From Ender’s Game, 2013, Directed by Gavin Hood and based on the novel by Orson Scott Card. Let’s train for our own financial battle. Don’t worry, it is all simulated – you aren’t unknowingly controlling real combatants like in Ender’s Game. No actual aliens were harmed in the making of this blog post.
If you haven’t done so already, download the Active Manager versus ETF Calculator.
To recap about the calculator:
- It is an excel workbook.
- The premise is that an Active Manager vs Passive ETF strategy will both match market returns (although most managers have failed to do this over the past decade net of fees). Fees kill. Taxes from active portfolio churn kill too. So, this is really a best case scenario unless you somehow can pick the consistently winning advisor in advance. I wish I could.
- It is pre-populated with the average fees for Canada, average historical returns for a balanced diversified portfolio (~8%/yr), and average inflation (~2%).
- Annual contributions are broken into 5 year blocks to correspond to major changes in your professional/personal life that alter how much you can save each year.
- Before you get all titillated that I have inadvertently flashed you my financial underwear, the numbers really are theoretical and not my numbers.
- You can adjust any of these numbers (in the yellow fields) to reflect what you think your situation does/will look like and see the effect of fees and inflation on your portfolio size over time. The other fields are locked so you don’t accidentally mess up the calculators.
- It will spit out in the bottom right: a) How much bigger your portfolio would be if you manage your own passive ETF portfolio compared to paying someone to do it for you. b) What difference that would make to your annual retirement income if you decided to retire at that time.
- The base case is a fee-based advisor vs. ETFs in the first worksheet tab. Changes there will automatically update the values in the other tabs which contain other comparisons such as mutual funds, inflationary effects, and comparisons of contribution timing in your lifespan.
- If you don’t want to download the calculator, no problem. I give some illustrative narrative and screenshots below. However, the calculator does offer more personalization.
I will share 5 of the interesting points from thousands, okay, well, dozens of simulatons with the calculator that are directly applicable to your financial planning:
1) The amount you can save managing your own portfolio using passive ETFs can be large (1st worksheet tab).
Using our model physician case, if you started residency at age 25, started practice at age 30 and retired completely at age 55……. You would have a portfolio of about 4.1M dollars which is $200K more than you would with a fee-based advisor. That translates to a gross retirement income of about $163K/yr of which $8K/yr is a result of the money you saved on fees.
2) If you are in a lower marginal tax bracket and earn/save less, a manager costs a lot more.
This is because a manager fee is tax deductible against your marginal tax rate for the parts of your portfolio that are in non-registered (not an RRSP, TFSA, or RESP). For example, if your marginal rate is 54%, it effectively reduces your manager fee by 54%. If you have a lower income and your marginal tax rate is only 20%, then you effectively pay more even if the advisor charges you the same amount (80% of the bill). You also pay a lower %AUM fee when your portfolio is larger. For example, if you made a more average 55K/yr income and invested 5K/yr, after 35 years, you would have a retirement income of 29K/yr instead of 35K/yr due to the drag of fees on your portfolio. That is a 17% drop in retirement income. These factors are why many wealth management firms won’t take clients with lower incomes and smaller portfolios. Not only do they get paid less, but they are also more expensive to their clients and it may be better for their clients to use a different option. Some may take doctors, dentists, lawyers, and other high earning professionals early in their career before they are earning and saving big with the hopes of retaining them. High earning high net worth individuals get the best value for dollars spent with a fee-based advisor.
3) You need to make sure that the % cost of managing your portfolio decreases as it gets bigger (2nd worksheet tab).
The most extreme example of this is with mutual funds where you get double slammed by the fact fees don’t decrease and that the MERs or commisions are not tax deductible. A recent review on Boomer & Echo of some of their blog follower’s portfolios illustrates how brutal that can be. Even if you are using a fee-based advisor, make sure that the %AUM fee drops as your portfolio gets bigger. They should offer to do this on their own, but they also may not. If they don’t offer, then I would wonder about how much they put your needs first!! If you are investing with mutual funds, it will cost you big over your life-time because the management fee (MER) does not drop just because you have a larger portfolio. For example, if your MER is 2% (the Canadian average in 2016), then it would shrink your nest egg at age 55 in our model by about $800K compared to ETFs and $1M compared to fee-based advisor. That translates to a 30-40K/yr gross retirement income drop!
