Everyone is talking about investment fees these days. There are ads on the radio, television, and online… there are podcasts, websites, blogs dedicated to low-fee investing… there are also books, magazines and research studies… all focused on one thing… how much the average investor pays in fees while saving for retirement.
But very few people are talking about the effect investment fees have on retirement itself. Mostly they talk about how fees impact you as you save for retirement, but very few mentions what happens if you continue to pay high fees as you enter retirement.
Fees definitely have an enormous impact on how much you can save for retirement. The average mutual fund fee is 2.35% in Canada, and that’s the average, there are lots of situations where the fee is even higher. The effect of this fee on a lifetime of savings and investments is enormous!
But what if you’re close to retirement? What is the impact then? Arguably the effect of investment fees on retirement planning is even greater than any other period.
Fees have an enormous effect on retirement planning because by the time we’ve reached retirement we’ve already saved up a huge nest egg. Unlike the accumulation phase, where you have limited assets in the beginning, when it comes to retirement, you’re starting with a huge amount of investment assets. This makes the impact of fees enormous, especially in early retirement.
The problem for retirees is that investment fees are hard to spot, hard to find, they’re almost hidden by investment providers, whether that is intentional or not. I’ve seen this on countless investment statements I receive from clients. Based on the statement alone you would NEVER know how much they’re paying in investment fees each year.
This isn’t an isolated issue, it’s a problem that many, many retirees face. Low-fee investing is a relatively new option in Canada. If you were investing 10-20+ years ago there just weren’t as many options to reduce your investment fees.
Many retirees who have high-priced investments are shocked (and somewhat saddened) to learn exactly how much they’re paying each year. It’s not their fault, this information is hard to find and not readily available to investors.
To figure out how much an investor is paying each year usually requires some digging. Mutual fund codes vary by fund and fund class. Sometimes fees can vary by 1% or more for the same mutual fund depending on the class.
But once you know how much you’re truly paying you can start to see the impact it will have on your retirement plans. There are two main effects that high fees can have on retirement, and the impact can be substantial.
ETFs have taken over the world of investing. Everyone is getting behind ETF investing, from DIY investors to Warren Buffet, from robo-advisors to huge institutional investors. But what is an ETF? What does ETF stand for? And how do they work?
ETF stands for Exchange Traded Fund… what that means is that it’s a collection of investments, stocks, bonds etc, and those investments are grouped together into one fund that you can purchase and sell on the stock exchange.
This is slightly different than mutual funds. Mutual funds also hold a collection of investments but you purchase them through the fund provider and at a set price at the end of the day based on how much the fund is worth.
The difference is subtle but it matters, and I’ll explain why.
ETFs have grown in popularity over the last 10-years. One of those reasons has to do with low-cost index investing. Index investing is when a fund (could be an exchange traded fund, or it could be a mutual fund) tries to replicate the returns of a particular index. And an index could be anything.
For example there is an S&P 500 ETF that aims to replicate the returns of the S&P 500, a collection of the 500 largest companies in the US. An index could also be a bond index, in this case a bond ETF aims to replicate the return of a certain type of bond, maybe corporate bonds, maybe government bonds, maybe high-risk/junk bonds etc.
The amazing thing about ETFs, especially index ETFs is how little they cost, how highly diversified they are, and how simple they makes investing for the average person.
But how do ETFs work?
It’s a great question.
There are a lot of risks that we face in retirement (including early retirement). When you enter retirement, there are lots of changes happening all at once. Along with big personal changes, and lifestyle changes, there are also big changes happening to your finances. After you enter retirement one of the biggest financial changes you’ll face is a shift from a regular income source (eg. employment) to an income source based entirely on your own savings and pension. Making this switch can create a few risks, one of those risks is the risk of running out of money.
One of the biggest risks facing retirees is something called sequence of returns risk. When a good portion of your retirement income comes from your own savings this is the biggest risk a retiree can face. But what does “sequence of returns risk” mean exactly?
Before we talk about sequence of returns risk it’s important to understand that most retirement plans are based on an assumed (and constant) investment return each year. This investment return is usually assumed to happen in a straight line with the same percentage return each year. An assumed return of return of 5% would be 5% per year starting on the day you retire, but in reality your investment return is going to fluctuate from year to year, and this is where the risk comes from.
