As in every industry, there are all sorts of terms that are thrown around without explanation such as mutual fund, bond, index fund etc. We believe that it is important to make our industry and services understandable and accessible.

As part of that goal let’s take some time to explore the mutual fund, the most popular investment structure in Canada holding over $1.9 trillion in assets as of July 2023¹. We will also explore a few other definitions that help provide the bedrock to understanding mutual funds.

Stocks

Also known as equities or shares, stock represents ownership of a corporation. When you own a stock, you own part of the business itself. Corporations will issue stock to investors to raise money to operate their business. The investors, through their stock ownership, have a claim to a portion of the profits and assets of the company.²

These stocks can then be bought and sold on a stock market, such as the New York or Toronto Stock Exchange.

Bonds

A bond is a loan made by an investor to a borrower (typically a corporation or government). The bond would have specific details regarding interest rates, payment dates and the loan repayment date (maturity). Bonds are referred to as fixed income since they traditionally pay a fixed interest rate to debtholders (investors).²

Bonds are used by companies, municipalities, states, and federal governments to finance projects and operations. Bonds can also be bought and sold on an exchange by investors.

Index Fund

An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track a financial market index such as the S&P 500. The S&P 500 tracks the stock performance of 500 of the largest public companies in the United States.

Historically when you invested through a mutual fund there were investment managers who did research and picked the investments of the mutual fund. This is considered active investment management, a person (or group) is actively making the decision on when to buy and sell the investments within the fund. This type of investment manager aims to outperform their peer group and market (such as the S&P 500).

An index fund is passive investment management, there is no person (or group) making individual investment decisions. Instead, the fund tracks an index (ex. S&P 500) and adjusts its investments based on the changes in the index². These funds tend to have lower costs because they do not need to pay the salaries and expenses of investment managers to make investment decisions. They do not aim to outperform the index but instead match it (minus their expenses).

Mutual Funds

A mutual fund pools money from unitholders to invest in securities like stocks, bonds, and other assets. Before the invention of mutual funds, it was extremely difficult for the average investor to have an adequately diversified portfolio. Instead of having to own stock in many companies directly an investor can instead own units of a mutual fund that owns the stock of those companies. ²

As an example, if there were 10 different companies and their shares were valued at $100 each an investor would need $1,000 to buy a share of each company. If an investor only had $500, they would need to wait, or only buy 5 of the companies. With a mutual fund the investor could pool their money with other investors and together they would have at least the $1,000 necessary to own each company. Each investor would then be entitled to proportional ownership of the companies based on the units of the mutual fund they own.

Exchange-Traded Funds (ETFs)

An ETF is the younger cousin to the mutual fund. Again, it is an investment where the money from a large group of investors is pooled and invested together according to a particular investment strategy. These strategies can be passive index investments, or they could be actively managed by an investment manager. ²

The biggest difference between mutual funds and ETFs is that ETFs are traded on a stock market and the price fluctuates throughout the day. Meanwhile a mutual fund is only traded once a day when the market closes.

Comparison

The benefit of mutual funds is that they do not have trading commissions on purchases or sales. Additionally, since you cannot trade them throughout the day it reduces the temptation to be a “trader”. Being a “trader” is dangerous for long-term investment returns.

Meanwhile, the benefits of ETFs are that due to their structure they tend to have slightly lower management fees and are slightly more tax efficient.

Conclusion

Both mutual funds and ETFs provide cheap access to diversification and a wide range of investment options/strategies. In most cases you can find mutual funds that use the same investment strategy as an ETF and vice versa. Due to this they can generally be used interchangeably.

Both mutual funds and ETFs are great options for all types of investors no matter the amount of money being invested.

Sources

¹ The Investment Funds Institute of Canada – IFIC Monthly Investment Funds Statistics – July 2023

² Investopedia.com – Financial Terms Dictionary

Admittedly, not the most interesting title. You likely have never heard the phrase “sequence of returns risk” but I guarantee that those of you approaching retirement have thought about it.

BUT Does it matter which order the returns come in?

I have reordered the 30-year annual returns into a bad start order and a good start order to examine the impact. The average over the 30 years is still 9.11% using either order. 

