You need to spend some time figuring out how to get the most out of your savings. Here is a “back-to-basics” primer.
Time is Money
Time is the key to long-term growth. Look for investments with long-term growth potential within your risk tolerance.
Long term investing allows you the advantages of compounding. This happens when interest is paid on interest on fixed income investments or when you reinvest your dividends to buy more dividend stocks. Stay with your investments unless there is a significant change to it or to your own personal circumstances.
By the way, many people think that “long-term” stops at retirement age, but there can still be twenty-five years or more of earning potential after retirement. After all, you won’t immediately need access to all your money at age sixty-five.
Dollar Cost Averaging
Make a habit of investing even small amounts of money frequently. When you start budgeting, get into the habit of paying yourself first. When done consistently over time, you will be amazed at the results.
Regular automatic withdrawals from your account into the same investment accomplish two things. One, you buy more of the investment when prices are low and less when prices are high, thus smoothing out the cost. This is most often done with purchasing mutual funds but is also effective with a DRIP (dividend reinvestment plans) on your stocks.
Secondly, an automatic plan takes the emotional element out of investing. If you stick to plan you are not as likely to start worrying and cash out when the market hits a rough patch.
Diversification
Spread the risk around. No single investment works well under all economic conditions. Spreading your investments around reduces the impact of one poor performer in your investment portfolio.
A portfolio that combines all three asset classes – safety, income and growth – is considered a diversified portfolio and can hedge against changes in the economic cycles. You can diversify within asset classes to compensate for other risks. And you can diversify globally as well.
Foreign investing
Foreign investing can protect you against any downside economic changes in any one country and you can diversify among economies and markets that may behave differently from ours.
Global markets can also provide greater access to high-growth areas such as technology, health care and entertainment. One way to get more exposure to foreign markets is to invest through an ETF or mutual fund.
Maximize your RRSP and TFSA
Take advantage of your higher earning years to save the most and decrease your income tax burden whether by deferring tax in an RRSP or tax free investment earnings in a TFSA. Keep track of your contribution limits and try to catch up.
Take advantage of group RRSPs offered by your employer or association. Some generous employers match all or part of your RRSP contribution. Also, mutual funds purchased under a group plan very often have reduced management fees, further increasing your savings.
A spousal RRSP allows you to split your retirement income resulting in lower incomes taxes for both of you as money is withdrawn. It’s worthwhile to check to see if this will benefit you.
Review periodically
Evaluate your portfolio at least once or twice a year. You want to see how each investment is doing by comparing data from your previous review, looking at your growth rate and performance.
Is your asset allocation still balanced the way you want it to be? Has your time horizon changed? Or your life circumstances? Has your investment manager or objectives changed? How about fees? Even if you choose a “buy and hold” strategy you can’t just let it be, you still need to do an assessment.
So there you have it. I know you’ve heard it all before but sometimes when you get complacent and neglect to monitor your investments, or start heading off into different directions based on the latest “great opportunity” you hear about, it pays to get back to the basics of your plan and stay on course.
Defined benefit pensions have been in decline over the past two decades in favour of the defined contribution plan, where plan membership has doubled over the same time period.
What is a Defined Contribution Plan?
In a defined contribution plan, the employer specifies how much will be contributed to the plan on a regular basis. Investment of the funds is generally directed by the employees from a selection of investment options available within the plan.
This is similar to managing a personal RRSP. The amount a retiree will receive will vary based on the amount contributed and the performance of the invested funds over time. The defined contribution plan offers more flexibility for an employee than a defined benefit plan but puts all the investment risk on the employee.
The contributions made to your pension plan are tax deductible and accumulate on a tax-deferred basis. Each year your pension contributions, and your Pension Adjustment (PA), are reported to Canada Revenue Agency on your T4 slip.
Your PA estimates the dollar value of the pension you earned in a particular year (based on a formula under the Income Tax Act) and determines the amount, if any, that you can contribute to an RRSP. Canada Revenue Agency will advise you of the maximum RRSP contribution you can make each year.
Why do Employers Favour a Defined Contribution Plan?
According to a 2008 research study by CGA-Canada on the state of the Canadian pension system, the recent financial crisis along with a string of high-profile bankruptcies highlighted the need for broader, more far-reaching reforms to pension legislation and the other side of defined benefit pension plans – the risk that an employer fails to fulfill its pension obligations i.e. Nortel. The shift to defined contribution plans were due in part to the following reasons:
- Unlike a defined benefit plan, a defined contribution plan affords certainty of expense and cash flow for the employer and hence assists in planning controlling and monitoring risk.