Over the short-term you will probably see your investment return fluctuate greatly from year to year. Instead of seeing investment returns of +5%, +5%, +5%, +5%, +5%, you might see +20%, +2%, -10%, +15%, +1%. In this case the average return is still +5%, but there were some huge swings from year to year. “Sequence of returns risk” refers to this sequence, the actual investment returns you see year after year.
The big risk for retirees happens when the sequence is negative for a few years in a row. Even if average investment returns recover over the long-term, that short period of negative returns can have a devastating effect on a retiree’s portfolio.
Rebalancing is one of those simple things that investors should do at least once per year. Rebalancing your investment portfolio can have a really positive impact on your long-term returns. Not rebalancing your portfolio can lead to some nasty consequences that we definitely want to avoid.
Rebalancing regularly will keep your portfolio’s risk level on target. Rebalancing can also help you avoid a lot of behavioural biases that can impact investor returns. And good rebalancing rules will help you buy-low and sell-high (which is exactly what we want right?!)
For small, medium, or large portfolio’s rebalancing should happen at least once per year. We rebalance three times per year in January, May and September. We do this as part of our tri-annual financial check-in. It’s easy to do and very beneficial. Rebalancing your portfolio can help increase your long-term investment returns and at the same time decrease your risk.
We’ve had two major rebalances in the last 5 years. During the last large decrease in Canadian equities we had to sell bonds to buy Canadian stocks. And more recently, after a big increase in stock market values, we had to sell equities to buy more bonds. Now after the recent changes in the market we will probably need to rebalance our portfolio again.
Rebalancing is something we look forward to, we know that rebalancing is a good thing for the reasons listed below. When we rebalance it means our investment plan is working the way it should and it’s a good indication that we’re on track for our long-term plan.
Investing is one of the best ways to build wealth. When you invest, you buy small a piece of a company and become part owner. And as a part owner of that company you get to share in the profit that they create. This profit can be distributed to shareholders in the form of cash dividends every few months (ie. Coke) or it can be invested back into the company to help it grow even faster (ie. Netflix).
When you invest you put your money to work. Rather than letting your money sit in a high-interest savings account, where it does next to nothing (earning minimal interest, sometimes less than inflation) instead, you give your money a real job.
When you invest, you get a higher return but this return isn’t for free. A higher return comes with higher risk. Investing is risky. When you invest it’s possible to lose a big chunk of your savings over a few years, months, or even days. The benefit is that over the long run you can earn a better return than your bank account, and this is important when you have long-term goals like financial independence or retirement (Note: you should never invest when you’re saving for short-term goals, for short-term goals a high interest savings account or GIC are the best options).
Related: My biggest financial mistake
What is the best way to invest? That depends on your specific circumstances. It depends on how much time you have, how involved you want to be, and how much you want to pay in fees etc. Investing today is easier than ever. There are new and easy ways to invest in a highly-diversified portfolio of stocks and bonds.
Which method you choose will depend on a few factors…
Financial independence is a goal for many people. Financial independence is when work becomes optional. It’s when your investments are large enough to support your annual spending indefinitely, without the need for employment income. Reaching financial independence frees you from the typical work/money/time equation. When you reach financial independence you no longer have to trade your time for money.
How much you need to reach financial independence is different for everyone, but the quick and most common metric is 25 times your annual spending. Once you reach this level of savings and investments (not including your home) you can withdraw 4% of your portfolio indefinitely. With the right portfolio your investments will grow enough each year to pay you 4% of the original principal and still keep up with inflation.
Taxes are obviously a big consideration when growing your investments. Tax free growth allows your investments to grow faster and lets you hit your goals earlier.
In Canada we have two main accounts that provide tax free growth, the TFSA and RRSP. With the TFSA you pay tax now but don’t pay tax later. With the RRSP you don’t pay tax now, but you do pay tax later. Regardless of when you pay the tax, the investment growth within an RRSP or a TFSA is tax free. Using your TFSA and your RRSP to its full potential means you can hit financial independence much faster.