Decumulate & Downsize

Most of your investing life you and your adviser (if you have one) are focused on wealth accumulation. But, we tend to forget, eventually the whole idea of this long process of delayed gratification is to actually spend this money! That’s decumulation as opposed to wealth accumulation. This stage may also involve downsizing from larger homes to smaller ones or condos, moving to the country or otherwise simplifying your life and jettisoning possessions that may tie you down.

How (and When) to Rebalance your portfolio

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Setting up the initial asset allocation for your investment portfolio is fairly straightforward. The challenge is knowing how and when to rebalance your portfolio. Stock and bond prices move up and down, and you periodically add new money – all of which can throw off your initial targets.

Let’s say you’re an index investor like me and use one of the Canadian Couch Potato’s model portfolios – TD’s e-Series funds. An initial investment of $50,000 might have a target asset allocation that looks something like this:

Fund Value Allocation Change
Canadian Index $12,500 25% —
U.S. Index $12,500 25% —
International Index $12,500 25% —
Canadian Bond Index $12,500 25% —

The key to maintaining this target asset mix is to periodically rebalance your portfolio. Why? Because your well-constructed portfolio will quickly get out of alignment as you add new money to your investments and as individual funds start to fluctuate with the movements of the market.

Indeed, different asset classes produce different returns over time, so naturally your portfolio’s asset allocation changes. At the end of one year, it wouldn’t be surprising to see your nice, clean four-fund portfolio look more like this:

Fund Value Allocation Change
Canadian Index $11,680 21.5% (6.6%)
U.S. Index $15,625 28.9% +25%
International Index $14,187 26.2% +13.5%
Canadian Bond Index $12,725 23.4% +1.8%

Do you see how each of the funds has drifted away from its initial asset allocation? Now you need a rebalancing strategy to get your portfolio back into alignment.

Rebalance your portfolio by date or by threshold?

Some investors prefer to rebalance according to a calendar: making monthly, quarterly, or annual adjustments. Other investors prefer to rebalance whenever an investment exceeds (or drops below) a specific threshold.

In our example, that could mean when one of the funds dips below 20 per cent, or rises above 30 per cent of the portfolio’s overall asset allocation.

Don’t overdo it. There is no optimal frequency or threshold when selecting a rebalancing strategy. However, you can’t reasonably expect to keep your portfolio in exact alignment with your target asset allocation at all times. Rebalance your portfolio too often and your costs increase (commissions, taxes, time) without any of the corresponding benefits.

According to research by Vanguard, annual or semi-annual monitoring with rebalancing at 5 per cent thresholds is likely to produce a reasonable balance between controlling risk and minimizing costs for most investors.

Rebalance by adding new money

One other consideration is when you’re adding new money to your portfolio on a regular basis. For me, since I’m in the accumulation phase and investing regularly, I simply add new money to the fund that’s lagging behind its target asset allocation.

For instance, our kids’ RESP money is invested in three TD e-Series funds. Each month I contribute $416.66 into the RESP portfolio and then I need to decide how to allocate it – which fund gets the money?

 

Rebalancing TD e-Series Funds

My target asset mix is to have one-third in each of the Canadian, U.S., and International index funds. As you can see, I’ve done a really good job keeping this portfolio’s asset allocation in-line.

How? I always add new money to the fund that’s lagging behind in market value. So my next $416.66 contribution will likely go into the International index fund.

It’s interesting to note that the U.S. index fund has the lowest book value and least number of units held. I haven’t had to add much new money to this fund because the U.S. market has been on fire; increasing 65 per cent since I’ve held it, versus just 8 per cent each for the International and Canadian index funds.

One big household investment portfolio

Wouldn’t all this asset allocation business be easier if we only had one investment portfolio to manage? Unfortunately, many of us are dealing with multiple accounts, from RRSPs, to TFSAs, and even non-registered accounts. Some also have locked-in retirement accounts from previous jobs with investments that need to be managed.

The best advice with respect to asset allocation across multiple investment accounts is to treat your accounts as one big household portfolio. Continue Reading…

Absurdity in certainty: finding yield during a pandemic

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Franklin Templeton/iStock

By John Beck, Franklin Templeton Fixed Income

(Sponsor Content)

An inverted yield curve, historically a harbinger of a recession, lived up to its reputation this year. The beginning of 2020 saw an inverted curve in both the United States and Canada as equity markets reached record highs. Then came the realization that COVID-19 was not simply a regional issue centralized in Wuhan, China, but a pandemic that would turn the global economy completely on its head.

