investment planningRetirement Investment Planning
In this chapter, I will try and discuss various investment strategies specific to people over
60 years of age – like our parents. After-all investment advice for a 65-year-old can be
very different for that of a 35-year-old. Brian McWilliams, my close friend of 15 years
and partner at Affinity financial, helped me pull this chapter together. Brian is also a CA
but his main focus is investment planning and managing funds for Affinity clients. So,
any part that you really love and found extremely deep and insightful was likely my
input. If anyone disagrees with anything, blame Brian.
Basic Investment Philosophies
In the last chapter I discussed the importance of planning to ensure the ultimate success
of any investment strategy. The challenge that most investment professionals face in
dealing with clients is that clients’ pick their investments long before they determine a
sound investment philosophy. This is especially true for our parents’ generation. We
have all heard of situations where someone buys a stock on a “hot tip” only to lose most,
if not all, of their investment. Unfortunately, even I have fallen to this many times. For
all my friends with hot tips, leave me alone (except Paul, you have been good to me). To
use our trip analogy from the previous chapter: selecting an investment before developing
a plan is like deciding initially that you are going to drive on your vacation and then later
deciding to travel to Barbados.
We once had a new client referred to me for general financial planning. She was a 72-
year-old widow and wanted someone to guide her. It was quite nice that her son was
with her and trying to help. Upon a review of her portfolio and recent investment moves,
we found that she had recently converted all her dividend bearing blue chip stocks and
mutual funds to bonds and GIC’s. Her son and her explained that they read that anyone
over 60 should have a safe portfolio and should therefore invest in nothing more that
interest earning bonds and deposits. I said that might make sense for her but for us to
know for sure, we needed to first know what she wanted to accomplish with her savings.
Was it to increase her monthly income, was it to ensure a safe growth of her investments
or something else? She said that given her current and her deceased husband’s
continuing pension she had more than enough money to live on and all she wanted was to
leave a legacy to her grandchildren. In light of that we determined that her portfolio’s
investments was not appropriate.
The above story shows that a sound investment strategy should flow naturally from a
well-defined investment plan. To use our “trip to Barbados” analogy, my client above
decided to vacation in the Barbados but without thinking, she took the car.
A friend of mine, Allen, an extremely bright guy, asked me to play golf and tip back a
few beers. Now Allen knows I don’t drink that much so I new he wanted to talk. We
started golfing and after seeing my first drive, he decided this was a good day to put some
money on the game and bet me accordingly. Did I say Allen was a friend of mine? Sure
enough his first drive sent that ball long and straight and he was already telling me how
he was going to spend his winnings. During the game, he asked me about planning for
his parents. He knew I was writing this book and wanted some free advice. I did say he
was a friend, didn’t I. He wanted direction on how to develop the over-all planning
strategy for his parents. After bemoaning my last slice into the woods, I explained a plan
should have several elements, starting with the very general and moving to the very
specific. He liked this since he is a detail kind of guy (he notices all the detail problems
in my swing – and tells me endlessly). The first element of the plan should be a
discussion of the intent of the plan. In other words, why are we doing this? What are we
trying to achieve? I explained we are doing this because we are trying to set up an
investment plan for his Mom and Dad that maximizes investment returns within an
acceptable level of risk. He replied, Okay, what does that mean? I explained that I
would get more specific as we talked. From this point on I spoke very generally and it
served him right.
The second element of the plan will be where the objectives of the plan are laid out. Here
is where we discussed general objectives such as: projected financial requirements (a
budget); how we will minimize the costs of administering the plan; the investment time
horizon and his parents’ tolerance to risk. Specific objectives would include specific
items such as a large upcoming payment on the cottage renovation – something I knew
Allen’s parents had coming. I said, let’s look at these items a little more closely. When
we look at your parents’ projected financial requirements, we need to determine the “easy
sources of income” as I call it, such as guaranteed pension plans, and the like. We
distinguish these sources of income from the investable assets. It is the return on the
investable assets that will ensure that the overall income plan objective is attained. If
your parents are in their mid-sixties then statistically one of them should live at least
another ten years. From an investment “time horizon” perspective, that is a long time.
Allen said something that his dad was so stubborn he will outlive all of us. I ignored that
and explained that it also means that his parents have the ability to accept a reasonable
amount of risk. Many advisers hold the view that when individuals reach retirement age
they should sell all their stock investments and buy bonds and term deposits. The theory
is that stocks are ‘not an appropriate investment’ for a retired person. The challenge to
this approach is that it is very one-dimensional. I emphasized to Allen that it fails to
factor in the financial requirements of individuals like his parents’. It also fails to
recognize that a significant time horizon could still exist and therefore the opportunity for
further gains in that particular investment. And, I think most importantly, it suggests that
the quality investment that his parents have held for many years is now no longer any
good. This, of course, is silly. As I explained to him, the point of all this is that he must
look at all of these items together and not in isolation in order to develop a sound basis
for his parents’ investment strategy. I felt I had given him so much to think about that his
game would now suffer.
Allan had just crushed another ball. It is amazing how inadequate I feel every time he
does that. He was quite and pondering. I had just enough time to hook a ball into a pond.
