The ETF solution

In Ontario, a couple we’ll call Larry and Alexa are moving toward retirement. Larry, 62, a homeappliance store manager, was forced to end his career as a petrochemical engineer several years ago when his employer went out of business. Unwilling to leave his defined-benefit pension in the hands of the failed company’s administrators, he converted it to a locked-in retirement account (LIRA).

Financial advisors helped him stock the LIRA and his RRSPs with mutual funds. Alexa, 58, is a senior administrator at a non-profit healthcare organization. She, too, has many mutual funds in her retirement accounts. Their take-home income, $7,500 a month, allows for a good life of restaurants, travel and good clothes.

The problem is that, at the threshold of retirement, they have a total of 70 mutual funds and other assets, including some stocks and GICs. The fees alone could support some people’s retirements. Those fees are a sure thing for the advisors, while the funds themselves offer no such guarantees for Alexa and Larry. How the collection was built is a tale of neglect rather than plan.

“My wife brought her investments with her into our marriage a decade ago and added to her funds with new investments,” Larry says. “I bought GICs with the money that I had in the company pension fund and bought a portfolio of funds. We gave discretionary investment authority to our advisors and we have, to be honest, tracked results rather than costs. … The results of the investments have not been bad, for we have been making money,” Larry adds. “But the costs we have paid are surprising. We see a need to consolidate our investments and reduce fees.”

“Our goal is to have $100,000 in income before tax when we have retired in three years,” Alexa says.

Family Finance asked Adrian Mastracci, a portfolio manager and financial planner who heads KCM Wealth Management Inc. in Vancouver, to work with Larry and Alexa. “Their question is how much they can draw from their retirement portfolios after they make a complete break with their careers in three years,” he says. “The problem really comes down to the adequacy of their retirement incomes. And that in turn depends on the investment costs they are paying.”

Larry and Alexa have $1.31-million in financial assets. Nearly all of it is in RRSPs and LIRAs. They make no RRSP contributions, but do add $7,200 a year to their Tax Free Savings Accounts. In three years, these retirement accounts, growing at a target 4% a year, will have almost $1.5-million. If they can maintain that return, which will take a change in portfolio structure, they would have investment income of $60,000 a year.

Assuming that they retire in three years when Larry is 65, their annual incomes would total $60,000 from investment income, $8,880 from Larry’s CPP benefits, $6,660 from Larry’s OAS, $7,140 from Alexa’s CPP benefits reduced for early application and $10,500 a year from Alexa’s pension from a former job. That’s a total of $93,180 in 2013 dollars. Four years later, when Alexa is 65, she can add $6,660 OAS to boost retirement income to $99,840. That would be within a hair of their $100,000 pretax retirement goal, Mr. Mastracci estimates. But they will have to wait four years to close the gap. On the other hand, if they can cut investment management fees, the gap could be eliminated.

Alexa has 33 mutual funds, which charge 2.5% average management fees or more. Alexa’s $554,000 of RRSPs, TFSAs and LIRAs generate $13,850 a year in management fees, which go to her portfolio manager and the advisors who sold the funds. Larry’s 37 funds generate $18,625 in fees on the same basis. They are an expensive way to replicate the Toronto Stock Exchange, the S&P 500 and several global indexes. Their total management fees are as much as $32,475 a year. They can capture much of this money by selling highcost mutual funds and using the proceeds to buy low-fee exchange-traded funds that track the same markets that their funds have shadowed.

The cost of slimming down the portfolio to perhaps half a dozen ETFs with fees of no more than 0.5% a year could bring penalties for early withdrawal of funds purchased within the past six or seven years. Those fees could be 6% or more, though most funds allow 10% of net asset value to be taken out every year with no penalty. First task: Find out the cost of the reduction process, then weigh paying perhaps 1% or 2% as transaction costs rather than waiting another year or two and paying 2.5% per year.

Larry and Alexa should shop for major index equity funds that are equally weighted by market capitalization (each stock counts the same) rather than weighted top down from the biggest stocks to the smallest. Equal weighting avoids the problem of paying top dollar for recent high performers and adds exposure to stocks that are bargain priced. Their portfolio should include an investment-grade corporate bondladder ETF with maturities of no more than five years to provide both counterweight to stock-market cycles and income with limited exposure to the erosive effects of rising interest rates.

If 70% of their financial assets are in equities with dependable and rising dividends and 30% in short corporate-bond ETFs, they could achieve a return composed of dividends, interest and asset growth of 5%. An alternative to buying short corporate-bond ETFs is to buy actual investment-grade corporate bonds with 10-year maturities. Actual bonds revert to cash at maturity, thus eliminating any chance — other than through default — of capital loss when the decade ends. An advisor’s fee of 1% of assets under review would still allow savings of 1% of $1.3-million or $13,000 per year. It would enable the couple to reach their retirement-income target when Larry is 65, four years earlier than with portfolio they have now.

“Larry and Alexa have to ensure that their invest- ments are more than a reward mechanism for advisors whose advice has come at a high price,” Mr. Mastracci says. “The irony of their situation is that they have so many funds and investments that it is almost certain they are shadowing several major market indexes but paying for active management. They can get the same index tracking with lower fees with ETFs, boost the returns they keep after fees by 1% per year and have a more prosperous retirement.”