Case Study: Successful couple tries goals-based investing

Client profile

Brad and Lydia Anderson* are both 50 years old and plan to retire in 15 years. They’re comfortable financially, but their investments are scattered across five institutions and their strategy isn’t optimised to meet their goals. Brad is a successful IT consultant and Lydia is a senior manager at a major construction equipment manufacturer. They have no children.

*This is a hypothetical scenario. Any resemblance to real persons is coincidental.

The situation

The Andersons’ assets total $2,076,000, spread across TFSAs, RRSPs, spousal RRSPs, and non-registered accounts (see “Before”). Their before portfolio also shows their allocation in dollar and percentage terms across all five institutions, as well as their overall asset mix.

Brad and Lydia have three main goals to fund:

• Retirement (long term)
• Vacation property purchase (short term)
• Discretionary spending (ongoing)

The experts

• Parik Malik, portfolio analyst, Manulife Private Wealth in Toronto
• Sam Sivarajan, head of Manulife Private Wealth in Toronto

Sam Sivarajan, head of Manulife Private Wealth, notes their current arrangement suffers from a lack of consolidation and co-ordination. But even if they brought all their assets under the same roof, their biggest problem—a sub-optimal investment strategy and asset mix—would remain.

Most people have competing goals with different time horizons and degrees of importance, notes Sivarajan. The amount of risk suitable for a goal that needs to be funded in two years won’t be the same as one that’s 15 years away. The problem is, “That short-term focus gets manifested in the way they answer the risk questionnaire and it ends up dominating the entire portfolio.”

After

Before

Brad and Lydia have fallen into this trap, says Parik Malik, portfolio analyst at Manulife Private Wealth. “They [want] to purchase a vacation property and know that outlay is coming soon; for that reason, it’s weighed heavily on their minds and has dominated their allocation for a long time.”

The skewing of their overall allocation toward one goal has negatively impacted their ability to meet their other goals as effectively as possible, since those other goals don’t require as conservative an allocation.

The solution

Brad and Lydia have the best chance to maximize available funds for their goals by having a separate portfolio and asset allocation for each goal. The goals-based approach isn’t new; it’s a more sophisticated version of a common-sense approach to managing household finances.

“You can think of goals-based investing as the equivalent of the old days when people put money in separate envelopes,” says Sivarajan. Rent went into one envelope, utility bills into another, groceries into another, savings into another, and everything else into a vacation envelope, for instance. It was understood you never dipped into the rent envelope for any reason. But you might draw from the vacation envelope if, say, you needed an expensive brake job or wanted to go to a concert.

The basic idea, says Sivarajan, is people are implicitly willing to take different levels of risk with different goals. By creating a separate portfolio for each goal, it’s possible to customize allocations to different time horizons and risk levels. Here’s how Malik and Sivarajan rejig Brad and Lydia’s holdings, beginning with asset mix by goal (see “After”). The retirement bucket’s 70% equity component reflects the fact Brad and Lydia’s retirement date is 15 years away, allowing them to take more risk. This means greater potential returns—an opportunity that was lost under their previous arrangement, where competing, shorter-term goals and a one-dimensional view of risk kept the equity component much lower. “That short-term goal isn’t dominating the portfolio, as it was before,” says Malik.

Degree of difficulty

8 out of 10. New ideas are hard to accept, even when they’re better versions of old ones that worked. Malik and Sivarajan lean on the numbers to help Brad and Lydia see the value added by the goals-based approach. They make a before-and-after presentation, contrasting expected results of conventional versus goals-based planning. “It’s an objective conversation with the client because we can show them the numbers,” says Sivarajan.

Malik and Sivarajan add goals-based planning involves significantly more work than conventional approaches. In Brad and Lydia’s case, it requires asset allocation, monitoring and reporting for three portfolios instead of one.

The 50% equity allocation in the vacation-property bucket is consistent with a nearer-term funding requirement, where less risk is suitable. Since the discretionary bucket covers short, medium and long terms, a 60% equity allocation is appropriate. “Asset mix by goal” (see “After”) gives a more granular look at the asset mix, in percentage and dollar terms, by goal.

Note the overall expected return of 6.29%, compared to 5.3% under the previous arrangement. The reason, notes Malik, is Brad and Lydia now have more equities overall (63% compared to 53%), stemming from the higher allocations in the retirement and discretionary buckets (see “Asset mix by goal”).

“By taking a separate risk questionnaire for each goal, [Brad and Lydia] were able to see that they have different time horizons [for each], necessitating different asset allocations,” says Malik. They’re now comfortable taking more risk, adds Sivarajan, because it’s targeted: it doesn’t impact their short-term goal, where a more conservative allocation is appropriate. As time passes and those long-term goals become short-term, the equity component will be gradually reduced.

Asset location

To prevent adverse tax consequences, Malik and Sivarajan avoid shuffling funds between account types. But instead of Brad having four RRSP accounts, for instance, he now has only one (compare “Investable assets” before to “Investable assets” after). Their after protfolio shows the distribution of funds by account, both before and after the reorganization.

Sivarajan notes Canadian dividend stocks should be placed outside the RRSP because they already get favourable tax treatment. But U.S. dividend payers should go inside the RRSP because, unlike TFSAs, RRSPs are recognized under U.S. law as tax-favoured retirement plans. U.S. dividends would otherwise be subject to withholding tax. Fixed income should also go in the RRSP, since interest income gets taxed at the same rates as ordinary income.

While tax considerations inform where assets go (asset location), they don’t dictate asset allocation. If, for instance, the registered accounts didn’t have enough room for all the fixed income and other non-tax-advantaged assets that need to be in the couple’s portfolios, those assets would go into non-registered accounts. Assets for the vacation and discretionary buckets will be parked in non-registered accounts. Assets in the retirement bucket ($1,196,000) will fit in the RRSP and TFSA; any future excess would go into non-registered accounts.

Client acceptance

9 out of 10. Brad and Lydia are initially hesitant to get their portfolios rejigged using the goals-based approach. On one hand, it seems like such a common-sense method, so it naturally sparked their curiosity; on the other, their friends aren’t with advisors using this approach, so they wondered if it was worth trying. The deciding factor was the before-and-after return projections comparing conventional and goals-based planning. With identical asset-class return assumptions, the goals-based allocation produces a higher expected return.