over the same period, you would have made $239,841. “When you leave that corporate structure, you will pay the piper,” says Pépin, “but until that happens you won’t have to pay tax.” In some ways, it’s like an RRSP; you only pay when you withdraw, which means your investments can grow tax-free. This is why it only makes sense to put non-registered investments in corporate class funds.

5. Forget the 60/40 rule
For years, the generally accepted rule for working-age Canadians was to put 60% of assets in equities and 40% of assets in bonds, and then move the allocation to bonds and away from equities the closer you got to retirement. But Rechtshaffen argues the equation doesn’t make sense anymore. He says that if you can get only a 2% return on bonds—rates we’re seeing today—and 5.5% yields on blue-chip stocks like BCE, it makes sense to overweight stocks, no matter what your age. Rechtshaffen’s not advocating people jump into risky buys. But purchasing stable, dividend-yielding equities will go a longer way than owning low-paying fixed-income assets.

Also, consider how much money you’ve already saved. “The classic example is an 86-year-old with a $3-million portfolio that’s invested 100% in guaranteed investment certificates

(GICs) because he’s a nervous investor and was told he shouldn’t take risk,” says Rechtshaffen. That approach, he says, is self-centered. Most of his money will go to his children, so he should try and grow those assets. “The older you get, and the more money you have, the less your age should apply to how you invest,” he says.

6. Cut your fees
In a low-return environment, cost-efficient investing should be a priority. If your investments are making only 6% returns, paying 2% to an investment professional will significantly reduce your savings, says Mackenzie. Consider buying exchange-traded funds instead of mutual funds. With an ETF, you’re usually buying an index, not an actively managed basket of funds, so you effectively subtract the cost of paying a portfolio manager from your fees. Costs can be 1% to 2% lower than for mutual funds.

According to Horizons Exchange Traded Funds, if you invest $100,000 for 15 years in an ETF with a 0.7% management fee, versus a mutual fund with a 2.25% fee, and get a 10% return on both, you’ll make $83,801 more with the ETF. You’d have paid $128,524 in fees for the mutual fund, and only $44,723 for the ETF.

This doesn’t factor in transaction costs, however. ETFs are generally for do-it-yourself investors, so every time you buy and sell these products at a discount brokerage you’ll be hit with a fee. Depending on the size of your portfolio, these fees could eat into your return.

If you’d rather let someone else handle your investments, make sure to negotiate fees. “You can negotiate commission on a single security stock or a managed portfolio,” says Cindy Davis, vice-president of estate planning at Raymond James. “You can negotiate on anything really.” Try and get fees down to 1.5% a year, she says, and do not pay a commission on fixed income.

7. Insure your parents
It sounds morbid, but young Canadians who want some significant cash in their golden years should take out an insurance policy on aging parents. “You get a great rate of return,” says Davis. “High single-digit if not double-digit territory.” Insurance isn’t taxed, so when the parents die, the children get a nice lump sum without having to shell out half to the government.

It’s 30-year-olds with healthy, 60-something parents who should consider this strategy. Premiums on boomers can be affordable—about $245 a month to insure a 60-year-old for $250,000. Ideally, parents will pass away in their 80s or 90s, so the financial windfall will come just as their children are ready for retirement.

Keep in mind that this is an illiquid investment. The money comes only when parents die, and you don’t know when that will be. Make sure to have other investments that can be easily cashed out in an emergency situation, says Davis.

While there are numerous other investment strategies people can use to prepare for old age in the 21st century, it’s important to know that the retirement rules have changed and will continue to change. You should be thinking about your golden years right now, so you’ll be ready for your last payday. “There’s only one thing you want to think about when you retire,” says Pépin. “When’s the next golf game?”