Pity the poor retirement portfolio. There’s so much riding on it, and so little room for error. It has to provide you with enough growth to support the retirement lifestyle you want, but it also has to defend you from the ravages of a possible market crash. It has to provide a generous income when you retire, but not so generous that you’ll run out if you live until you’re 93. It has to weather all sorts of different markets over several decades—and it still has to come through with a dependable retirement income you can count on. Really, it’s a lot to ask.
Given all those demands, you might think that only the experts could design a portfolio structure that does everything you need, but there’s a surprisingly simple solution. It mainly comes down to the right mix of investments. “The trick is not to put all your eggs in one basket,” says Norbert Schlenker, a fee-only financial planner with Libra Investment Management of Salt Spring Island, B.C. “So if the basket falls, all your eggs don’t break.”
We believe that with just three components—stocks, fixed income and annuities—you can design a retirement portfolio that performs as soundly as many of those designed by the pros. Read on and we’ll show you how. When you’re done, you’ll have a retirement portfolio structure that will provide you with a good return and a good night’s sleep—then you can jump to our Retirement 100 feature where we even suggest which stocks you could select to load it up with.
Estimate your income
The first step is to figure out what kind of income you’ll need once you’re retired. You could spend hours with a calculator trying to come up with an exact number, but as a rough guide, if you have a spouse and kids, you own your home and your mortgage is paid off before you retire, it’s safe to assume that you’ll be able to comfortably live on between 50% and 60% of your working income. If you’re single, you have no kids, or you rent, you might want to boost that to 70%. To generate that kind of income, you would have to save up a lot of dough, but luckily, not all of your retirement income has to come from your portfolio. That’s because you’ll also get regular payouts from government programs such as the Canada Pension Plan (CPP) and Old Age Security (OAS), and you may also have a defined benefit pension at work. That means your portfolio will only have to provide the total income you need in retirement, less your annual government and pension benefits.
Let’s run some numbers to get you started. We’ve found that a typical middle class couple spends about $40,000 to $60,000 a year in retirement, assuming they own their home mortgage-free. (That’s only a rule-of-thumb: many retirees get by comfortably on less and many feel they need more.) Of that, a couple might get about $30,000 a year from CPP and OAS, if both members worked most of their adult lives. Thus many retired couples without pensions through work find that their portfolio needs to provide them with an income of between $10,000 and $30,000 a year. Consider that your “retirement income” gap.
Size up your savings
For simplicity’s sake, let’s assume that your retirement portfolio only has two kinds of investments in it: stocks, and fixed-income investments, like bonds. If that’s the case and you retire at age 65, research shows you’ll need a nest egg that’s roughly 25 times the amount you expect to withdraw from your portfolio each year to live on. Once you retire, you can then withdraw 4% of your total nest egg a year, plus inflation adjustments, and as long as you get roughly market returns, there’s only about a 10% chance that you’ll outlive your money.
In real numbers, that means that if your retirement portfolio has to supply you with $20,000 a year and you retire at age 65, then you’ll need a nest egg containing $500,000. If you retire earlier than 65, you need to bump up the size of your nest egg, as you’ll rely on the income from your portfolio for longer, and you need to bridge the gap between when you stop working and when you start collecting OAS. If you retired at 60 instead of 65, you’d be wise to start with a nest egg of about $650,000. Either way, you still have a small chance of outliving your money, but you’ll probably do considerably better—which means that you might well end up with a tidy sum in the bank for your heirs or charity when you die.
The right mix
Now that you know roughly how much you need to save up, the next step is to figure out how to invest it. A great starting point for almost any situation is to put between 40% and 60% of your savings in stocks, and the remaining portion in fixed income investments like bonds and GICs. The stocks will help ensure growth so your nest egg keeps up with inflation, while the fixed-income portion provides some stability in your returns and helps to protect you from market crashes.
Once you have your allocation roughly sketched out, you can further adjust it to fit your particular situation. For instance, a good rule of thumb is to go heavier on stocks the younger you are. That’s because you’ll have plenty of time to recover from a possible market crash before you need your money. On the other hand, if you’re only a few years away from retirement, many say you should play it safer by loading up on fixed income. You don’t want to lose 40% of your savings in a nasty crash just as you’re about to quit working.
There are several ways to accomplish this, but Norbert Schlenker suggests setting the proportion of your fixed income equal to your age. If you adopt that approach, you would invest 40% of your portfolio in fixed income when you’re 40 (and put the rest in stocks), and by the time you’re 60, you would have 60% of your portfolio in fixed income, and only 40% in stocks.
There are other factors that may cause you to go a bit heavier or lighter on stocks. These include how wealthy you are relative to your future financial needs, your ability to work longer if your investments perform poorly, whether you have a pension through work, and your willingness to cut retirement spending if things don’t work out.
Perhaps the most important factor in determining the right balance between stocks and bonds, though, is your risk tolerance. It’s important that you feel comfortable with the ups and downs in your portfolio no matter how wealthy you are. So even if you’re young and you have much more money than you need, if the idea of losing money in the market terrifies you, then don’t put much money in the market. If you do, it could lead to panic selling when the market falls, and that could have a big impact on your returns.