Then he simply said. Ok, all this makes sense but where do we go from here – ah,
besides that wonderfully scenic pond to get your ball that is? Did I mention Allen has
absolutely no sense of humor? I explained, now that we have some objectives we can
start getting into some specifics. We know what your parents’ projected financial
requirements are; we know what a reasonable time horizon is; and we have identified any
specific objectives that must be factored into the plan. Based on this information we can
now develop some specific statements about the following:
• Cash flow needs? How much money does the investment plan need to generate in
order that your parents’ achieve or maintain their desired lifestyle goals?
• What is your parents’ time horizon? Are they relatively young and in good health?
Are they going to spend it all and leave you nothing? If so, over what period of time?
Or, are they trying to save everything to pass on to your children? You can see that
the answers to each of these questions will dramatically alter the time horizon and
therefore the decision as to how to diversify your investments – commonly called
your “asset allocation” decision.
• Are there any income tax considerations that need to be factored into the plan? I told
Allen that if he wants more specifics on taxation he can buy my book and read the
chapter on it. He just smiled and sank a 9 to 10 foot put. I hate him. Suffice it to say
for the moment that tax considerations are a very important part of your overall
investment strategy.
I was trying to ignored that I was getting my “you know what” kicked and explained to
him the following two issues tie the above points together:
• What is your parents’ required rate of return? – What rate ensures that the cash flow
target set above, is attained?
• What sort of risk profile can your parents’ accept? – Given the cash flow needs and
the time horizon identified above, what sort of risk level is either acceptable or, in
some cases, a requirement in order to achieve the objectives laid out previously?
By now Allen and I had finished the game and ordered some beers. He was tallying the
score and I realized my children’s education might have to wait. He was a very happy
man. Yet again, he beat me silly, took my money and got free advice. At least I didn’t
give him any tax advice. That he will have to pay for.
Asset allocation – Now we are ready to start talking investments. Remember at the
beginning of this chapter the story of the person who bought the stock on the hot tip? I
wonder if they did all this analysis in order to arrive at that ‘buy’ decision? We have
identified a number of objectives and some constraints that we must keep clearly in mind
as we consider asset allocation. We have to look at historic rates of return for each asset
class while recognizing that each asset class has a different level of risk. We have to look
at asset allocation bearing in mind that we are striving to achieve a “total after-tax return”
not just a nominal return. What does this mean? The nominal return on an investment is
the simple percentage return. For example, if a $1,000 investment yields $50, it would
have a 5% nominal return. The total return is an inflation-adjusted return. Using the
same example, if inflation is 2%, then the total return is only 3%. So, on the $1000
investment, $20 is inflation and $30 is the actual return you earned on the investment.
Total after-tax return is critical to your parents’. Taxes are a given and there is no point
in discussing pre-tax dollars because it is the after-tax dollars that your parents will be
spending. Total return is imperative because inflation is always present to some degree.
If we develop an investment strategy for your parents without adjusting for inflation, then
in a very short period of time your parents will be spending their capital and will run out
of funds long before they planned.
We are now at the point where we can make some specific asset determinations. In the
next section of this chapter I will discuss the various types of investments in some detail.
We are guided to the securities that we pick by all the planning that has preceded this
point in the process. Selecting the securities is much easier once we have an idea as to
what is appropriate and what is not appropriate for this investment plan. It is also at this
stage that we select money managers. Unless you are an investment professional
yourself, someone is going to be charged with executing this plan. Your parents will
have to select an investment professional that they are comfortable with and who shares
their thoughts on how this plan is to be managed. The last point you need to consider at
this, the beginning of the overall process, is what are the control procedures? Control
procedures, is the method your parents will use to assess the ongoing effectiveness of the
investments themselves as well as the people managing the investments. Remember this,
your parents have just entrusted someone to manage their investment portfolio and to
execute a plan that they and you were instrumental in developing. You should help your
parents establish clear and timely reporting procedures; they will also want to determine
performance measurements and the time period over which the manager is to be
As I just mentioned, this is just the beginning of the process. This is a dynamic process.
As time marches on, things happen. Your parents’ health situation may change,
necessitating changes to the plan. Your parents’ may finally decide to take that threemonth
trip to Hong Kong and Australia (this was never mentioned in the original plan).
The point is you should help your parents to constantly monitor and re-balancing their
portfolio to keep up with the then current realities.
Types of Investments
The good news is that there really are not that many types of investments. The bad news
is that within each investment type there are potentially thousands of investment
securities from which to chose.
Asset types include the following: Cash equivalents, fixed-income, equities, real estate
and venture capital. Cash equivalents include Government treasury bills, Commercial
paper (treasury bills issued by companies), Bankers Acceptances and other short-term
deposit instruments. Fixed income includes mortgage-backed securities as well as bonds
issued by various levels of government, Crown corporations as well as businesses.
Bonds with a maturity of less than one year are considered cash equivalents. Bonds with
maturity dates in excess of one year are considered fixed income. Also considered a part
of fixed income is preferred shares. This is because although the security is a share in the
company, it has more of the characteristics of a bond than a common share. Preferred
shares have a priority over dividends issued by the company. In addition, like most bond
issues, preferred shares have a priority claim on assets. Preferred shares typically have
after-tax yields that are similar to yields on bonds. It is because of this secured position
that prices of preferred shares do not fluctuate wildly in the marketplace, as would the
common shares of the same company. Here is where things start to get a little
complicated. There are convertible bonds, retractable bonds and redeemable bonds.
