Investing for retirement is all about taking advantage of compounded returns. You want to be able to maximize your investment returns while minimizing risk. There are two major phases of investing for retirement. The first is the saving years and then the withdrawal years.
The first phase, the saving years, typically last the longest. However, with proper planning, you can change this and get more out of your retirement years. During this phase, you will be adding to your retirement savings while working through your career. You can take more investment risk during the beginning of this phase as you have more time before you will need to use your investments. During this phase, you will be accumulating wealth and increasing your net worth.
The second phase, the withdrawal years, is the retirement phase. During this phase, you will switch to more safe investments and withdraw from your savings. The goal during this phase is to withdraw as much as possible of your savings without running out of money before your death.
See the graph below for an example of what this looks like for someone who starts saving at age 20, retires at age 60, and lives to 90 years old.
Notice the exponentially rising curve in the first phase? That’s the power of compounded returns. The longer your investment period, the more of an impact this will have on your returns. For those starting to save later, or those who wish to retire earlier, the affect of compounded returns is smaller and you will need to rely on a larger savings rate, as discussed in Saving for Early Retirement.
Retirement savings can be divided into two categories of investments, Bonds and Equity funds. Bond funds are safer but provide lower returns in the long run. Equity funds may produce much larger returns, but experience more fluctuation when looking at shorter time periods. Depending on your place on the graph above, different investment portfolio splits are recommended between bond funds and equity funds.
See the chart below for my recommended split between equity and index funds, based off the time to retirement.
This recommendation is a bit more aggressive than the standard 50/50 or 60/40 Equity/Bond split that have often been recommended historically. There are a few reasons for this. Current interest rates are at a low and Bond Funds have been performing below their historical average. ETF (Exchange Traded Fund) products currently available offer access to equity indices around the world, allowing for easy diversification into different industries in different continents. ETFs in general allow for low management cost (MER), further increasing returns on investment regardless of how the market performs.
To fully understand this strategy, you must consider how you will withdraw your savings during retirement. The most commonly mentioned withdrawal rate is known as the 4% rule, which can be calculated as your investments equalling 25X your annual spending money. With a large portion of your portfolio being invested in bonds, you will likely run out of savings at current rates. This is especially true if you plan to retire early (55 or younger). Investing a large portion in global indices will offer you a strong chance of sustaining this withdrawal rate throughout a long retirement.
The original example (first graph above) shows a withdrawal rate of 5.5% starting at age 60. Portfolio returns during retirement are averaged at 4% per year (6% minus 2% inflation). In this case, the savings will last until 93 years old. If you are retiring earlier, and are unlucky with a market performing below 4% after inflation returns (historically very rare when looking at just the S&P500 index), you may run out of savings.
The second example (graph below) shows a withdrawal rate of 4% starting at an early retirement age of 50. Portfolio returns during retirement are averaged at a poor 3% per year after inflation.
If inflation is shown on the graph, with a 4% withdrawal rate increased per year to match inflation (2% per year) on a portfolio return of 5% before inflation (3% after inflation), the graph will look like this:
These two graphs above illustrate the same point. That the 4% rule is still a safe bet in most market conditions if a larger part of your retirement savings remains in diversified index funds. However, it isn’t 100% safe, there can still be a market crash at the moment of retirement impacting your early retirement plans with a safe withdrawal rate of 4%.
To minimize this risk, I recommend dividing your retirement spending budget into two categories, needs and luxuries. Your needs are the essential spending and should be capped at 2.5-3% of your initial retirement savings value. Luxuries can be targeted at 1-1.5% of your initial savings value, and adjusted during your retirement depending on last year’s portfolio performance. If the market hits a bad period, you have a safety cushion of quick areas where spending can be reduced. If this strategy is applied properly, it is possible to withdraw up to 6% per year (Needs+Luxuries) if global markets achieve historical average returns and you are invested in mostly equity. The important thing is to keep your essential ‘needs’ spending to a safe level.
RRSP, TFSA Considerations
For Canadians, it is important to maximize the benefit of saving for retirement inside a TFSA (Tax Free Savings Account) and a RRSP (Registered Retirement Savings Plan) to minimize taxes. When you retire, you will then have 4 sources of income, TFSA, RRSP, CPP or QPP (Government Pension), and OAS (old age security).
CPP/QPP and OAS are government run plans that provide income for people over a certain age. What’s important to note is that OAS is subject to clawback for people who have income above a certain level ($74,789 for 2017). However, income from TFSA investments is not seen as income for tax purposes and will not impact the clawback. Therefore, a proper balance between TFSA, RRSP and pensions will allow someone to earn over this amount and not be subject to any clawback.
Apart from clawback, RRSPs will generally beat out the advantages of a TFSA when contributions are made in a higher tax bracket than the tax rate of retirement. When tax rates are even or less, the TFSA will be the better account to use. Both accounts have contribution limits, therefore a mix of both will need to be used.
As mentioned earlier, I recommend index ETFs representing the global markets as the most reliable way to save for retirement. Avoid home country bias as many individual investors have a habit of doing. As a rule of thumb, try to limit your exposure to your home country equity market to a maximum of 40%, or 50% for Americans as the USA market is more diversified than the average domestic market. An example portfolio might look like: 40% Home country Index ETF, 50% Global Equity Index ETF, 10% high quality bond index ETF. The low management fees of index ETFs will really benefit your retirement savings as the gains are compounded over a long period.