- A Defined contribution plan allow the employee to exercise greater control over retirement planning and increased adaptation to their own individual circumstances and lifestyle.
- A Defined contribution plan impose ownership responsibilities on the participants for shaping their working lives and retirement expectations.
What to Expect in Retirement?
In a defined contribution plan, at retirement age they will receive all of the funds which they have contributed, those which their employer has contributed, as well as all accumulated investment income. At retirement, they have the choice of transferring the defined contribution plan funds to a locked-in RRSP, a Life Income Fund (LIF) or an annuity. Retirement income will depend on the option(s) chosen.
For example:
Let’s take the case of an employee making $80,000 per year who joins a defined contribution plan at age 35 and retires at age 65. The terms of the plan are:
- the employee contributes 4% of salary matched by the company also contributing 4%
- employee contributes an additional 3% of salary matched by the company contributing an additional 1.5%
The contributions and benefits would be calculated as follows:
- total combined contribution is 12.5% of the employee’s annual salary per year
- $80,000 x 12.5% = $10,000 contributed per year ($5,600 employee, $4,400 employer)
- The retirement income will depend on the actual rate of return achieved on the investment over the 30 years in the plan and the life expectancy of the retiree.
Possible results (stated in today’s dollars) are:
- $35,000/year to age 83, assuming an investment rate of return of 6%
- $27,000/year to age 83, assuming an investment rate of return of 5%
Assumption: $80,000 salary grows at rate of inflation but all values are stated in today’s dollars
Defined Contribution Plan: Manage Your Own Risk
A defined contribution plan offers an employee more choice and flexibility in their investment than a defined benefit plan. This allows a knowledgeable investor to tailor the plan to suit their own investment goals and tolerance for risk.
Someone who is less comfortable with investment decisions must still be careful to put the same effort into pension plan investments as any other registered or non-registered investments they may have. This includes understanding their asset allocation mix and risk tolerance.
A defined benefit plan fits the traditional view of company-provided, guaranteed retirement income and there are still many of these plans available in Canada. But as defined contribution plans become more common in the private sector, it is important to understand what type of plan you have and how to incorporate it into your overall retirement strategy.
When my sons were young they used to talk about the cars they would buy when they grew up. One wanted a Porsche, the other a Lamborghini. Luxury items were high on their “wants” list.
The whole lottery business is aimed at “living the dream” and the commercials show winners with their own private islands, yachting around the world and playing games with their helicopters and motorboats. Nice fantasies indeed. But most people really wouldn’t change their lifestyles at all.
If you listen to interviews with lottery winners they say they want to pay off their bills, purchase a new house or truck, take a nice vacation and help out their families – statements common to almost all of them and pretty boring actually. There’s never any mention of pursuing anything extravagant.
What Does Wealth Mean To You?
What constitutes “wealth” is relative. Some people think they will be wealthy when they attain a high income or a net worth of a certain dollar amount. Others associate money with being successful and attempt to show how important they are with a display of opulence by living in a large estate, driving a fancy car and joining the best clubs.
In fact there are more than a few people that earn a six-figure income or more who live paycheque to paycheque and are as stressed as those living at poverty level. It becomes a race to have it all and someone will always have newer and/or better and it’s hard to keep up. Also, job loss is a real possibility these days – then what?
The pursuit of wealth and riches by working long hours can be detrimental to health and relationships. There are a lot of millionaires who are alone in the end miserably counting their piles of money.
There are those who take awful risks to strike it rich – gambling on dubious financial schemes as well as games of chance. There are the Bernie Madoffs of the world who take advantage of the gullibility of others to make themselves rich. And of course there’s always someone who expects to get something for nothing. Greed rears it’s ugly head and makes them targets and surprised victims of scams and con artists.
The book “Millionaire Next Door” by Thomas J. Stanley examines wealthy people who are not extravagant and don’t need to show their wealth to the world. They go about their business quietly and do whatever they want to do with their lives. They know what it takes to become a millionaire.
I think that most people want enough money to feel a sense of security – no more worries about monthly expenses and unexpected bills, the ability to pay for some luxuries and live life on their own terms. Some aren’t satisfied until they have it all.
How much money do you need to be wealthy? It’s a personal choice. It’s whatever feels right to you.