Retractable means that the company may call them in. Redeemable means that the
investor can ask the company to redeem them. Bonds are valued and priced by the
underlying assets of the company. The better the credit rating of the government or
company, say AAA, the lower the interest rate that the bond will pay. Corporate bonds
typically pay higher yields than government bonds because it is very difficult for
corporations to achieve the AAA status that the Canadian Government enjoys. Bonds
will trade at a discount or premium to its par value, which is always ‘100’. The reason
for the discount or premium has to do with the daily swing in interest rates. If the coupon
rate on a bond is 8% and the current interest rate in the market is 6%, then the bond will
trade at a premium, say at 103. Why? Because you will pay more to have the bond that
pays the higher interest rate. Conversely, the bond with the rate below 6% will trade at a
discount to par value or, say 98. Mortgage-backed securities are as the name implies: It
is a debt instrument, like a bond, that is secured by a portfolio of mortgages. The value
of a portfolio of mortgage-backed securities will vary with the underlying credit quality
of the mortgages. If the individual mortgages in the underlying portfolio are all current,
the mortgage-backed security will maintain a strong value. If many of the underlying
mortgages default due to a recession, the value of the mortgage-backed security will
diminish. There are many more complexities to fixed income products that will require
several more volumes. I have just tried to touch on some of the major products and some
of their elements. It can be complicated which is why I recommend a good investment
advisor be retained.
The same sorts of complexities hold true for equities. Equities, or stocks as they are
commonly referred, also have many complex products within the overall framework of
the asset class. Generally speaking, where fixed income assets represent a debt of the
company, equities represent an ownership stake in the company. The differing types of
equity investments include the most well recognized type, the common share. In
addition, there are securities such as warrants and American Depository Receipts
(ADR’s). A warrant is typically issued in conjunction with a common share offering and
allows the holder to purchase more common shares in the company at a favourable price.
ADR’s allow non-US companies the ability to obtain a listing on a US exchange. The
most common method of investing in equities is to buy common shares and hope they go
up in value so that they may be sold for a profit. There are many more strategies used by
professional and non-professional investors alike to generate returns on equity
investments. For example, a strategy might include the purchase of privately issued
restricted common shares, issued at a deep discount to the price in the stock market.
When the common shares become unrestricted, they are sold in the market at the higher
market price. Another strategy might involve derivative securities such as options. Most
people at this point make a hasty retreat to the exits when they hear the words ‘derivative’
or ‘options’. This is generally because of media reports involving spectacular losses
involving derivatives. This is the exception rather than the rule. Derivative securities are
as the name implies: The security is ‘derived’ from the underlying asset, such as a
common share. An option is simply that: It is an option to buy or sell the common
shares. The common strategy involves purchasing shares in a company you like and then
selling the option for someone to buy these shares from you. Why would you do this?
First, it is safe! Second, it can enhance your return on the stock you purchased. If you
bought ABC Company stock at $57 per share, and it went to $63 per share in one year,
you would have a one-year return in excess of 10 per cent. Now suppose that each month
you sold an option (that expires in one month) to sell your shares at $65 per share, and
you sold these options for $1 per share. If the price of the stock never went above the
$63 noted above, then the purchaser of your options would never exercise them (why
would she if she can buy the stock at $63 or less?). This means that each month the
options would expire and you get to keep the $1 per share. Using this example, your
portfolio would have grown by $18 during the year or 31.5%. Wow! You say, sounds
great but obviously there is a risk. Of course there is, but let us analyze the risk. You
sold the option for the stock to be bought from you at $65. Let us say the stock hit $65 in
the first month you sold an option and the option was exercised. Let us summarize what
happened. You sold the option for $1 per share; the stock was bought from you at $65
per share when the option was exercised (that equals $66 per share); You bought the
shares for $57 per share; your profit is $9 per share or almost 16%. Okay, so where is the
risk. The risk is that the stock could have gone to $70 or $80 per share. But, you have not
lost a dime, a safe way to earn superior income using derivatives. Again, what is the
conclusion from all this: There are many different methods in the marketplace for earning
superior investment dollars. If you are advising your parents on their investments, the do
your parents the service of educating yourself to the fullest extent possible to ensure that
you are providing them with the best possible advice. Will you ever have the detailed
knowledge of an investment professional? Likely not. The important thing to remember
is that a solid understanding of the investments that you are contemplating for your
parents’ portfolio is an integral part of the overall portfolio structuring process. If you do
not have a fundamental understanding of the assets that you have selected for your
parents portfolio, then how will you: a) be sure they are appropriate to your parents
situation; and b) how will you measure your parents’ investment adviser on their ability
to manage the portfolio.
I will only touch briefly on the other asset classes mentioned earlier. Real estate would
involve direct investments in properties such as rental houses, apartment buildings, or the
like. Indirect investments in real estate would involve the purchase of shares in real
estate companies or purchases in Real Estate mutual funds or trusts. Venture capital
involves the investment in start-up or high-risk companies.
Why would we consider investing in different asset classes? Why would we not just put
all our money into say, fixed income? The main reason is diversification. The different
asset classes tend to move very differently to changes in the marketplace. If all your
money was in fixed income and interest rates fell, your return to the portfolio would fall.
But if you were balanced between fixed income and equity, as the value of the fixed
income portion was falling, the equity portion could be growing to offset the decline.
