Christian Charest: For Morningstar, I'm Christian Charest. It's RRSP Check-up Week on Morningstar.ca and I'm here with Morningstar's Director of Personal Finance, Christine Benz.
Thank you for joining me.
Christine Benz: Christian, it's great to be here.
Charest: In a previous video we talked about the importance of having a plan for your retirement, and one of the elements that was mentioned was setting goals and I'd like to come back a little bit on that and expand on the importance of having goals for your retirement. A lot of people have this amorphous goal of just accumulating as much as they can. But that's not really the way to go about it.
Benz: Saving as much as you can is always a great idea, but it does, I think, help to quantify how much you'll actually need in retirement and that in turn can help you back into what is an appropriate savings rate. You can count on maybe a little bit of a helping hand from the market, but if you do quantify how much you'll need that can help you see how much you need to be saving on an ongoing basis. So, it can help you set that savings target which ultimately will be more impactful than anything you do in terms of investment selection. Your own contribution rate is going to be by far the biggest determinant of whether you reach your financial goal and have a comfortable retirement.
The second key reason to set a goal and be specific about it is that most of us have other financial goals that we'd like to achieve in our lifetimes in addition to retiring comfortably. So, we might want to buy homes, we might want to help pay for college, we might want to do other things along the way while we're accumulating money for retirement. By quantifying each of those goals, taking time to determine how much they will cost, we can help juggle them and prioritize them to determine which ones should take precedence over the things that might be more in the category of "nice to have."
Charest: What's the best way to quantify a financial goal and to see if you're on the way to achieving it?
Benz: You can certainly break out your financial calculator and do the math yourself, or you can take advantage of any number of good online tools, either online savings calculators or calculators that are geared specifically to retirement planning. The nice thing about those tools is that you can tinker with the different variables. So, you can help come up with a plan that makes sense given the trade-offs that you personally can stomach. So perhaps rather than retiring in 20 years maybe you're willing to consider retiring in 22 years or maybe you are willing to nudge out your allocation to stocks, understanding that it will give you a little more volatility in the short term but it might enhance your portfolio's returns. So, that's one thing that is valuable about using a retirement-specific calculator; most of them do let you play around with the variables to help arrive at a good trade-off for you.
Charest: How does asset allocation relate to goal setting?
Benz: Well, your proximity to your goals should determine your asset allocation. So, for people who have many years -- 30 to 40 years -- until retirement, they can tolerate the higher volatility that accompanies stocks because stocks do generate higher returns over very long periods of time than other asset classes. For people who are near to retirement, they need to pay closer attention to the volatility of the portfolio that they put together. They need to have more in safe securities like bonds or cash, because if they have a big drop in the value of the stock portfolio they will need to have assets set aside to tide them through to wait for those equities to recover.
Charest: Now, what comes into it now is risk capacity and not simply risk tolerance. It's something we've talked about on Morningstar. But it doesn't hurt to go over the basics. What's the difference between risk tolerance and risk capacity?
Benz: It's funny. A lot of the questionnaires you'll see online that help you arrive at the appropriate asset allocation for you really do focus on this concept of risk tolerance like if you lose 10% in your portfolio would it affect your ability to sleep? That's risk tolerance. That's how we feel about losing money and losing money certainly doesn't feel good. But the bigger question, what I think most investors should put an emphasis on, is risk capacity, and what that means simply is if you have a big drop in your investment portfolio, is that going to affect your ability to achieve your goal? So, if you're a 65-year-old and you see your portfolio drop in half over a period of three years, as we saw during the financial crisis for many investors, is that going to cause you to have to recalibrate your retirement date? That's a bigger deal than losing a night or two worth of sleep because of short-term volatility.
So investors really need to keep those two things straight and make sure that when they are constructing their portfolio, they are accentuating risk capacity. The same is true with younger investors. Sometimes you run into younger investors who say, well, I'm very uneasy with losing money. I didn't set aside this money to lose it. I want to keep what I've managed to earn and save. The problem is that young folks, especially given the low interest rates that we have really across the board on low-risk savings vehicles, they are going to get eaten alive by inflation over their holding period if they just settle for very safe securities that dovetail with their risk tolerance. So, you need to keep these two issues separate, try to put a preference on risk capacity when setting your plan.
Charest: Thank you very much Christine for your insights. 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 all week.
