Frugality Now - Security Later
A 34-year-old woman we'll call Joanne has worked for a municipal government in Ontario for a year. She has bright prospects but, currently, a modest income of $2,966 per month after taxes, union dues and contributions to her defined benefit pension plan. She saves diligently for a retirement that is three decades in the future.
"My lifestyle is frugal, my goals are modest," Joanne explains. "I don't want a big house - just a vegetable garden. I don't want to retire early or extravagantly - just to maintain my current lifestyle largely centred on bicycles. But I must have the means to pay for assisted living when I am old."
Facelift asked Derek Moran, head of Smarter Financial Planning Ltd. of Kelowna, B.C., to work with Joanne.
"She is productive and has proven herself an efficient saver with a hunger for investment knowledge," he explains. "There are many unknown factors in her life to come. What will make the difference in her retirement will be returns from her savings."
Joanne has built up substantial assets for a relatively young government worker. In addition to her $200,000 condo she has non-registered cash and investments that total $36,119, and $26,350 in her registered retirement savings plan, the planner notes. Her only liability is a $40,000 loan from her father that bears no interest. The loan presents a moral dilemma, for on a financial basis, it is a terrific deal. Yet the right thing to do would be to pay it off. She should make an offer to pay it down in whole or in part and have the honour of doing the right thing, he says. She is likely to rise to a higher level of trust and capability in her father's eyes, he explains.
Retirement in three decades is a long way off, but Joanne has decided to plan for it now. She will be entitled to her defined benefit pension at 65 of $22,300 in 2009 dollars based on current gross annual earnings of $51,540. On top of that, she will be entitled to Old Age Security, currently $6,204 per year, and
Canada Pension Plan benefits of as much as $10,905 at current rates, for a total of $39,409 per year plus returns from her savings.
If she saves $500 per month out of her $1,800 monthly discretionary income, she could build up a base of $358,000 at age 65, assuming that her assets grow at 3 per cent per year after tax. That capital would provide $19,960 per year to her age 90 and give her total retirement income of $59,369 in 2009 dollars.
Were she to save $1,000 per month and get the same returns, she would build up $652,000 by age 65, from which the annual income would be $36,350 per year and total retirement income $75,759 annually. Higher savings would expose more of her income to the Old Age Security clawback that begins at $66,335 for 2009. The clawback rate is 15 cents per dollar over that threshold.
The issue in estimating Joanne's retirement income is what her assets will earn.
She does not want to be a passive investor, yet she is also aware of the fees that mutual funds and some financial advisers charge. Those fees erode returns. Some managers are worth their fees, of course. She has selected a low-fee index fund from a chartered bank and is content with its returns. The next step would be exchange-traded funds (ETFs) with even lower fees. But, asks the planner, are ETFs right for her portfolio?
Canadian mutual fund administration fees are among the highest in the world. For all of the nearly 10,850 funds in the Globefund database, from low-risk money-market portfolios to exotic hedge operations, the median expense ratio is 2.87 per cent per year with potential additional sales charges. Fees for index funds run by chartered banks tend to vary from as little as 0.30 per cent to more than 1 per cent per year. Exchange-traded funds that track various market indexes such as the S&P composite or bond indexes tend to range from 0.10 per cent to 0.50 per cent.
Cheap is not necessarily best for Joanne. Most ETFs and index funds track market mood rather than fundamentals. The typical TSX index fund in 2000, when
Nortel Networks was valued at over $120 per share and was a third of the market's capitalization, took a severe loss as Nortel stock shrivelled. Moreover, index funds and ETFs generally do not have asset selection strategies, though some funds are structured to follow themes or trading concepts. Picking one's own stocks is an alternative, but for most investors, a handful of companies will not achieve diversification. What to do?
Mr. Moran suggests a middle way. Joanne can buy a few shares in companies that offer dividend reinvestment plans (known as DRIPs) in such sectors as financials, energy and resources, consumer discretionary, and manufacturing. DRIPs use dividends to buy shares without commission, often at a small discount to market price. Each company has to be reviewed periodically to ensure that it remains an appropriate investment, Mr. Moran cautions.
"I'll take the suggestion to look into DRIPs," Joanne says. "I will probably end up with both low-fee funds and some DRIPs. I don't want to put all of my eggs into one basket of theories."
The Person: Ontario municipal worker, age 34
The problem: Plan retirement based on a high savings rate and a growing knowledge of investment markets
The Plan: Set up a cost-effective investment program
The Payoff: Potentially strong investment returns and training in managing household assets
After-tax monthly income: $2,966
Assets: condo $200,000; taxable assets $36,119; RRSPs $26,350 Total: $262,469
monthly disbursements: condo fees $214; prop. tax $96; shed rent $106; food & restaurant $487; entertainment $40; clothing $38; RRSP $200; travel $50; home ins. $21; charity, gifts $100; misc. $100; savings $1,514 Total: $2,966
Liabilities: Family loan at 0 per cent interest: $40,000
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