I want to tie up the discussion on the different asset classes by talking about mutual
funds. I did not mention it previously because mutual funds are not an asset class. What
is a mutual fund? A mutual fund is simply a pool of money that is accumulated to invest
in one or more securities of one or more of the asset classes discussed previously.
Instead of me selecting individual stocks or bonds to purchase for my portfolio, I can
choose to invest my money into a pool of money, or a mutual fund where the manager of
the fund selects the stocks or bonds for me. The amount of return that I earn is relative to
the amount of money I invest in the mutual fund. If the mutual fund I invest in has a total
of $1,000 and my investment in the fund was $100, then I am entitled to 10% of all
returns and I will also be allocated 10% of all costs, such as management fees. How do I
know if the mutual fund manager will buy the type of stocks or bonds that I want to own?
This is where we get back to research. You have to learn about the different types of
funds. Does the fund that you are interested in invest in large companies or small hightech
companies? Are they Canadian? Or American? Or European? Does the manager
invest in companies because the outlook for that business sector is good or are companies
selected based on a detailed valuation of the individual companies? As you can see, a lot
of questions to answer. People who don’t take the time to understand basic investment
concepts are always going to rely on strangers to insure their lifestyle is maintained in
their retirement years. Back to the travel analogy. It would be equivalent to saying to a
travel agent “I want to travel”. She will decide where you are going, for how much, for
how long and by what method of travel. You won’t know what is going on until it
happens. You are just along for the ride hoping you get someplace you like. Not many
people would allow this to happen to their travel plans. So why let it happen to your
investment planning.
Pros and Cons of Different Asset Classes
Over the years, I have been approached by so many people who have asked me about the
pros and cons of different types of investments. It is not entirely proper to judge an
investment based on its specific attributes only. It is more proper to judge the investment
considering both its basic attributes and the investor’s personal situation and how the
investments attributes makes sense within the over-all investment plan. As I discuss the
pros and cons of each asset class, you must remember that diversification in a portfolio is
key to the overall success of the portfolio. Also, investing a portion of the portfolio in an
asset class that is more risky than another asset class may sometimes be a very necessary
component of the overall portfolio strategy. None-the-less, with the patient assistance of
Brian McWilliams, the following should help explain the basic pros and cons of different
types of investments:
• Cash equivalents – The ‘Pro’: It does not get any safer than this. The vast majority
of the different instruments that comprise this asset class are backed by AAA rated
issuers and can be converted into cash so quickly that it is highly unlikely that a loss
would ever occur. Conversely the ‘Con’: The rate of return on this type of asset is
very low. You will notice this theme running throughout this section, and I am sure
you have heard this comment before: ‘The greater the risk, the greater the return’.
Cash equivalents, because they are such a low risk security, yield a very low rate of
return. Why should the government or company issuing the Treasury bill or
commercial paper pay more interest than is required to obtain investment funds?
• Fixed income – The ‘Pro’: Fixed income securities are interest rate sensitive so they
can be an effective hedge against inflation. If inflation is rising then interest rates
tend to rise as well. Why do interest rates rise as inflation rises? A simplified answer
is that it is a case of supply and demand. As inflation rises, economies begin to
contract. As economies contract, companies lay-off workers which means there is
less cash circulating in the economy. If demand for money remains steady, but the
supply has decreased, the price of money (the interest rate) will increase. Another
‘pro’ is that many fixed income securities are backed by AAA rated issuers, so they
are very safe. The ‘Con’: In a period of low or no inflation, as experienced during the
late 1990’s, the return on fixed income securities has not been too attractive. For
many investors the returns have not been attractive enough to provide the rates of
return required to sustain their lifestyle during retirement.
• Equities – The ‘Pro’: Equities and fixed income securities are the two largest asset
classes. The breadth of choice in equity securities provides an investor with a large
population from which to choose his investments. Over the last 25, 50 or even 75
years, equity markets as a whole have always provided a higher rate of return than
fixed income or cash investments. The ability to provide diversification from another
asset class and to provide diversification within the asset class is tremendous. Equity
investments have provided investors with the ability to earn large gains in the
appreciation of their investments. During the 1990’s, many investors have made
significant annual returns (20% to 50% per year) on investments in common shares.
These types of returns would not be possible in a portfolio comprised solely of fixed
income securities. The ‘Con’: Equity investments must be purchased with the long
term in mind. As I mentioned earlier, over long periods of time equity investments
always out-perform fixed income investments. The challenge is in the short-term.
Stock prices tend to go up and down in the short term. Some of the price swings can
be dramatic. If you have invested in the shares of a quality company, your
investment should yield handsome returns in the long term. However, in the short
term, you have to be prepared for a bit of a roller coaster ride. A big problem that
investors face is that they will invest in an excellent company only to see the price of
the shares drop after their purchase. In a panic they sell their shares to avoid a large
loss. But a large loss was not on the horizon. The drop in price was a part of general
market volatility. Had they held their shares for the long term, they probably would
have reaped handsome returns. Another common occurrence: The investor sits and
watches as a stock rises, and rises, and rises. Finally they decide it is time to jump in
and invest. Then, the price begins to drop. They watch the price drop, and drop, and
drop. They decide it is time to sell and cut their losses. Buying high and selling low
is no way to invest in equities. A systematic approach, based on the goals and
objectives outlined in a detailed investment policy, will ensure that you do not fall
into the traps of many naïve investors.
