Saving for your retirement involves making a lot of financial decisions, and not all of them have easy right-or-wrong answers. One of the thorniest revolves around how you invest your money. The investments that give you the highest gains on your money are precisely the ones that pose the most risk of losing your money.
For Canadian investors, two of the most common retirement vehicles are mutual funds and guaranteed investment certificates, or GICs. They represent very different approaches to retirement planning.
Basics of GICs
GICs are a exactly what the name implies, a product that gives a guaranteed return on your money. You're providing the bank with an opportunity to use your money for a set period of six months to 10 years or more. The bank profits by earning higher interest on your money invested elsewhere, so you don't pay management fees.
At the end of the term, you can roll over the proceeds into a new GIC or simply take the money and run. Conservative investors and those nearing retirement appreciate GICs for their soothing predictability and consistency, compared to the volatility of market-driven equity investments.
Basics of Mutual Funds
Mutual funds provide a way for small investors to get involved in the financial markets. They pool your monthly contributions with money from other small investors, so collectively you can invest with the budget of a Trump or a Buffett. The fund manager purchases a broadly diversified portfolio of investments with the money, according to a predetermined strategy.
Ideally, this means you get to profit when markets are up but have some protection when they go down. In practice, both of those benefits are variable and depend on the skill of your fund manager.
Risks of Equity Investing
Equity investing involves a lot of risks, even when you do it through a mutual fund. If the markets as a whole take a beating, you'll lose a lot of the value in your funds. If your funds are invested too heavily in a single company, industry or geographic region, a downturn there can have the same effect. Foreign investments can lose value through fluctuations in the currency exchange rates.
Most investors compensate for this by reducing their exposure to equities as retirement gets closer, switching to safer products such as bonds and GICs. Unfortunately, these aren't bulletproof either.
Risks of a GIC
There are two primary issues with interest-bearing investments such as GICs. The first is what's called inflation risk. If your GIC is paying 5 percent and the inflation rate is 3.14 percent – the historic Canadian average from 1915 to 2018 – your purchasing power has only increased by 1.86 percent. Unless you start with a pretty big nest egg, you won't retire to the Riviera on such returns.
The second issue is taxation. Interest income is taxed at your full marginal tax rate, while the dividends and capital gains you'd earn in equity investments receive more favorable taxation.
GIC Investment Strategies
Ultimately you must identify your own limits for risk and reward. There are smart ways to invest in either GICs or mutual funds.
With GICs, minimize your taxation by holding them in a tax-sheltered registered retirement savings plan or a tax-free savings account. Negotiate the highest rates with your bank and minimize the impact of low-interest years by constructing a "ladder" of GICs with staggered maturity dates. Banks pay more for five-year GICs than they do on one-year GICs, so you'd initially buy GICs ranging from one to five years. Each year, as a GIC matures, renew it on a five-year term.
Mutual Fund Investment Strategies
With mutual funds, pay close attention to the fees they charge. For example, if your return for the past year was 8 percent and fees were 3 percent, fees would consume over a third of your return. If your fees were 0.8 percent, they would account for only a tenth of your return. Over decades, that's a big difference.
Some of the lowest-cost funds simply purchase stocks paralleling a major index, such as the Dow Jones Industrial Average or the Toronto Stock Exchange. By reflecting the market as a whole, these funds are often more effective than actively managed funds. For additional security, transition to conservatively invested funds as you approach retirement age.