Let’s examine the impact of the order of returns in different investment scenarios.

Lump sum investment

Both scenarios start with a lump sum investment of $10,000. After the first 4 years there is almost three times more money with the good start. Yet, both end up in the same place after 30 years. The order of the returns does not matter if there are no contributions or withdrawals.

Annual investment returns source: S&P 500

Lump Sum Investment With Regular Contributions

Again, we start with $10,000, but now each year another $5,000 is added. You might expect that a bad start to investment returns would be terrible. In fact, a bad start is better! (As long as the average return is the same).

Under the bad start there is about $865,000 at the end of 30 years while the good start has only $669,000. With the same average return, you would have 29% more money at the end of 30 years if you had a bad start to your investment journey (and a good finish).

Annual investment returns source: S&P 500

Retirement Drawdown

This is the classic scenario when sequence of returns risk is discussed. You have reached retirement with $800,000 and plan to withdraw $50,000 every year for the next thirty years. 

If you happen to retire right before a string of bad investment years your retirement can be severely affected. With the bad start order you run out of money before the end of year 26. Under the good start order you would have $1,539,000 left at the end of the 30 years. This is a massive difference considering the average return is the same. 

Created by Thomson Allison Financial Solutions

What are some solutions?

If you have saved for decades, the last thing you want to hear is that a string of bad years to start your retirement could derail the whole thing. So, what are some strategies to deal with this risk?

There is nothing we can do as investors to change the behaviour of financial markets, but we can mitigate the impacts of sequence of returns risk. Here are two strategies:

1. Flexible Withdrawal Strategy

In years where the market is down you cut spending and reduce withdrawals. This reduces the impact of a down market as more funds are available for the future increases. This strategy has some limitations as spending tends to be difficult to cut.

When markets recover spending can be increased again. The flexibility allows you to weather the storms during retirement.

2. Cushion Strategy

This is a strategy we employ for our clients. Separate the investments into different time periods based on when you expect to spend the money.

• Short-term (1 – 2 years) is invested in a cash equivalent such as a high-interest savings account.
• Medium-term (3 – 5 years) is invested in fixed income funds (bonds)
• Long-term (5+ years) is invested in equity funds (stocks)

The investor’s situation and risk tolerance are an important consideration when applying this strategy.

We refer to the short- and medium-term investment periods as your “cushion” investments. If there is poor stock market performance, you can draw money from the cushion until those investments recover. This avoids withdrawing from assets that are down in value.

Conclusion

Sequence of returns is a legitimate risk when entering retirement and your portfolio should be adjusted to protect your investments. A string of bad investment years as you begin retirement can derail your plan if you are not properly prepared.

The above strategies limit your need to make withdrawals from equity investments during a downturn in the market, protecting your long-term retirement health.

We are continuing with the theme of debt repayment. Last month we reviewed how to choose between debt repayment and investing. This month we’ll explore two different debt repayment methods: the snowball method, and the avalanche method.

Snowball Method

The snowball method approaches debt repayment from a psychological and human nature basis by providing positive reinforcement. You repay the smallest debt balance first while making minimum payments on the rest. Then once you have repaid the first debt you tackle the next smallest debt and so on. You do not consider the interest rate of the individual debts. The snowball method focuses on providing wins and positive reinforcement as individual debts are paid off.

Avalanche Method

The avalanche method approaches debt repayment from an efficiency basis. You repay the debt with the highest interest rate first while making minimum payments on the rest. Once that debt is repaid you focus on the next highest interest rate debt. This method aims to minimize your interest costs and get you out of debt as quickly as possible.

Example

You have an extra $500/month you can use to repay debt (after minimum payments). You have the following debts:

• $4,000 student loan debt at 3.50%
• $1,000 line of credit debt at 7.00%
• $5,000 credit card debt at 19.99%

Using the avalanche method the debt is paid off in 22 months and total interest paid is $805.15. Under the snowball method the debt is paid off in 24 months and total interest paid is $1,729.37.