• Real estate – The ‘Pro’: Again, the major benefit of an investment in real estate is the
benefits from diversification. Pure investments in real estate react differently to
market and inflationary forces than do equities and fixed income. Real estate values
are typically based on the discounted cash flow of future rental income. As such, real
estate values do not fluctuate the way stock prices will. The ‘Con’: Investments in
real estate mutual funds or trusts often act more like stocks than they do like real
estate investments. This is because the units in the mutual fund or trust trade like
shares. This reduces the effectiveness of this investment as a diversification from
equities. In addition, investments in specific real estate are highly illiquid. Whereas
stocks and units in a real estate fund can be sold in a matter of minutes. Specific real
estate investments can take months sell.
• Venture Capital – The ‘Pro’: Venture capital investments can be the most lucrative
investments that an investor ever makes. Rates of return in the thousands of
percentage points (increasing your initial investment by 10 times) are not uncommon
in venture capital investments. The ‘Con’: Most, and I mean most, investments in
venture capital lose the investor all of their money. That said some investment
advisors feel it is still a viable investment class that should be considered, to some
small extent, by all investors. In spite of its very risky nature the one investment that
returns you the one thousand per cent, will more than adequately compensate you for
the losses in the other investments. I, on the other hand feel this type of investment is
totally inappropriate for our parents. They may not have the stomach for this type of
investment and it certainly requires sound management that is difficult to find.
Another ‘con’: Venture capital investments are also highly illiquid. This is because
the investment is typically in a private, start-up company, and there is no ready
market for the shares.
Basic Investment Plans
Now, I would like to tie all of this together by giving you specific examples of basic
investment plans. I will lay out three plans for you: The first plan will be for a retiree
who is widowed and who plans to set aside the bulk of her estate to set up trust funds for
her grand children. The second example is for a couple whom wishes to spend as much
of their money on traveling and is not concerned about leaving funds behind to their wellestablished
children. The third example will be for a couple whom wishes to provide a
balance between their desires for travel and for providing for their children and
Scenario One
Hazel is 73 years old and has been widowed for several years now. She use to work as a
maid who ended up marrying her widower boss, Mr. B. For those of you who remember
the show, you have got to love this. She is in excellent health and is very active in her
community and spends much of her time as a volunteer with a number of local charities.
She does not like to travel and her living expenses are modest. Under the terms of her
late husband’s company pension plan, she will receive 60% of his pension, guaranteed
and inflation-adjusted for the rest of her life. She is also covered by her husband’s
company medical plan for the remainder of her life. Her home is mortgage-free, she has
no other debts and has $200,000 in a RRIF from which she draws the minimum amount
of income. Lets have some more fun. Lets say that Hazel is your mom and you look just
like her. I think that makes you “little B” or “B Junior”.
The Intent of the Plan
The income that Hazel is earning from the pension plan plus the amount she is drawing
from the RRIF is more than sufficient to cover her annual expenses. In fact, she is still
saving money. Through her discussions with you, she has determined that she wishes to
leave the bulk of her estate to her grandchildren. Given that she does not require any
income from the RRIF and that she is saving money from her current income, she can
accept a higher degree of risk. Her investment horizon is also much longer since she is
now investing for the grandchildren’s benefit, not hers.
Objectives of the Plan
Hazel is earning an inflation-adjusted pension that is guaranteed until she dies. It is more
income than she currently requires and you and your mother do not foresee any changes
to her income requirements. Given our discussions above your mother has a very long
time horizon. At a minimum we can say that her time is equal, at the very least, to the
time when your children will be of university age and will be drawing on the income.
Even then, your children will not be drawing all of the income from the trust funds so that
the time horizon increases further. The portfolio is therefore able to accept a significant
degree of risk. As we think of asset allocation we would pursue a portfolio profile that
has a greater allocation to longer-term investments and has less reliance on shorter-term,
more liquid assets.
Cash flow needs
As discussed earlier, Hazel has no need for income generated from the portfolio of
investments. In fact, she is a net saver. This allows us to focus our attention on longerterm
assets such as equities that tend to offer a greater potential return and to deemphasize
any allocation to lower yielding securities such as Treasury bills and other
cash equivalents.
Time horizon
As discussed, the time horizon for your mother’s portfolio is very long. There is no need
for cash flow generated from the portfolio so funds can be invested in longer-term
investments that may have a higher risk profile and may be more volatile. The volatility
would not be a concern due to the long time that your mother’s portfolio would hold the
Tax considerations
The bulk of your mother’s portfolio is invested in her RRIF. Any income or gains earned
by the RRIF are sheltered from taxation until the money is withdrawn. Since she only
withdraws the minimum amount required by law, she is minimizing her tax exposure.
The ultimate transfer of your mother’s RRIF to your children’s trust funds will involve
the payment of tax in your mother’s estate, but this cannot be avoided. The excess funds
that your mother is currently saving should be invested in equities that you plan to hold
for the longer term. By holding these types of assets, your mother can earn capital gains
without incurring taxes until the equities are sold.
Required Rate of Return and Risk Profile
Hazel’s portfolio has no required rate of return since we are not striving to generate
additional income to satisfy her lifestyle requirements. That said, the profile of the
portfolio allows us to seek a higher rate of return because of your mother’s above average
ability to tolerate risk. This is based on the cash flow requirements and time horizon
discussions outlined above. Given that we are striving to maximize funds for your
children, we will pursue investments that have a higher risk profile but also have higher
long-term rates of return.