A precipitous drop in stock valuations followed, reaching a nadir in mid-March, but stocks have rallied strongly since then, recovering many of the losses of that late-February/mid-March period. In the bond markets, unprecedented monetary stimulus and across-the-board rate cuts meant yields remained anemic throughout the crisis. That started to change in early June when better-than-expected job and growth numbers saw bond yields edge up. A steepening yield curve with a wider spread between short and longer duration securities is good news for both fixed income investors and the wider economy.

Across the Atlantic, the European Central Bank (ECB) announced in early June that its bond purchasing program would run to at least this time next year, spurring a rally in European bond markets.

Central bank policy

Any macro forecast must come with the caveat that a prolonged economic recovery is entirely contingent on the pandemic. A second wave of COVID-19 this fall or winter will likely mean further lockdown measures across the globe. The French philosopher Voltaire famously said: “Uncertainty is an uncomfortable position, but certainty is an absurd one.” Apt words for the current environment, but investors can take encouragement from the efforts of governments and central banks throughout this crisis. Continue Reading…

Retired Money: When do Pension Buybacks of extra service make sense?

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MoneySense: Photo by LinkedIn Sales Navigator on Unsplash

My latest MoneySense Retired Money column looks at the complex question of Pension Buybacks: putting extra money into a Defined Benefit pension to in effect “buy back” extra years of service. You can find the full column by clicking on the highlighted headline: Should you buy back pensions from your Employer? It ran on June 19th.

While this column often adds my own personal experience, this is a topic that I have never had the opportunity to explore. I can say that while I am now receiving pension income from two rather modest employer DB pension plans, the chance to buy back service never arose. If it had I probably would have jumped to take advantage of it as the guraranteed-for-life annuity-like nature of a DB plan strikes me as being particularly valuable, especially in these days of ultra-low interest rates and ever-more-volatile stock markets.

If your DB pension is inflation-indexed all the better. Again I lack such an employer pension and my wife is not in any pension at all, so our only experience in inflation-indexed pensions are the Government-issue CPP and OAS, so far deferred by my partner.

You will need cash for a buyback, or you can tap RRSPs or both. If cash, you must have available RRSP contribution room this year. Buybacks fall under the Past Service Pension Adjustment calculation, or PSPA. The PSPA reduces your RRSP in the current year, and Ottawa permits an $8,000 contribution beyond your RRSP room. Thus, the value of your buyback may be greater than your RRSP room once you consider employer contributions and future benefits.

In the MoneySense column, financial planner Matthew Ardrey of Tridelta Financial says the biggest “pro” for a buyback is simply a bigger pension at retirement. Since pensions reward longer service, buybacks let you buy more past service, and the deal is sweeter still if your employer matches contributions.

Longevity, interest rates, employer matching all considerations

Longevity can be a pro or a con, depending on when you die. The longer you live the more attractive the pension becomes, and with it the value of a buyback.   Continue Reading…

Why the 4% rule is actually (still) a decent rule of thumb

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By Mark Seed

Special to the Financial Independence Hub

I’m not a huge listener to podcasts but I do enjoy them from time to time – beyond the ever popular Joe Rogan Experience that is.

Recently, I found the BiggerPockets Money Podcast with financial independence enthusiast, financial planner, along with a host of other financial designations Michael Kitces very interesting.

For an hour+ the hosts of that podcast dove deep into the simple math behind the 4% safe withdrawal rate so many investors in the early retirement community rely on, and, why Michael Kitces ultimately believes the 4% rule actually remains a very good rule of thumb to plan by.

If you don’t have an hour and 22 minutes to listen to this episode (not many people do…) then no worries, I’ve captured the essence of the interview from this solid podcast below. Kudos to the folks at BiggerPockets for the deep dive.

Let me know your thoughts about the 4% rule in the comments section. I look forward to them.

Mark

Background – what is the 4% rule???

In general terms, the “4% rule” says that you can withdraw “safely” 4% of your savings each year (and increase it every year by the rate of inflation) from the time you retire and have a very high probability you’ll never run out of money.

Some things to keep in mind when you read this:

  1. This ‘rule’ originated from a paper written in the mid-1990s by a financial planner in the U.S. who looked at rolling 30-year periods of a 50% equity/50% fixed income asset allocation. His name was Bill Bengen.

4% rule

You can find the details of the report here.

2. This rule was developed almost 30-years ago. A lot has changed since then including real returns from bonds. There are also products on the market now that allow investors to diversify far beyond the mix of large-cap U.S. stocks and treasuries the Bengen study was based on.

3. The study was designed to answer the question: “How much can I safely withdraw from my retirement savings each year and have my nest egg last for the duration of my retirement?” Little else.

4. The study assumed (at the time) most retirees would retire around age 60. Therefore, a “good retirement” would be ~30 years thereafter; what is the safe withdrawal rate to make it through retirement until death.

