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3 villains can steal your retirement dreams

Building a strong financial castle to fund your retirement is hard. If you're not careful, you may discover a hole in your vault and three villains sneaking off with the family jewels.

To see these predators in action, let's begin by considering a portfolio that follows the total return of the S&P/TSX Composite index as shown in the following graph. The index has performed well since 1970 with an average annual return of 9.4 per cent.

Graph of the returns of the S&P/TSX Composite after fees, taxes, and inflation
[larger version]


But these happy returns don't factor in the annual fees charged by funds. These typically range between 2 per cent and 2.5 per cent for Canadian stock funds and are called management expense ratios (MERs).

Problem is, funds - on average - have a hard time beating the index's returns before fees. They tend to trail badly after fees. Indeed, there are theoretical reasons to think that funds, as a group, merely yield index returns less the fees they charge.

The fee line on the graph is based on the uncharitable view that funds achieve index returns minus a 2 per cent annual fee. Over the period, those seemingly small charges reduce the size of the ending portfolio by more than 50 per cent. Such is the misery of compounded fees.

Fund fees are one thing but the crown also likes to extract a pound of flesh. The third line on the graph - the one just under the fee line - represents the returns of the index after the 2 per cent fund fee and a 23 per cent tax on gains from the prior peak levied annually.

The point here isn't one of precision - after all, different investors are subject to different tax burdens - but to highlight why proper tax planning is important. Stingy investors want to legally reduce taxes and fees, all else being equal.

Inflation is the third sapper of wealth and the last line on the graph shows the combined impact of 2 per cent annual fees, 23 per cent annual taxes on gains, and inflation.

The result? The 9.4 per cent starting annual return for the index is reduced to a mere 1.3 per cent after fees, taxes, and inflation are taken into account. Put in dollar terms, instead of growing each dollar invested to $43.20 over the period, you'd only be left with $1.70 after fees, taxes, and inflation.

But you can foil two of the villains. Fund fees can be reduced by favouring low-fee active funds or lower-fee index funds and exchange-traded funds. On the tax front, you can save via TFSAs or defer taxes by using RRSPs or opting for longer holding periods.

The bar chart shows several different low-fee and low-tax scenarios. For instance, a 0.3 per cent annual fund fee and a zero tax rate would have put $6.40 in your pocket, adjusted for inflation, per dollar invested. That's a darn sight better than $1.70.

The impact of various fees and taxes on the real returns of the S&P/TSX Composite
[larger version]


The moral of the story? Be sure to keep a close eye on fees and taxes. If you don't, a pack of villains might run off with the bulk of your retirement portfolio.

First published in the Globe and Mail, January 28 2012.

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