Asset Allocation
Now, is the time that we decide on the investments to purchase. Not as a reaction to a
‘hot tip’, but after some detailed analysis of the situation that helps us to determine the
appropriateness of the investment we are about to select.
Based on the profile of this situation I would recommend an allocation of 75% to
equities, 20% to fixed income and 5% to a growth fund focusing on say, the high-tech
industry. Within the 75% I would focus more on growth companies than large
capitalization, established companies. Again, given the risk profile that we established
for this portfolio, we can accept the greater inherent volatility in the growth fund in
search for above average rates of return. Of the 75% I would invest ¾ of the funds in
growth assets and the remainder in large capitalization stocks. Hazel is fine with the
plan. They way she feels, it is really a portfolio for the children and she can always go
back to being a maid. In fact she may meet her next husband that way again.
Scenario Two
Jack and Jill are both 65 years of age and are in good health. Jill was a Homemaker and
Jack had a senior engineering position will a large multi-national engineering firm
specializing in water delivery infrastructures. You and your brother are the couple’s
children and both of you are well established in your own careers. Now that your parents
are retired, they wish to do a lot of traveling. They are not so concerned about providing
an estate for you and your brother because you are both well established. Your parents
live in a large house in the city that was purchased in 1965. It is now mortgage-free.
Jack has a good pension plan that provides enough income to cover day-to-day expenses
and provides a small amount for savings. The pension is inflation-adjusted and is
guaranteed for life. If Jack dies before Jill, the pension will continue at 60% of Jack’s
pension amount for the remainder of Jill’s lifetime. RRSP savings are negligible since
your Dad always relied on his pension to provide the income for your parents’ retirement.
The Intent of the Plan
Jack and Jill have more than enough money to cover their day-to-day living expenses,
however they do not have enough to fulfill their desire to do a lot of traveling. Your
parents are open to the idea of selling their large city home and buying a condominium
apartment outside the city. This will provide the capital required to finance their
traveling. Your parents are optimistic that their health should remain good until they are
75. They wish to do as much traveling as they can over the next ten years. Given that
your parents traveling urge is immediate, their ability to accept risk is low.
Objectives of the Plan
Jack is earning an inflation-adjusted pension that is guaranteed until either of your
parents die. This ensures that there will be steady income, sufficient to provide for your
parents’ day-to-day needs for the rest of their lives. The objective is to generate
additional short-term income that your parents can use to fund their world travel. The
house should be sold and the condominium outside the city should be purchased to freeup
investment capital. Given our discussions it is clear that your parents have a shorter
than average time horizon. Ten years is still a long time from an investment standpoint
however there will be annual income requirements from the capital that reduces the
investment time horizon considerably. The portfolio is therefore only able to accept
moderate risk. The asset allocation decision would attempt to strike a balance between
immediate cash flow needs (to pay for travel expenses) and the need to generate higher
rates of return to provide more income to pay for those larger trips. The ten year time
horizon still provides some longer-term flexibility.
Cash flow needs
Your parents’ cash flow needs are immediate. Once the net capital is available from the
move to the condominium, your parents want to start traveling immediately. This
requires us to focus some of our attention on assets such as Treasury bills and fixed
income securities to provide the cash flow required to pay for the trips. That said, your
parents are not going to spend all of their capital traveling in the first year. Their plan is
to travel for the next ten years while they remain in good health and have the energy to
travel. This allows us some opportunity to invest in longer-term assets, with a greater
degree of risk, to provide higher returns to preserve the capital and provide more income
to spend.
Time horizon
As discussed, from an investment perspective, the ten-year time horizon is still long.
However, because your parents’ wish to start traveling immediately, their time horizon is
shortened considerably. We will have to ensure that there is a balance between longer
term assets that have a higher return and risk profile and short-term assets, such as
Treasury bills, which do not provide much income, but provides the cash flow required to
fund your parents’ travel.
Tax considerations
Your parents have negligible RRSP investments. The bulk of their income will come
from an investment portfolio that is outside of their RRSP’s. Any income or capital gains
earned on these funds will be taxed in the year earned; there is no deferral. From a tax
perspective capital gains are more attractive than interest income. Capital gains can be
deferred if you buy a security and hold it for a long period of time, therefore deferring the
gain. The challenge here is that your parents’ cash flow needs outweigh these types of
tax considerations. Interest income, while carrying a heavier tax burden, achieves your
parents lower risk, shorter-term cash flow needs.
Required Rate of Return and Risk Profile
Your parents have an interesting challenge. They want to earn as much income as they
can (take higher risks), but they need income immediately to fund their travel (take lower
risks). Somewhere there must be a balance. We must determine the amount of money
that your parents intend to spend on travel each year. Comparing this to the capital base
generated from the move to the condominium will determine how much capital at current
interest rates is required to fund current expenditures. This will leave us with remaining
capital that can be invested in longer term, higher risk assets.
