Deciding between investing in a TFSA or RRSP
For many Canadians, RRSP season is all about getting a tax refund in the spring. The fact that “retirement” is one of the Rs in registered retirement savings plan is too often overlooked.
A survey from Edward Jones Canada this week found that while fewer than half of us plan to make a contribution before the March 1 deadline (due in part to uncertainty over the pandemic), 31 per cent of respondents view RRSP season as transactional without serious thought of how their contributions support their longer-term financial goals.
In this case, “transactional” means you make a contribution to your RRSP and the government gives you a refund. But it descends much deeper in an age of day-trader activism where markets are viewed as casinos by some participants who think investing is nothing more than a series of unrelated wagers in search of that big score.
You don’t need to contribute to your RRSP this year to think about retirement. It starts with forming a mental picture of how you want to live in the future; financial security versus material comfort.
For most Canadians not born into money, reaching that goal requires sacrifice and commitment over the long term. It also requires a serious effort to control and reduce debt because interest accumulation is a certain way to draw from uncertain investment gains.
The next step is forming a strategy to get there by growing your savings and managing risk to ensure you hold on to what you have accumulated. In many cases that means taking actions that require no risk but result in financial gains, such as reducing debt or a tax strategy. Tax experts estimate that the coordinated use of RRSPs, tax-free savings accounts (TFSAs), and other tax benefits available to most Canadians can result in a 25 per cent increase in the value of an investment portfolio over a lifetime; provided the tax savings are re-invested.
Other ways to maximize portfolio growth over the long term while limiting risk come through asset allocation. Adjusting the portion of your savings between equities (stocks, mutual funds, exchange traded funds), fixed income (bonds) and cash allows you to tweak the risk/reward dynamics to meet your retirement goals over time. With interest rates near rock-bottom, yields on fixed income are dismal but the safety of their returns allows you to counterbalance riskier equities with the potential for greater growth. Many investors and investment professionals have turned to dividend paying equities as substitutes for income despite higher risk levels.
Having a good chunk of cash on hand also allows you to be ready to take advantage of opportunities when markets dip and ensure you can cover living expenses in retirement.
Diversifying specific investments can also limit risk during market downturns while keeping your broader investment portfolio exposed to opportunities. That means holding a portfolio of equities that spans sector and geographic lines. As examples, resource and emerging market stocks took a big hit at the start of the pandemic lockdown while technology stocks gained in value. Those roles could be reversed in the future but gains will exceed losses if a portfolio holds good stocks in all asset classes. You can’t win them all but you should have more wins than losses. Experts call it hedging.
To manage risk, Edward Jones suggests investments in any single company be limited to five per cent of the overall portfolio, which means stocks that rise in value should be trimmed and the cash should be allocated to under-represented sectors.
Edward Jones also suggests exposure to any individual sector or mutual fund be limited to 25 per cent of the overall portfolio.
The rules of diversification even apply to the fixed income portion of a portfolio. Edward Jones suggests the same sector restrictions and advises bond maturities should be “laddered” over various periods of time to ensure frequent opportunities to get the best yields when they are reinvested.
Diversification can also apply to risk levels and currencies for Canadians who want to spend a good part of their retirement in the United States.
Creating a diversified portfolio isn’t easy for the average investor and that’s where a good, qualified, advisor comes in handy. However, it’s important to ensure fees don’t surpass their usefulness. Most fees are based on returns and - like debt and taxes - lowering investment fees is a risk-free way to boost returns.
Most financial institutions provide online calculators to determine the average annual rates of return required to meet retirement goals. Somewhere between five and eight per cent on an entire portfolio is realistic. Being diversified allows you to pull back portfolio risk when returns are good, or ramp up risk or revise goals when returns are bad.