Before you begin choosing your individual investments you need to consider your asset allocation.
Asset allocation is your portfolio’s blend of stocks, bonds and cash. Finding the best asset mix is crucial if you want to meet your goals.
Rules of thumb
A typical balanced asset allocation is 40% fixed income and 60% equities.
A common rule of thumb is that a retirement portfolio should have a percentage of equities equal to one hundred minus your age, and the rest in fixed income investments. Recently that rule has been updated to 120 minus your age.
The trouble with averages and rules of thumb is they provide only general information. They are not tailored to your specific needs.
Calculators to get you started
There are a variety of online calculators, such as bankrate or smartasset, which are designed to help you create a balanced portfolio of investments by determining your optimal asset mix. Since they use your age, ability to tolerate risk and other factors, they can be a good place to start your analysis.
Related: Fun with calculators (and other online financial resources)
Most calculators are set up to assist you with retirement needs, but they can be used for any medium to long-term goal.
Once you’ve decided on your goal, you only need four other pieces of information:
- How much money you need for your goal.
- The number of years until your goal is reached.
- How much you can invest right now (or have invested already).
- How much you can contribute each month.
Limitations of asset allocation tools
If you use several different online asset allocation tools, you may get as many different recommendations for what your asset mix should be. That’s because every tool uses a different set of assumptions, for example inflation rates or returns for each asset class. Some calculators let you put in your own figures for these.
You may find your goal is unattainable with the inputs you submitted. You can play around with the figures, but be very careful about the assumptions you are making, or increasing your weightings in equities to increase returns.
As with rules of thumb, calculators offer general information. For example, someone with stable employment, a generous pension plan and no heirs will likely choose a less conservative asset allocation than a freelancer with three preschoolers, even if the other figures are the same.
Related: The real cost of investing
When I used Bankrate, my recommendation was 25% cash/ 26% bonds/ 49% stocks. I may be a bit more aggressive than others my age because this seems too conservative to me. Personally, I would not hold that large of an amount in cash unless I had some purpose in mind.
Rethinking your risk tolerance
Many of our investment decisions are based on our comfort with taking risks and the right balance of investments for each stage in your life.
People tend to be over optimistic about returns and their own risk tolerance.
When determining risk tolerance try to do so from a long-term perspective. Many of us are influenced by recent events: taking a too conservative approach when markets are volatile and being too aggressive after a long positive stretch.
You also need to think about the likelihood of your needing to withdraw your investments for any reason in the future. This is tough because you just don’t know what the future brings.
Final thoughts
Finding the right mix of investments is an essential part of reaching your financial goals, whether you are just starting to invest and retirement seems far way, or you will need your money in the next few years.
But don’t stop there. Revisit your portfolio at least once a year. Normally your asset mix won’t change from year to year, so you can rebalance your existing investments back to your desired allocation, or adjust future contributions appropriately.
Once your situation changes – getting closer to your goal, for example – you need to adjust your holdings. You can see how asset mixes change in target date mutual funds (also known as life-cycle funds) for a good ballpark. Select the profile that most reflects you.
Less than one-quarter of Canadians contribute the maximum to their RRSP each year, but if you’re one of those keen savers you’ll want to pay close attention to your RRSP contribution limit to avoid going over.
A blog reader named John realized he might be pushing his limit due to automatic monthly contributions and a generous employer-match. He sent an email and wanted to know his options for rectifying this situation:
Over-Contributing to RRSP
John: “I discovered that I am over-contributing on my RRSP this year. When I looked up this topic online I only found remedies for when you find out after the fact, i.e. at tax time. But what can I do if I’ve discovered this now?
Does my employer contribution (my employer doubles my contribution) count towards my contribution limit? Obviously I don’t want to give this up.
And, come March 2016, do I have to include my contributions for the first two months on my 2015 tax return, or can I leave these until the 2016 tax year?
If the answer to both is “no”, then I may be okay. But either way what would one have to do to correct this?”
Hi John, thanks for your email. My first question to you would be; do you have any unused RRSP contribution room from prior years?