Asset Allocation
Based on our previous discussions it is clear that a balance must be achieved between
shorter term, lower risk assets and longer term, higher risk assets. If we assume that your
parents current income needs can be generate from 55% of the capital, then the asset
allocation would be 55% to fixed income and 45% to a balance of equities, real estate and
venture capital. The fixed income allocation would be balanced between shorter and
longer-term maturities to reduce the risk of interest rates swinging quickly in the short
term. A percentage of the fixed income assets will be allocated to Treasury bills to
provide for immediate cash flow needs. Of the remaining 45% I would not be inclined to
invest in venture capital or real estate. While your parents can accept some risk, I do not
think their objectives warrant taking the additional risks associated with investments in
aggressive equities (high tech, e-commerce) and real estate. I would weight the equity
portion more heavily to international investments, especially the United States. I would
focus on larger capitalization companies but I would still include smaller percentage
investments in smaller capitalization stocks and some emerging market stocks.
Note how when we compare the different portfolios of scenarios one and two, Hazel, who
is older, can accept much more risk than Jack and Jill. It is clear that this type of defined
approach to investment planning is a crucial methodology to assist your parents in
arriving at the correct asset allocation decision.
Scenario Three
In this scenario, your parents are both 65 and recently retired. They have a modest home
in the suburbs, (which is mortgage-free) and they have no intention of moving. Your
parents both have good pensions that are inflation-adjusted and provide for their day-today
expenses. Each pension expires on the death of the pensioner. In other words, your
Father’s pension does not carry on to your Mother; it ends with his death. Your parents
are confident that only one pension would be required to provide for the surviving
spouse. Your parents’ have combined RRSP’s of $100,000. They also have non-RRSP
investments of $100,000.
The Intent of the Plan
Your parents have decided that they wish to do a lot of traveling over the next few years
while their health is still good. However, they also want to ensure that they leave some
funds to your siblings and their grandchildren. This investment plan will have to ensure
that both divergent objectives are achieved. On the one hand, with the short-term ‘travel’
objective, a lower risk fixed income approach is warranted. On the other hand, with the
longer-term ‘estate maximization’ plan, a higher risk, equity based approach is warranted.
Objectives of the Plan
Your parents’ earn sufficient income from their pensions to cover day-to-day expenses
and they are debt-free. They can use their investment assets to provide for their dual
objectives of travel and providing an estate for their heirs. Your parents have two time
horizons that will both have to be addressed in the plan. One is a fairly short time
horizon and the other is a long time horizon. The short-term portion of the portfolio will
have to be structured to accept lower risk with a small allocation to higher risk assets to
ensure the portfolio maintains its purchasing power. The long-term portfolio can accept a
much higher degree of risk and can be allocated to a greater extent to equities, real estate
and venture capital.
Cash flow needs
Your parents have no direct need for cash from their investments. The need is based on
their travel plans. Investments in the short-term portion of the portfolio should be geared
to providing the necessary cash flow to fund travel on an annual basis. Since the longterm
portion of the portfolio is being set aside for the estate, no there are no cash flow
requirements for your parents from that part of their assets.
Time horizon
Similar to Scenario Two, your parents have a desire to travel. If their health is
maintained they may be traveling for ten years. As discussed previously, ten years is a
long time from an investment perspective. Rather than repeat myself I will not spend any
time on the shorter term ‘travel’ portfolio. I would structure it the same way as we did in
Scenario Two. I would like to focus on the longer-term portion of the portfolio and how
we can split investment assets to cover the two objectives of your parents’ investment
plan. Since the longer-term portion of the portfolio is being set aside for the next
generations, the time horizon is extremely long, certainly longer than your parents’
lifetimes. This is similar to the situation with Hazel in Scenario One.
Tax considerations
Tax considerations are very important to your parents investment planning. They have
two portfolios: A RRSP portfolio and a non-RRSP portfolio. They also have two
divergent objectives (isn’t that convenient): Travel (short-term) and estate maximization
(long-term). You have probably figured out where I am going with this. The RRSP
portfolio is tax-deferred. In other words, no tax will be paid on any earnings within the
plan until the money is withdrawn. We will use this portion of your parents’ assets to
serve as the long-term portion of the investment plan. Since the earnings generated on
the non-RRSP portfolio are going to be taxed annually, we should use this portfolio to
provide the funds for your parents travel plans. Under current tax legislation your parents
do not have to withdraw money from their RRSP’s until they are 69 (4 years from now).
This will give the longer-term portfolio a jump-start to achieve some good growth. Even
when your parents hit 69, the mandatory annual withdrawals are quite small and,
although tax must be paid on the withdrawals, the net after-tax funds can be set aside to
continue the objective of estate growth.
Required Rate of Return and Risk Profile
The required rate of return and risk profile has two elements in this case. In the case of
the short-term, or ‘travel’ portfolio, while your parents may desire a high rate of return,
this is clearly not practical give their short-term objectives for this portfolio. Their return
requirement would be based on the amount of money they wish to spend annually on
travel and on the available capital in the portfolio ($100,000). As discussed earlier, this is
similar to Scenario Two. The longer-term portfolio can strive for much higher rates of
return and accept much higher risk. The only limitation to the longer-term portfolio
would be any restrictions imposed on RRSP investments. Under current rules, 80% of
RRSP assets must be invested in Canadian assets. In addition, certain investments, such
as options and restricted securities that I mentioned earlier in the chapter, do not qualify
as RRSP investments. That said, there is a tremendous selection of investments in the
financial marketplace.
Asset Allocation
As mentioned earlier I will not spend any time on the short-term portion of the plan.
