SENSIBLE DOLLARS

A plan that can bring you to tiers

By Allan Kunigis

Allan Kunigis is a Canadian-born freelance financial writer based in Shelburne, Vermont. He has written about personal finance for more than two decades. He is the author of A Kid’s Activity Book on Money and Finance: Teach Children About Saving, Borrowing, and Planning for the Future, published in September 2020.

One of the least discussed but potentially most powerful concepts in saving and investing is to use time-based tiers for any investment goal. Picture layers of investments working together like a cohesive team, with each serving its own purpose while collectively providing an optimal mix of protection, income, and growth.

(Note: In this article, I use the terms “tiers,” segments,” and “portions” interchangeably.)

The idea is to create two or three distinct timeoriented tiers for your investments. The shorter-term portion should be more conservative, focused on preserving your original investment (the principal). That protection can allow you to be a bit more aggressive with a long-term segment, with a goal of earning a higher return. If there’s a middle portion, it can provide a blend of income from bonds and growth potential from stocks without leaning heavily in either direction.

To put this in practical terms, let’s look at two timelines – saving for a goal that’s two or three years away, and saving for a longer-term event, like retirement a decade or more in the future.

A THREE-YEAR GOAL

For a relatively short-term goal of three years, you needn’t have everything you save sitting in a single account. Instead, you could divide it into a couple of tiers, each serving a different purpose.

The first portion is the safest one, but also the lowest-yielding. That’s based on the tendency for risk and reward to go hand in hand. Super-safe and secure investments have the lowest yields. The first $100,000 in your savings account is 100% guaranteed by the Canadian Deposit Insurance Corp. It doesn’t get safer than that.

But how much is your bank savings account yielding these days? Next to nothing. That’s why you might want to put some money into another tier, where you can earn higher returns.

...based on the tendency for risk and reward to go hand in hand. Super-safe and secure investments have the lowest yields.

For example, you could place some money in a highinterest savings account, earning perhaps 1% to 1.5%. Here’s a link to see what you can expect to earn in various one-year to five-year guaranteed investment accounts (GICs):

https://www.highinterestsavings.ca/gic-rates/

The drawback with GICs is that the money will be locked into a non-redeemable account. So you’ll have to choose between the low-yield, full-accessibility short-term tier and the higher-earning but less accessible longer-term portion. A third choice – which I would recommend – is to combine both so that you have some money immediately accessible while another tier is earning a higher return.

LONGER-TERM INVESTMENTS

A more powerful example is how you can benefit over the course of your life by using short-term, medium-term, and long-term tiers in your retirement investments. Here, it’s important to consider both your immediate and life-long financial well-being.

Let’s say you’re on the cusp of retiring in your mid60s. Because your family members have tended to live a long time, and you remain in good health, you might last well into your 90s. You don’t want to face the problem of outliving your money (longevity risk). But at the same time, you need to protect against the impact of short-term market risk (volatility).

A diversified mix could address both concerns. Let’s take your money and create shorter-term, mediumterm, and longer-term portions. To make this simple, let’s assume you have a nest egg of $1 million.

INCOME NEEDS

First, ask yourself how much you need to live on each year and how much of that income you’ll receive from your combined Old Age Security and

Canada Pension Plan/Quebec Pension Plan benefits. Subtract that government pension income from your overall monthly income needs, and that’s what you’ll need to withdraw from your retirement savings.

Let’s assume that comes to $40,000 a year. The shortterm portion of your savings could provide you with enough income for two years of living expenses, or $80,000 in this example. That money should be kept safe, perhaps in a combination of bank savings accounts and a one-year renewable GIC.

By creating that two-year buffer of cash, you can afford to take more risk with the remaining $920,000. Each tier creates more of a buffer, allowing you to take on incrementally higher risk and earn potentially higher returns with each successive tier.

A QUESTION OF BALANCE

Let’s now address the income that you might need from the beginning of Year 3 through Year 10. Multiply $40,000 annual income by eight years. That $320,000 would cover you all the way to a decade from now. You could invest it in something with reasonably moderate exposure to risk, like a Canadian bond index mutual fund or a balanced fund, which typically contains a mix of about 60% stocks with 40% bonds.

Based on returns for the three-year, five-year, and 10-year periods ending December 31, 2020, you could expect to have earned roughly 3.5% to 4.5% per year in a typical Canadian bond fund and perhaps more like 5% to 6% a year, on average, in a balanced fund. And you could opt to set this up to provide regular monthly income. The 3.5% to 6% cited here is much more than you’d earn in your short-term savings but less than in a more aggressive portfolio with greater exposure to stocks.

But that’s where the longest-term tier comes in.

STOCK MIX

Now let’s look at the investments you do not expect to touch for a decade or longer. Because you have already invested $400,000 in a mix of cash, bonds,

and stocks, covering your income needs for the next decade, you can invest the remaining $600,000 more aggressively, primarily in stocks.

Let’s look at a mix of 80% stocks and 20% bonds. This will provide you with greater growth potential over the long term, addressing longevity risk. By potentially growing more over longer periods of time and being able to recover from shorter-term market ups and downs, this is the tier that is targeted for best returns for the rest of your life.

STRONG PATTERNS

It is also extremely crucial here to state the basic disclaimer: Past performance is no guarantee of future returns. Money invested in stocks and bonds is not protected by the Canadian Deposit Insurance Corp. But if you look back in time at various periods spanning a decade or more, you’ll see that stocks have tended to earn higher returns than bonds or cash. And the longer you can leave that money alone, the more time your investment would have to recover from any short-term losses.

DIVERSIFY GLOBALLY

That $600,000 in longer-term investments could be diversifi ed in Canadian, U.S., European, and Asian stock mutual funds or exchange-traded funds, as well as various higher-risk bonds, like high-yield bonds and emerging markets bonds. The idea is that not all investment sectors will rise or fall at the same time. One might zig while the other zags. For example, an event that is good for China might have a negative impact on Canada. This type of asset class performance is what makes investment diversifi cation work.

You don’t want to face the problem of outliving your money (longevity risk). But at the same time, you need to protect against the impact of short-term market risk (volatility).

SHIFT AS REQUIRED

As time passes and you spend money from your short-term tier, you can transfer some money from your medium-term tier into the short-term one. Similarly, as needed, you can shift some investments from the longer-term tier into the medium term, so that you always maintain your three tiers and each continues to play its role for you.

I hope I haven’t bored you to tears while trying to drive you to tiers!