Your RRSP contribution limit is 18% of your prior year’s earned income (to a maximum of $24,930 in 2015) minus any pension adjustment you receive from being a member of your company pension plan (if applicable), plus any unused RRSP contribution room carried forward from prior years. The amount is printed on your Notice of Assessment from Canada Revenue Agency (CRA), which you can also view online using CRA’s My Account.
Related: Should you make RRSP contributions if you have a pension?
You can contribute more than your limit, up to a $2,000 maximum overage, but anything beyond that is subject to a penalty of 1% per month. Contribute $1,000 more than the limit and pay a penalty of $10 per month, or $120 per year.
The contributions you make in the first 60 days of 2016 must be reported on your 2015 tax return, so no reprieve there. However, while the contribution must be recorded, you don’t have to claim a deduction that year – it can be carried forward to a future year.
While it’s great to take advantage of your employer’s generous offer to double your contributions, note that employer-matching contributions do indeed count towards your RRSP contribution limit.
Bottom line: Check your Notice of Assessment to determine your actual RRSP contribution limit. You can over-contribute by up to $2,000 without being penalized, however you cannot claim a deduction for the excess amount.
If you discover that you have over-contributed make sure to withdraw the excess amount as soon as possible. You’ll have to include the withdrawal as income on your tax return; however – according to H&R Block – you can claim an offsetting deduction as long as you do so within the required time frame and the following conditions are met:
- You reasonably expected to be able to claim a deduction for the contribution, either in the year you made the contribution or the year before; and
- You did not make the contribution with the intention of later withdrawing it and deducting the offsetting amount.
You can ask the Canada Revenue Agency (CRA) to certify the amount of the excess contribution using Form T3012A. The financial institution will release the funds without withholding tax with this certified form.
Related: 5 common myths about RRSPs
And if it’s clear that making contributions over the next four months will put you over your RRSP contribution limit then the obvious answer is to halt or adjust your contributions so that you do not exceed the limit and then make sure to modify your monthly contributions next year so that you don’t run into this situation again in the future.
If you have been following this series – and doing your homework – you should now have:
- Done some serious thinking and reflecting on what you want your retirement to look like. Where will you live? What kinds of activities will you participate in? What’s on your “Bucket List?” When will you begin?
- Have a good estimate of how much money you will need – in today’s dollars – for both your fixed expenses and the fun things you will do, without being too conservative in your spending projections.
- Figured out a fairly realistic approximation of how much you will receive from pensions and government benefits. We’ll call this guaranteed income.
This is a simple self-assessment of how you might stand as you look toward retirement.
- Your guaranteed income will cover both your fixed and variable expenses. You’re in good shape. Congratulations your retirement planning is largely done. You have the option of increasing your lifestyle spending, helping your family, giving to charity, or leaving a legacy.
- Your guaranteed income will cover at least your fixed expenses. This is a good situation to be in. Your investments will finance nice-to-have luxuries or provide a buffer against inflation. It’s a good idea to plan to use a bigger portion of your money for travel, etc. in the early years of retirement, when you’re going to be the most active and healthy enough to enjoy it.
- Your guaranteed income and variable income from your investments will cover your fixed and variable expenses. Figure out ways to cut costs as much as possible and leave some savings for emergencies. You might want to consider using a portion of your investments to purchase an annuity to increase your guaranteed income and protect your future by ensuring that your must-have needs are well covered. You can vary your nice-to-have expenses based upon how your investments perform.
- Your guaranteed and variable income will cover your fixed expenses. Eliminate any nonessential items and cut costs as much as possible, but you don’t want your retirement years to be all Brussels sprouts and no dessert. If this is your situation you have several options available to you. Delaying your retirement by working longer will increase your savings and maximize pension benefits. You might also consider working part-time in retirement.
Final thoughts
Don’t underestimate your income needs during retirement, but do take into consideration the evidence that, for most people, their spending tends to naturally decline as they age. The important exception to this trend is health-care costs, which tend to increase with age.
Calculate your must haves. You want to ensure you have enough to live on without feeling deprived of anything important to you. The amount you need may be a lot lower than you think – especially as a couple.
Budget for your dreams, but remember age takes its toll. Travelling or golfing every day may no longer be desirable once you hit 75 or so.
Be sure to balance the present and the future.