Please see Scenario Two for my comments on this type of plan. For the long-term plan I
would choose an allocation that is heavily weighted in equities, say 75% to 80%. Within
this allocation I would allocate up to small capitalization start-up companies and I would
also allocate up to 5% to 10% to real estate through investments in real estate trusts or
mutual funds. The remainder I would allocate between large capitalization stocks and
mid-capitalization growth stocks. I would ensure that 20% of all RRSP funds were
invested in foreign assets to ensure that the portfolio was diversified and could seek
higher returns in the global marketplace.
Scenario Four
Your dad passed away some time ago and left just enough insurance to provide for a
proper burial. Ally, your mom, is 62 and a former lawyer. She lost everything in a
business deal years ago and has since been able to save around $35,000. She lives in a
small clean apartment and has no private pensions. She collects her CPP and OAS but
doesn’t need much to live on (she doesn’t eat that much). You have offered to have her
move in with you but she still wants to be independent and not be a bother to you.
Intent of the Plan
Quite simply, the intent is to ensure Ally will have enough money for the rest of her life.
She realizes that she has minimal income and may have to rely on family for financial
support. You have also convinced her that she will certainly require a budget to help
identify her financial needs more thoroughly. She is very scared that she will lose her
investments again. As a result, the plan must be very conservative.
Objective of the plan
The objective is to ensure that she can live comfortably enough on her government
pensions and use her savings as a safety net for her and hopefully provide her with
additional annual income. Her time horizon is short in that she cannot afford to invest in
equities with long-term returns.
Cashflow needs
Her basic living needs are barely met with her pensions. Christmas, birthdays and other
events requiring extra moneys presents a challenge to her. Here, you need to assess what
short-term investments can best provide a safe additional cashlfow.
Time horizon
As stated, there is a very short time horizon. The single largest factor affecting the time
horizon is her fear of her inability to make up losses in the equity or other “long-term”
type of investments.
Tax Considerations
Due to her fears and resulting conservative nature of the plan, we have very little options
with respect to tax planning. We must choose investments from a practical needs
perspective first with taxation considerations secondly. Obviously, interest earned on
savings bonds and GIC’s are taxed higher then capital gains or dividends earned on
equities. However, her taxable income is likely very low and any difference in over-all
taxes between interest, dividends or capital gains would be minimal
Required Rate of Return and Risk Profile
You guessed it. Very conservative investments in shorter termed interest earning
instruments like GIC’s will only allow low rates of return. Ally can expect to receive 4%
to 5% per year.
Asset Allocation
A very boring yet very safe investment into GIC’s and t-bills. It would be prudent to take
the $35,000 and split it up in $5,000 segments to invest in GIC’s with different maturity
dates. Say, $5,000 into 30 day t-bills, $5,000 into a 6 month GIC, $5.000 into a one year
GIC and so on increasing each $5,000 amount by 6 month increments. This may allow
Ally to take advantage of higher interest rates offered on longer termed deposits while
keeping liquid if she needs money immediately.
Each of the scenarios, while fairly simple situations, showed very differing investment
objectives. As different as the objectives were, you can see that the methodology is still
the same. The key point I am trying to make here is that investment planning and
execution is a process, and the process is much more important than the actual selection
of the investments. There is no ‘right answer’ to any of the scenarios, either. You may
not agree with some of the conclusions that I would reach regarding your parents’
investment assets. That’s fine! That is what this is about: To stimulate thought about
how best to manage your parents’ funds.
In the first three scenarios, your parents have good pensions to cover day-to-day expenses
and each of the individuals is in good health. Realistically, this is not always the case as
shown by the fourth scenario. Many people reaching retirement age have not adequately
save or planned for retirement and will not retire with the pension plans used in the
examples, above. Many will also retire in poor health and will require part- or full-time
caregivers, at considerable cost. While these are very emotional issues to deal with, the
reality is that emotion must be set aside. Investment planning must be unemotional in
order to ensure that it is as objective as possible.
Investment Planning Checklist
To summarize, these are the elements that you should strive for in your parents’
investment plan:
• The Intent of the Plan – What are we trying to achieve here. This is like the
Executive Summary of the plan.
• Objectives of the Plan – Here we try to outline some of the objectives of the plan.
This would include what sort of income is required from the plan, what sort of time
horizon we are dealing with and if there are any specific objectives, such as the
$25,000 required to complete the renovation on the cottage.
• Cash flow needs – Now we are starting to get specific. Exactly how much is required
and where are we going to get it. This will help us focus a bit more on the portfolio’s
required rate of return and its ability to accept risk.
• Time horizon – This is critical to the planning process but must be analyzed in
connection with the cash flow needs of the beneficiaries. A longer-term time horizon
suggests the ability to accept more risk, however immediate cash flow requirements
would suggest a less risky approach to ensure capital is maintained to provide the
income required.
• Tax considerations – Again, an important component of the plan. It can help you
focus your investment strategy by asset classes and by portfolio type, i.e. RRSP
versus non-RRSP.
• Required Rate of Return and Risk Profile – This is where we take all of the
information we gathered above and summarize it to provide us with direction as to
how much income is required from the portfolio and what sort of risk level can the
portfolio accept. This focusing of the information will lead us to make much better
decisions as we lead to the next, and final part:
• Asset Allocation – here is where we finally get to choose what we are investing in.
But, hopefully by this point, we have a pretty good idea of what we should be
investing in and why we are choosing that particular investment. The only way you
can really structure a sound investment plan is to ensure that this step is the very last
step and not, as is often the case, the very first step!
Good Luck!