The avalanche method results in less interest and a quicker payoff period. The downside is that it takes about a year to pay off the first debt which may cause you to lose motivation and miss payments. The loss of motivation is even more likely when the debt balances are larger and the payoff periods much longer than what is shown in this example.

Under the snowball method you pay off the line of credit in just over two months and pay off the student loan in under a year. Paying these off provides positive reinforcement and keeps you motivated to repay the remaining debt.

Conclusion

Choosing between the two methods comes down to knowing who you are as a person and what motivates you. Honestly assess yourself. Will seeing individual debts being eliminated motivate you to stay on the journey? Or will knowing you are using the most efficient method be enough motivation for you?

Although we are partial to the most efficient debt repayment option (avalanche), the goal is to continually make progress paying off the debt and putting yourself in a better financial position. Having a good plan that you can stick to is more important than having the perfect plan.

Over the last 15 years this has been an easy question to answer. Unless it was credit card debt (or other high-interest debt) the answer was to invest and only make the required payments on your debt. Interest rates on mortgages were so low there was little financial benefit in paying them off early. With the rapid increase in interest rates over the last year the answer may not be quite so simple anymore.

In general, the best place to deploy excess cash is where it can get you the best long-term rate of return. This has usually been the stock market, for example the S&P 500 has an annual return of 9.0% since 1996 (source: McKinsey).  Over that period, it would have been a better decision to invest excess cash rather than to make extra mortgage payments.

The Financial Impact

Let’s examine what happens if you used $5,000/year to make extra mortgage payments or invested over the 15 years from 2008 to 2022.

	Mortgage repayment	Invest
Excess annual cash flow	$5,000	$5,000
Interest rate/rate of return	3.20%*	9.50%**
Number of years	15	15
Change in net worth	$94,400	$146,800

You would be $50,000 better off at the end of the 15 years if you had invested the money instead of making extra debt payments. This is 50% more net worth on the same $5,000/year.

While the decision to invest was easy over the past 15 years, things have become more nuanced with the increased interest rates. A five-year fixed mortgage is now at 4.50% or higher (source: Ratehub) and at the same time the average home price in Canada fell 12% in 2022 (source: Canadian Real Estate Association).

Other considerations

1. Risk-free return – The “return” from repaying debt is risk-free but the return from investing is not. If you make an extra debt payment you are guaranteed to pay less interest in the future but the return you get from investing can fluctuate and even be negative.
2. Anxiety/Stress – Large amounts of debt can cause anxiety and stress. There is often great relief knowing that all your debts are paid off.
3. Liquidity – If you have an emergency or opportunity, it is easier to liquidate your TFSA then to go and refinance your home.
4. Diversification – If all your net worth is tied up in the value of your home you are exposed to a large amount of risk if the housing market declines in your area. Meanwhile having a diversified investment portfolio protects you from industry specific or asset class specific risks.

Conclusion

Investing and paying down debt are both good uses for excess cash. Paying off your high-interest debt, such as credit card debt, is the priority. Afterwards the decision becomes more nuanced and personal.

Consider your personal appetite for risk and your relationship with debt. If having a large mortgage causes you anxiety and repaying it aggressively brings you peace and confidence, then that may be the best option for you. If holding mortgage debt does not bother you then investing has almost always been the better option to maximize growth.

The decision also does not need to be either/or, in fact it may be best for you to do a bit of both at the same time.

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* Average Canadian fixed mortgage rate from 2008 – 2022 (source: Ratehub)

**S&P 500 rate of return 2008 – 2022 (source: officialdata.org)

In our August 2022 blog post we reviewed the details of CPP and OAS. Now we can address one of the most frequent questions we hear from pre-retirees:

When should I start taking CPP and OAS?

This is an important question for those approaching retirement and the decision can dramatically change the chance of running out of money in late retirement.

Impact of Start Date on Benefits

Old Age Security – Benefits can begin anytime between ages 65 and 70

• For every month after age 65 that you start your benefits, your monthly payment is increased by 0.6% (7.2%/year). Maximum increase of 36% if started at age 70.