5. The rule takes none of the following into account:

  • Will you (or your spouse) have a defined benefit pension plan?
  • Do you expect to receive an inheritance?
  • Will you downsize your home?
  • Do you have a shortened life expectancy or health issues that should be considered?
  • Will you continue to earn some form of income in your senior years?
  • And the list of what ifs goes on and on and on

My 4% rule example:

My wife and I aspire to have a paid off condo AND own a $1 M personal portfolio to start semi-retirement with in the coming years.

If we can grow our portfolio to that value, markets willing, the 4% rule tells us we could expect to withdraw about 4% of that million nest egg (or about $40,000 per year indexed to inflation) and have virtually no concerns we would run out of money for the next 30 years (mid-70s by then).

To the podcast and my takeaways!

On the subject of a 4% withdrawal rate – is that conservative?

Michael: Yes. If your time horizon is 30-years, it probably is. Because, when Bengen looked at his different rolling periods … he found the worst case scenario was a withdrawal rate of about 4.15%. “It was the one rate that worked in the worst historical market sequence…”

Does recent data say anything different since the 1994 study?

Michael: Not really. Continue Reading…

Tackling changes to your Retirement Income Plan

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Spending money is easy. Saving and investing is supposed to be the difficult part. But there’s a reason why Nobel laureate William Sharpe called “decumulation,” or spending down your retirement savings, the nastiest, hardest problem in finance.

Indeed, retirement planning would be easy if we knew the following information in advance:

  • Future market returns and volatility
  • Future rate of inflation
  • Future tax rates and changes
  • Future interest rates
  • Future healthcare needs
  • Future spending needs
  • Your expiration date

You get the idea.

We can use some reasonable assumptions about market returns, inflation, and interest rates using historical data. FP Standards Council issues guidelines for financial planners each year with its annual projection assumptions. For instance, the 2020 guidelines suggest using a 2% inflation rate, a 2.9% return for fixed income, and a 6.1% return for Canadian equities (before fees).

We also have rules of thumb such as the 4% safe withdrawal rule. But how useful is this rule when, for example, at age 71 Canadian retirees face mandatory minimum withdrawals from their RRIF starting at 5.28%?

What about fees? Retirees who invest in mutual funds with a bank or investment firm often find their investment fees are the single largest annual expense in retirement. Sure, you may not be writing a cheque to your advisor every year. But a $500,000 portfolio of mutual funds that charge fees of 2% will cost an investor $10,000 per year in fees. That’s a large vacation, a TFSA contribution, and maybe a top-up of your grandchild’s RESP. Every. Single. Year.

For those who manage their own portfolio of individual stocks or ETFs, how well equipped are you to flip the switch from saving to spending in retirement? And, how long do you expect to have the skill, desire, and mental capacity to continue managing your investments in retirement?

Finally, do you expect your spending rate will stay constant throughout retirement? Will it change based on market returns? Will you fly by the seat of your pants and hope everything pans out? What about one-time purchases, like a new car, home renovation, an exotic trip, or a monetary gift to your kids or grandkids?

Now are you convinced that Professor Sharpe was onto something with this whole retirement planning thing?

One solution is a Robo Advisor

One solution to the retirement income puzzle is to work with a robo advisor. You’ll typically pay lower fees, invest in a risk appropriate and globally diversified portfolio, and have access to a portfolio manager (that’s right, a human advisor) who has a fiduciary duty to act in your best interests.

Last year I partnered with the robo advisor Wealthsimple on a retirement income case study to see exactly how they manage a client’s retirement income withdrawals and investment portfolio.

This article has proven to be one of the most popular posts of all time as it showed readers how newly retired Allison and Ted moved their investments to Wealthsimple and began to drawdown their sizeable ($1.7M) portfolio.

Today, we’re checking in again with Allison and Ted as they pondered some material changes to their financial goals. I worked with Damir Alnsour, a portfolio manager at Wealthsimple, to provide the financial details to share with you.

Allison and Ted recently got in touch with Wealthsimple to discuss new objectives to incorporate into their retirement income plan.

Ted was looking to spend $50,000 on home renovations this fall, while Allison wanted to help their daughter Tory with her wedding expenses next year by gifting her $20,000. Additionally, Ted’s vehicle was on its last legs, so he will need $30,000 to purchase a new vehicle next spring.

Both Allison and Ted were worried how the latest market pullback due to COVID-19 had affected their retirement income plan and whether they should do something about their ongoing RRIF withdrawals or portfolio risk level.

Furthermore, they took some additional time to reflect on their legacy bequests. They were wondering what their plan would look like if they were to solely leave their principal residence to their children, rather than the originally planned $500,000. Continue Reading…