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Investing for Retirement

Your method of investing for retirement depends on your long-term financial goals, your aversion to risk and your preferences for income and taxation. When done right, retirement investment can provide you with a very comfortable living long into your retirement. But it is essential to start early and invest often to maximize your potential gains.

Pension and Retirement Investment

Investors looking ahead to retirement need to focus on two main elements when investing for retirement:

  1. How should savings be invested now to provide for retirement some years in the future?
  2. How should savings be invested to provide income for someone who is already retired?

Retirement Investment and Your Pension

Investing for Retirement: The Future

The goal when investing for retirement should be to accumulate the highest value of investments by retirement age to maximize pension. In order to do this, it is important to save early! The following example illustrates why.

Example: Which investor ends up with more money at retirement?

Investor A invests $12,000 per year for 10 years starting at age 35, and then doesn’t add any more. Total contributions: $120,000.

Investor B waits until age 45, then invests $12,000 per year for the next 20 years. Total contributions: $240,000.

Both earn 7% compounded, sheltered from taxes as they would be in a Registered Retirement Savings Plan. At age 65, Investor A’s investments would amount to $686,494, while Investor B’s investments would total $526,382. Why does Investor A do so much better despite investing only half as much? Because Investor A started earlier. The compounding of returns over time is very powerful!

Strategic Investing

The next most important rule when investing for retirement to achieve high retirement savings is to use a sound strategy. However, a sound strategy does not necessarily mean the safest strategy. Rather, a sound strategy is one that goes further, taking on a moderate amount of risk, in order to boost the average annual return over time. Consider someone starting with $100,000. After 30 years, the value of the portfolio, compounded at 5%, would be $444,671. If, instead, the portfolio compounded at 8%, the value would be $1,052,470. This is an enormous difference and would probably mean a lot to a retired person’s comfort level and enjoyment of life. This illustrates why it is important to work hard to produce the extra two or three percentage points of average annual return.

The safest route when investing for retirement is to hold government treasury bills and short-term government bonds. Currently, this would give a return of no more than 2% per year. This provides for the almost certain return of money invested, plus interest. However, there is an important shortcoming to this approach for those seeking to maximize return over time. Historically, stock markets have produced a higher average rate of return than treasury bill or bond investments when measured over periods of several decades.

Certainly, there is a higher risk associated with owning stocks, and the returns cited are for the broad stock market as a whole (not individual company stocks which may have done better or worse). In addition, there is greater volatility of returns year by year for stocks compared to the others, although over 10 year periods since the 1950s, stocks have shown positive returns. Will history repeat itself? That is, will a properly diversified stock portfolio continue to outperform T-bills and bonds? There are no guarantees. However, with history on their side, investors with at least 5 to 10 years until retirement should consider some stock ownership in their portfolios. Perhaps, with a portfolio half in stocks and half in bonds, they would be able to achieve something closer to 8% on average than 5% over a period of a decade or more.

Various studies of historical data have concluded that portfolios that are diversified into different types of assets, such as bonds, T-bills, and domestic and foreign stocks, provide the best return and lowest risk over time.

Investing to Fund Current Retirement

For many people who are drawing on their savings to fund current pension and retirement, the safest route often makes the most sense. This means being invested in T-bills and bonds that are certain not to lose value. However, like all issues in investing, there are some drawbacks to the safest approach.

Bond interest is taxed fully as income. For investments outside of tax-sheltered retirement plans, investors can often achieve greater after-tax income, with a minor amount of extra risk, by owning preferred shares of large, established companies. The dividend interest is taxed at an approximate 35% rate for top income earners, compared to around 50% for interest income. This can mean a considerable tax saving at all income levels. People owning bonds are often at a disadvantage due to inflation. The amount of interest from bonds may be sufficient for current expenses, but will it be enough in 10 or 15 years when expenses are higher? A sound strategy, then, for people who are just retired and are facing another 20 or more years of life expectancy, would be to have at least some portion of their investments in assets that keep up to inflation. For some, the ownership of their home or other real estate may be enough. For others, it may be wise to have some ownership of stocks, in order to achieve the higher returns over time.

For retired people invested in stocks via mutual funds, a systematic withdrawal plan could work well as an alternative to owning bonds. Such a plan would allow the withdrawal of funds on a monthly or annual basis, much like receiving interest from a bond. There are two important benefits: (1) the amount withdrawn in the early years would be treated for the most part as return of capital, and therefore not taxed; and (2) if the rate of withdrawal is less than the rate of return achieved by the mutual fund, then the amount invested would continue to grow over time. Instead of, or in addition to, investing in bonds, using a systematic withdrawal plan connected to an equity mutual fund could well allow a retired person a higher after-tax income as well as inflation protection.

Your method of investing for retirement and pensions depends on your long-term financial goals, your aversion to risk, and your preferences for income and taxation. When done right, investing for retirement can provide you with a very comfortable living long into your retirement. But it is essential to start early and invest often to maximize your potential gains.