Canada Pension Plan – Benefits can begin anytime between ages 60 and 70

• For every month before age 65 that you start your benefits, your monthly payment is reduced by 0.6% (7.2%/year). Maximum reduction of 36% if started at age 60.
  • For every month after age 65 that you start your benefits, your monthly payment is increased by 0.7% (8.4%/year). Maximum increase of 42% if started at age 70.

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The benefits of delaying CPP & OAS are significant, yet most Canadians do not take advantage. In fact, the 2020 paper Get the Most from the Canada & Quebec Pension Plans by Delaying Benefits noted that:

• Over 95% of Canadians have consistently taken CPP at age 65 or earlier. Less than 1% of Canadians delay till age 70. Historically the most popular age to take CPP is age 60.

The author also calculated that:

• An average Canadian receiving the median CPP income who takes their benefits at age 60 rather than age 70 is giving up over $100,000 (in today’s dollars) worth of secure lifetime income. 
• By delaying CPP from age 60 to age 70 the average Canadian will receive over 50% more CPP income over the course of their retirement.

The results are similar with OAS. Most Canadians begin taking OAS as soon as they turn 65 and therefore give up a significant amount of lifetime income.

Why Don’t Canadians Delay Their Benefits?

There are many reasons that Canadians choose not to delay their CPP and OAS benefits, including:

Lack of advice – a 2018 Government of Canada poll found that more than two thirds of Canadians nearing or in retirement do not understand that waiting to take their CPP benefits will increase their monthly pension payments. (Employment and Social Development Canada, 2020)

Bad advice – much of the financial planning advice focuses on the “breakeven age” which is the age you need to live till to receive more money by delaying.

• This approach is misleading and doesn’t consider the largest risk for most retirees – the risk of outliving their savings (longevity risk).

Stability of CPP and OAS pensions – Canadians are concerned these pensions will not be around in the future

• CPP is one of the most stable pension plans in the world. Significant changes were made in the 1990s to the structure and funding to ensure stability. The most recent report on CPP (completed by the Office of the Chief Actuary) said the pension is sustainable for at least the next 75 years.
• OAS comes from general government revenues, so it is more vulnerable to cutting by the Canadian government. Yet seniors are one of the most important voting blocks in elections and reducing OAS benefits would be politically disastrous.

Fear and uncertainty – no one knows how long they will live so many opt to think in the short term and secure the money now rather than consider the long-term impact.

• The greater risk to most retirees is that they outlive their savings. The average life expectancy of a 60-year-old in Canada is now 86 years old. This means retirement savings need to last 20-30 years. Delaying CPP and OAS locks in a much higher secure income, thereby reducing the chance of outliving your money.

General Recommendations

1. Delay the start of CPP and OAS while fully employed.
2. It is more beneficial to delay CPP after age 65 than OAS.
   • Delaying CPP – increases benefits by 0.7% per month after age 65
   • Delaying OAS – increases benefits by 0.6% per month after age 65
3. High-income seniors should seriously consider delaying OAS due to the OAS clawback.
   • For every dollar of taxable income above the threshold ($81,761 in 2022) you must repay $0.15 of OAS income. By delaying OAS, you can avoid the 15% OAS clawback until age 70.

Conclusion

Most Canadians in reasonable health who can afford to delay their CPP and OAS benefits should do so. The biggest risk for retirees is not having secure income for life and delaying pension benefits can help address this risk. 

We encourage you to seek advice from an expert on your personal situation as the decision should be considered within the broader context of your retirement plan. Each situation is unique and deserves specific contemplation. We would be happy to help you if you have any questions or need help analysing this decision.

Citations

MacDonald, B.J., (2020). Get the Most from the Canada & Quebec Pension Plans by Delaying Benefits: The Substantial (and Unrecognized) Value of Waiting to Claim CPP/QPP Benefits. National Institute on Ageing, Ryerson University.

Employment and Social Development Canada (ESDC) (2020). Summary – ESDC Survey on Pension Deferral Awareness. Ottawa, ON: Government of Canada.

Office of the Chief Actuary. (2019). 30^th Actuarial Report on the Canada Pension Plan as at 31 December 2018. Office of the Superintendent of Financial Institutions.