RRSP - Why you need a plan and how to get one

Christian Charest: For Morningstar, I'm Christian Charest. RRSP season is in full swing in Canada and all this week on Morningstar.ca we're helping you do an RRSP check-up. I'm here with Christine Benz, Morningstar's Director of Personal Finance.

Thank you very much for being with us.

Christine Benz: Christian, it's great to be here.

Charest: Many investors proceed straight to the security selection when it comes to their retirement plan. Why is it important to step back and make sure you have a framework in place for what you're trying to achieve?

Benz: You're right that a lot of investors proceed straight to the fun part of the investment process. They start picking various funds. In my experience a lot of investors end up with sort of an investment collection as opposed a well-thought-out portfolio. So, it's kind of equivalent to building a house without any sort of blueprint. You've got a room over here and one over there and you haven't really thought about how the whole thing works together. That's what a portfolio plan will do for you. It will help ensure that the portfolio that you put together is based on a blueprint that takes into account your time horizon, how much you expect to save and other factors like that.

Charest: What are some of the elements of a proper financial plan?

Benz: Well, I think the key first step is to make sure that you have quantified your goals. So, in this case -- retirement -- that you spend some time looking at how much you'll actually need in retirement. For many people I think this will be a surprisingly large number given the drag on inflation over time; you'll probably need to have more than you might think. So, quantify that goal and also think about how that might drive your savings rate on an ongoing basis. See what you can do in terms of your own contributions to try to hit that goal with maybe a little bit of a helping hand from the market.

The other key component is that asset allocation blueprint. How much you should have in stocks, bonds and cash given your proximity to retirement. You want to step back and think about that. What makes sense for me given my life stage, given my risk capacity? Finally, you want to think about the extent to which you can take advantage of tax-advantaged vehicles to enhance your take-home returns. We all have government incentives to save more for retirement. So, you want to make sure that you are maximizing those incentives by saving in vehicles like your RRSP.

Charest: So, let's take a look at this by life stage. Let's start with young accumulators, people in their 20s. What sort of advice would you give them? What are some of the pieces that they should be considering, assuming they don't have a plan in place, if they want to get started?

Benz: The first thing would be to just get started because people who are in their 20s and 30s have such a long time horizon. That's one of the most powerful assets that they have. So they need to get started and take advantage of it. When you look at even a fairly modest contribution rate, say, someone who is contributing $100 a month and plans to do that for the next 45 years until they retire, even if they earn a pretty modest return on that money over that time horizon, say a 5% return, they will have $200,000 set aside by retirement. So, harness the power of compounding. That's just a tremendously powerful ingredient in young accumulators' portfolios.

They should also have an asset allocation framework in mind for them, for people who do have a very long time horizon a very high equity weighting will make sense because when we look at the long-term data on asset class returns over long periods of time what we see is that stocks do tend to outperform every other asset class. So, you want to make sure that you have a healthy allocation to stocks. I'm comfortable saying that folks who are in their 20s should think about having the majority, the vast majority of their portfolios in equities. Those would be a few key things that young accumulators should have in mind.

Charest: Moving on to the next major stage, let's say, people who are in their 40s or 50s, obviously, they are in a different situation. Presumably they have already accumulated some assets. If they don't have a plan, how should they go about it at this point?

Benz: Well, at that life stage, I think if you're lucky your salary is stepping up as you move into your middle accumulation years, so you should also be stepping up your savings rate at that point, make sure that you're not experiencing lifestyle creep. So, you're not spending everything that you're earning. You should in fact be steering a higher percentage of that salary into your investment portfolios. So, make sure that you are continuing to step up your contributions. Also make sure that you are continuing to hold a healthy percentage of your portfolio in stocks, but perhaps trimming that equity allocation a little bit, holding a little bit more in safe securities and the simple reason is that as you get closer to retirement and certainly this is true for people in their 50s, you want to start preserving some of what you've been able to earn. So, you want to be thinking about making your asset allocation modestly less aggressive at that life stage.

Finally, for people at this life stage I think it's also important to be thinking about if I have multiple investment goals that I'm trying to achieve. So I have some other things I want to get done in addition to making sure that I can retire, you want to make sure that you are quantifying those goals and making sure that you can in fact save for those multiple goals. Saving for retirement is paramount because if you have a shortfall as you approach retirement, you won't have that many levers to make up for that shortfall. While you're still in your 40s and 50s you can evaluate some of those trade-offs, see if perhaps you can forgo that large house if in fact it will help you retire on time.

Charest: Now, what about someone who is, let's say, in their 60s who are approaching retirement age, how do they go about it?

Benz: Well, at this life stage I think it's a great time to start looking at the viability of what you have been able to save to-date and see if that retirement plan is on track. If you are still working, you still have some trade-offs that you can potentially take advantage of to still make your retirement plan work even if it right now looks you'll fall short. So, you can continue to work, you can continue to kick up your savings rate. You could potentially steer a little bit more of your portfolio into stocks but you just have to understand the trade-offs of each of those decisions and make sure that you're comfortable with them.

It's also crucial at this life stage to start thinking about having an even greater share of the portfolio in very safe securities. I've been a proponent of what we call the bucket system for retirement planning. What that means really simply is that you're segmenting your portfolio by your anticipated income needs. So under the bucket system that I've written about means that you want to hold about one to two years' worth of living expenses in cash instruments, maybe income for years three through 10 of retirement in fixed income securities and the rest of the portfolio in stocks. What that means for an investor with, say, a 30-year time horizon in retirement is that he or she will still have the bulk of the portfolio in stocks. But it's helpful as you get close to retirement to think about how your spending needs in retirement should dictate what that asset allocation of the portfolio should look like.

Charest: That's great advice. Thank you very much, Christine.

Benz: Thank you, Christian.

Charest: For more on Morningstar's RRSP Check-up Week, we invite you to click on the links that are right below the video player and check back with us throughout the week.