4) The numbers the calculator is spitting out seem huge! You need to account for inflation to get a sense in “today’s dollars” (3rd worksheet tab).
If inflation is about 2%/yr, then the buying power of your portfolio is decreased by 2%/yr. It compounds over time (hopefully just like your portfolio growth). To account for this, subtract inflation from you annual return rate. This is done in the 3rd tab of the worksheet.
You can see that in our model, a passive ETF portfolio would be $4.1M if you retired at age 55, but when adjusted for inflation of 2%, it is really worth $3M when priced in 2017 buying power. Inflation ate $1.1M or about $22k/yr of your retirement income buying power. The average inflation over the past 25yrs has been about 2%, but has ranged from 0-12% over the past half century. Try adjusting it up and down in the calculator and see the effects.
5) When you start saving matters. To let the magic of compound gains work for you, you need to maximize the time your portfolio has to compound (4th worksheet tab).
Let’s say you have a 30yr career. If you invest $100K/yr for the first half of your career and then nothing for the last 15yrs, you would have $5.9M inflation adjusted dollars for retirement. Let’s say you spend whatever you make for the first 15 years of your career, then go, “Oh crap I am getting tired – I’d better start thinking about retirement planning”. Well, tired person, you could work like a beast and “live off the land” to save $200K/yr for the next 15yrs and you would still have $1M less of a nest egg to retire on after a 30yr career than if you had saved half as much early on. That makes the difference between an inflation adjusted pre-tax income of $236K/yr versus $197K/yr despite your hard core saving later in life.
6) Do the numbers still seem pretty large! You also need to account for tax drag to get your “real return”.
Tax can also eat away at your portfolio while you are trying to grow it. How much of an effect this has depends on your income tax bracket, use of tax sheltered accounts (like TFSAs, RRSPs, RESPs), tax deferral strategies (like CCPCs), and the investment income type (interest, dividends, capital gains). It is complex and the effects are significant. Because of the effects of compounding over time, handle this one right and you can minimize the impact, neglect it and it is like giving Cookie Monster a gamma radiation laced cookie, poking one of his googlie eyes to tick him off, and then releasing him onto your chocolate chip portfolio.
7) Do the numbers not seem large enough?
In the Early vs Late start comparison tab, there is also a column estimating your annual inflation adjusted pre-tax income. It is based on a 4% withdrawal rate (generally considered safe). Remember that tax will take some of that and again it depends on the account and investment types. Does this seem like not enough or too much to support the retirement lifestyle that you want? Saving for retirement, at its core, is about smoothing your income over you lifetime. That means balancing how much you earn/spend/invest now with how much you plan to earn/spend/invest in the future to support the lifestyle that you want now and the one you want in the future.
That means you need to think about earning, spending, investing, and lifestyle to populate that equation and you need to start now!
I hope that you found this work with the Manager versus Passive ETFs Calculator useful.
There were some more basic calculators on the web, but they did not have the granularity of being able to change fees as your portfolio size changes, account for inflation, or allow for different contribution rates as your life changes. That is why I made this one because as I hope this simulation shows – it matters.
It is also sets the scene for why financial planning in a world of changing income, costs of living, and taxes as you move through your professional life cycle is vital to consider.
This basic calculator still won’t account for all of those effects, but my Loonie Calculator that I eluded to in my Shooting for the Moon post will. The more advanced calculator is basically done and incorporates inflation, account types, investment types, and corporate and personal tax calculators to automate much of the hard work. I am just updating it to reflect the proposed tax changes to CCPCs that just came out. I also want to make sure that there is enough supporting material on the website for people to really realize the benefits of its intricacies. We have given the Loonie Doctor Nerd Dept here at looniedoctor.ca some food, water, and some time off to do whatever it is nerds do in the interim.
In the meantime, let’s continue our financial schooling.
My next few posts will be Financial Anatomy 101 where we will dissect some of the commonly used accounts and tools like TFSAs, RRSPs, RESPs, non-registered investment accounts, Mutual Funds, ETFs, stocks, preferred share, and bonds. Hopefully, it will smell better than the anatomy lab I remember.