How your savings tend to disappear – and what you can do about it
This is a challenging time for building your wealth and saving for retirement. The needs have never been greater. But, increasingly, it seems as if the odds are heavily stacked against your being able to save anywhere near enough for a comfortable golden age: low government pensions, changing private investment landscape, inflation, market volatility, to name a few. Is it time to panic? Not necessarily! Start by understanding the challenges facing you. Only then will you be able to come up with a workable plan to save for your own retirement.
The challenges of building wealth for retirement
Canadians are living longer raising the possibility of running out of money in retirement. A significant decline in health, sudden critical illness, and a need for quality long-term care are risks we all face as we age. And our biggest concern is whether we will have sufficient financial resources to provide for our needs beyond the bare minimum offered by government programs.
- Stressed government programs
With an aging population, government pension plans are increasingly stressed. The average monthly payment for Canada Pension Plan was $596.66 per person as of the end of 2013 (depending on age and how long you’ve been contributing to CPP at the time of retirement). And the maximum monthly Old Age Security payment was $550.99. That’s about $1,147 per month. Would that be enough to cover your retirement needs?
- Stressed private pensions
The way we manage our personal pension retirement plans is also changing. Against a backdrop of slow global economic growth and unstable financial markets, defined benefit pension plans, in which the employer takes on responsibility for managing employee pension funds, are being seen as increasingly exposed to systemic risk. Some plans may become underfunded or insolvent if the employer faces financial difficulty (including recent cases of municipal government plans in the U.S.). This may mean a severe reduction or even total loss of pension benefits. As a result, more people are opting for defined contribution plans, which let individuals choose contribution levels and pension management options.
- Inflation: the silent wealth destroyer
Even if you have some control over your own pension plan, how can you be sure of achieving maximum real return – that is, after the corrosive effects of inflation. Inflation is always a threat because it quietly and steadily erodes the purchasing power of your savings. For example, taking inflation into account, an item purchased for $10,000 in 1993 would cost $14,170.56 in 2013. That’s a 41.7% reduction in purchasing power over 20 years. Your pension plan investments would have had to grow by 41.7% at a minimum over that 20-year period just to stand still in terms of purchasing power. They would have had to grow a lot more in order to increase in real value.
Risk and return
So how do you achieve that kind of growth while keeping risk to a minimum? Interest rates are at historic lows. For example, 1-year GIC rates were listed at an average 0.78% in November 2013. Interest-bearing investments are currently just barely keeping pace with Canada’s average 1% annual rate of inflation.
So how about the stock market? Stock market returns over the long term are typically higher than fixed-income returns. By the same token, risk is higher. The 3-year volatility (risk) for the S&P/TSX Composite Index at the end of 2013 was around 10.6, which is relatively high volatility. By contrast, the 3-year volatility for the DEX All Government Bond Index is about 1.0, which is a very low level of volatility. In other words, stocks are about 10 times riskier than bonds.
Bordering on panic?
The wealth challenge is to find your investment comfort level somewhere between these two extremes. To create an investment plan that lets you sleep nights but one that ensures a longer-term rate of return sufficient to provide a comfortable retirement and meet your needs into old age.
To build the investment plan that’s right for you, it’s important to create a comprehensive investor profile: What are your financial objectives? What’s your risk comfort zone? What’s your investment personality: play-it-safe capital preserver or aggressive market pit-bull?
Once you’ve developed an honest self-assessment of your investment personality, you can set an investment mandate and start thinking about asset allocation, diversification, security selection, monitoring, reporting, reviewing, and annual rebalancing to make sure your portfolio is on track.
And if all this stuff seems like a huge additional complication for your already insanely busy 24/7 life (and for most of us, it is), your next step is to chat with an independent financial planner, who is trained to quell the panic and put it all into perspective.
© 2013 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited.
