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portfolio makeover

Every time Darryl looks at his investment statements, he wonders whether he's getting his money's worth.

"When it comes to the funds, talking with friends and colleagues, I know I have been paying more in MER [management expense ratio] fees," says the 55-year-old, who works in a management role in Alberta's public education system, earning $132,000 annually.

"I'm currently doing a 10-year review of how my portfolio has been performing and making decisions about what to do next."

Among those decisions is whether to move to another advisory firm.

Darryl's money is mostly invested in mutual funds with Investors Group. He has more than $500,000 in a registered retirement savings plan, and he suspects he could be paying less in fees for better performance.

He also questions whether he is getting good advice or whether his adviser is recommending funds with higher fees that, in turn, result in higher compensation.

Darryl, who is a divorced empty-nester, would like to retire at the end of 2015 when he is eligible to take his defined benefit pension. Yet a significant hurdle stands in the way: a $180,000 mortgage on his three-bedroom condominium – worth about $380,000. The home had been mortgage-free, but in 2007 he borrowed against it to buy a condo in Arizona for retirement. The second home is now worth $80,000, about half of its purchase price.

Darryl says he wants to pay as much of the mortgage as possible – while saving for retirement – so he can retire as early as possible.

To that end, he makes $20,000 lump-sum payments to the mortgage annually. As for retirement savings, besides contributing $700 a month, he also makes a $10,000 lump-sum payment in February to his RRSP. Still, he's uncertain whether his savings, with his monthly pension payment of $1,900, will be enough to support his retirement lifestyle.

"If I can't retire in two years, can I at least do it in five years?"

Two financial advisers have provided Darryl with planning and investment tips regarding his retirement objectives: Sue Derlago with National Bank is a Calgary-based certified financial planner, and Alan Fustey is a Winnipeg-based wealth manager with Index Wealth Management.

The basics– $475,000 RRSP (16 mutual funds with Investors Group).

– $75,000 RRSP (two exchange-traded fund of funds portfolios with Bank of Montreal).

Both experts say Darryl would be better off delaying retirement until he is free of debt. Although he has ample investments and a good pension, he will experience a substantial drop in income if he retires as planned.

Sue Derlago's advice

1. Delay retirement five years longer than planned.

If Darryl retires beginning in 2016, his after-tax income will be about $50,000 a year. This is based on a 5.7-per-cent annual return on his portfolio while inflating his investment income annually at 2.75 per cent. The projected income stream incorporates the Canada Pension Plan at age 60 and Old Age Security, and would last until 94. Darryl earns about $78,000 in after-tax income annually, so he may find it difficult to adjust to the lower income in early retirement, especially if he's still paying $20,000 extra a year on the mortgage. By delaying retirement until 62, he will save more in his RRSP, pay down more of his mortgage and increase his work pension income. As a result, his after-tax retirement income would rise to about $60,000 annually.

2. Downsize.

Even though delaying retirement gives Darryl more time to pay off his mortgage, he will still owe about $98,880 in seven years. To retire free of debt, he should consider downsizing. "At that time Darryl could sell his existing condo and move to a smaller one with the intention of eliminating the remaining mortgage balance, and achieving his goal of retiring debt-free."

3. Manage the risk to investments.

Darryl's portfolio is comprised of 70-per-cent equities and only 30-per-cent fixed income. Ms. Derlago says this is likely too risky of an asset mix with retirement in sight because a stock market plunge similar to 2008-09 would decimate his portfolio, further delaying retirement. A more suitable portfolio asset allocation would be 40-per-cent bonds with the remaining 60 per cent invested in shares of companies with long track records of increasing their dividends. "The result would be a portfolio focused on a predictable, stable cash flow that can be relied on regardless of market conditions."

Alan Fustey's advice

1. Reduce the fees.

The MERs on Darryl's Investors Group portfolio range from a low of 1.82 per cent to 3.11 per cent at the high end. All told, he is paying about $11,500 in annual MER costs, Mr. Fustey says. "These fees make it difficult for the manager of each fund to outperform the comparative benchmark return of an appropriate financial market index."

As an alternative, Darryl could invest in exchange-traded funds (ETFs), which are passively managed and track the performance of an underlying index, such as the TSX composite index. ETFs charge a small fraction of the management costs of actively managed mutual funds. By making the switch, Darryl would save as much as 90 per cent in MER costs compared with his mutual fund portfolio.

Furthermore, several studies have found investors rarely get their money's worth by paying higher fees because most mutual funds do not outperform their benchmark index. "Additionally, the few managers who do outperform cannot be identified reliably in advance and tend not to repeat the accomplishment in a consistent, predictable way in the future."

2. Get personalized advice.

Darryl is right to question whether he's getting good guidance from his investment adviser. In Canada, the adviser title can be a little misleading, Mr. Fustey says. Essentially salespeople, licenced advisers must ensure the mutual funds or stocks and bonds they recommend to clients meet a "suitability standard." This means they can't sell clients inappropriate investments. Still, a number of conflicts of interest can arise.

"In some circumstances, the suitability standard can allow advisers to recommend suitable investments that are not necessarily investments that are in the best interests of the client," Mr. Fustey says. For example, an adviser could recommend investments with higher fees than similar products even though the lower-cost investments have better track records.

Alternatively, Darryl has enough investible assets to hire a discretionary money manager who would buy and sell investments on his behalf. Available to higher-net-worth investors, like Darryl, discretionary managers charge management fees lower than mutual funds. As opposed to paying on average more than 2 per cent annually, a money manager would charge 1 to 1.25 per cent a year to build him a portfolio of ETFs, stocks, bonds and other investments.

Furthermore, unlike a licensed investment adviser, personal portfolio managers have a fiduciary duty or legal obligation to act in their clients' best interests. "Generally, CFA [certified financial analyst] charter holders and registered portfolio managers who operate on a discretionary basis owe this type of duty to their clients."

3. Focus on mortgage repayment.

Darryl wants to pay off his mortgage as soon as possible, so this should be his focus – not RRSPs. Even though RRSP contributions provide him with a refund, his lump-sum annual contributions aren't making much ground under his current portfolio scheme. "His [lump-sum] $10,000 contribution isn't even enough to pay the annual embedded MER fund costs."

By redirecting his lump-sum contributions to his mortgage, the condo would be paid in about six years. While retirement would still be delayed, Darryl can look forward to a healthy income from a good pension and substantial investment income. "That's an enviable position to be in compared to many pending retirees."

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