“People don’t generally have a good idea of their own risk tolerance,” says Schlenker. “I try to educate people in how their emotions get them to buy during euphoria and sell during panic, and how those are exactly the wrong things to do.” To get it right, Schlenker advises that “you sit down when things are reasonably calm, you think about what kind of losses you can take, and you set your asset allocation accordingly. Then stick with that.”
Buy yourself a pension
A simple portfolio of stocks, bonds and GICs works well for many people, but how do you like the sound of a guaranteed income for life? If that sounds good and you don’t want to risk outliving your money, you may want to throw some annuities in the mix.
A life annuity is essentially a guaranteed stream of income that lasts as long as you do. You hand over a large sack of money to an insurance company, and in return, they pledge to give you a set number of dollars back every month for as long as you live, no matter what the market does. Moshe Milevsky, professor of finance at York University’s Schulich School of Business, has just co-written a book about the advantages of adding annuities to your retirement plan. In Pensionize Your Nest Egg, Milevsky and co-author Alexandra Macqueen note that annuities provide many of the benefits of a defined benefit pension from work, which takes some of the load off your retirement portfolio. As they write in their book: “If you don’t have a pension—and you probably don’t—make sure you go out and buy one.”
But like many choices in investing, the decision to annuitize involves a trade-off. The main problem with buying regular fixed annuities is that there’s no turning back. If you convert $250,000 into an annuity and both you and your spouse die within five years after collecting only $90,000 in income, the insurance company will keep the rest of your money, and your heirs will get nothing. (Though on the other hand, if you both live to 98, you’ll make out like bandits.) Because of that, many people decide to put only part of their nest egg into an annuity for safety, and keep the rest in a standard mix of stocks and fixed income.
To figure out how much you should “pensionize” in an annuity, look at the size of your retirement income gap relative to the amount of pension income you already have. You should also consider the flexibility of your spending plans, your keenness to leave money to your heirs or charity, your state of health and your tolerance for risk.
If you already have a good defined benefit pension plan, you’re very wealthy, or you’re likely to die young, annuities probably don’t make much sense. However if you don’t have any other guaranteed income, and your health is good, many advisors suggest that you put enough in annuities to at least cover your most basic spending needs. That way if your regular stock and bond investments don’t work out, then you only have to cut back on non-essentials.
An income for life
The annual payout you get from an annuity depends on current interest rates and how old you are when you buy them. The older you are, the higher the payout for a given purchase price. Keep in mind though, that the cost goes up if you buy an annuity with extra features, such as inflation indexing. It also goes up if you buy an annuity that covers both you and your spouse.
A standard fixed annuity for a 70-year-old couple currently pays about 7% a year until the death of the second spouse (and it is guaranteed to be paid for at least five years). So if you put $250,000 down, you would get $17,500 a year for life. After inflation, that would provide a payout of about 5%, as long as inflation stays in the current 2% range. If you’re not concerned about a bequest to your heirs, you can see that a 5% payout after inflation with no risk of outliving your money looks better than the 4% after inflation you would get from a standard stock and bond retirement portfolio (with no guarantee of an income for life).
Some experts recommend inflation-indexed annuities, which raise the annual payout by the number of percentage points that inflation goes up each year, but the extra cost to these products may outweigh the benefits. There are also variable annuities, which are advertised as providing a guaranteed income for life plus the ability to profit from rising markets. These are hybrid investments consisting of a mutual fund wrapped in a minimum payout guarantee (usually 5%). They offer some hope for upping payouts if your embedded investments do particularly well, and you can cash in what’s left of your investment if need be. But the guaranteed payout is much lower than with regular fixed annuities and the fees are very high (about 3.5% a year or more), which reduces the chance of getting your payouts bumped up.
Hit the sweet spot
The longer you wait before buying an annuity, the higher the monthly payment will be, although obviously you will collect over a shorter period. Milevsky says to get the right balance, you should annuitize gradually in the sweet spot period between the ages of 65 and 75. Many Canadians will find it convenient to convert a chunk of money to annuities as they near the age of 71, which is when the government forces seniors to convert their RRSPs into either an annuity or a Registered Retirement Income Fund (RRIF). However, you should be cautious about annuitizing a large proportion of your wealth at once, because you’ll be at the mercy of whatever the annuity rate happens to be on that day for the rest of your life.
When you do add annuities to your retirement plan, you should make some adjustments to the savings you have in your portfolio of stocks and fixed income to compensate. Regular fixed annuities aren’t inflation adjusted and have many characteristics similar to long-term bonds (they insulate you from stock market swings, but their worth is vulnerable to rising inflation and interest rates). So if you’re adding those kind of annuities to your retirement plan, you’ll want to adjust the rest of your portfolio to make it less susceptible to inflation and rising interest rates. You can do that by reducing the average time to maturity on your bonds and GICs, or by adding real-return bonds. Or you can simply go a bit heavier on stocks.
Now all you need to know is which stocks to buy for the Canadian equity portion of your perfect retirement portfolio. As luck would have it, you can find some excellent suggestions among our top-rated Canadian dividend stocks in the Retirement 100.