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As we approach tax season, many among us ponder annual contributions to our Registered Retirement Savings Plan (RRSPs) and Tax-Free Savings Accounts (TFSAs). While some tend to ignore or play down their annual contributions, it is important to understand the role regular contributions play in generating wealth. It is easier to understand the importance of regular contributions when viewed as part of a long-term investment framework. This framework has four elements essential to long-term investment success: Saving habits; Investment time horizon; Investment returns and Cost of investing.

Saving habit is the ability and desire to save a portion of earnings at a pre-determined frequency. Investment time horizon refers to the number of years available to save and invest before retirement – the longer the better. Investments generate returns by way of interest, dividends as well as rising market values, which can be reinvested. Cost of investing is commissions paid to own stocks, bonds, mutual funds, ETFs as well as fees paid to advisors and portfolio managers.

The investor or client is responsible for producing the savings and the investment time horizon, while the portfolio manager is responsible for generating returns and keeping costs low. Thus, there is a symbiotic relationship between the saver/investor and the investment manager.

I want to share an example of how some of these elements (savings, time horizon and investment returns) work together:

Jill and Alex, a couple in their mid-thirties have accumulated $50,000 in savings and together save $12,000 a year in some combination of their RRSP and TFSA. In their early forties they are able to raise their savings to $24,000 per year until the year they turn 60, at which point they stop new contributions but continue to hold their investments until age 71 (when RRSPs are terminated). Their Portfolio Manager generates 8.0% rate of return net of fees, so by the age of 71 they grow their retirement nest egg to $3.78 million, in nominal dollars (unadjusted for inflation). Now let’s say that instead of making a lump sum contribution of $12,000 once a year, the couple invested $1,000 a month in their RRSPs and TFSAs while in their thirties and $2000 a month in their 40s; then in the same timeframe they end up with $300,000 extra, only by changing the frequency of savings.

As seen in the example above, the level of wealth generated over future years is linked to the amount of accumulated savings up to this point and regular additions to that pool from new savings.

The cost of investing also impacts long-term investment results and wealth creation. Even a small difference in investment returns and in cost of managing those investments by even as little as one percent each year can cause a significant difference to the level of future wealth.

Consider the example of a 25-year old individual who saves approximately $450 a month in her TFSA ($5,500 per year) and continues until age 65. Assuming a long-term average net rate of return of 7.0% per annum (after typical portfolio management fees of 1.5%) she will have gathered $1.21 million at age 65. Now assume that she invests the same amount in mutual funds that typically charge fees of 2.5% per annum and so generates a 6.0% net rate of return after fees, in the same time frame her assets would have dropped to $917,000. This is a staggering $300,000 loss of cumulative returns only due to higher cost of investments by just 1.0%. In addition to this explicit cost, it is worth remembering that especially over the long term, we are also battling inflation and that is a critical cost over which we have no control. The fees we pay on the other hand is within our control.

Malcolm Hamilton from the CD Howe Institute commented in a media interview on fees paid by Canadians for investment advice: “They’re too high on average. That’s fine if you’re getting good advice and you’ve decided that your adviser’s advice is so valuable and so good that you want to pay him or her a lot of money. But there are too many people who are just stumbling into investments that have fairly high fees and aren’t going to have good performance net of fees, and they’re not getting any good advice in the process.” We could not have said it better.