Young Canadians have to approach retirement savings in a way that is different from the strategy used by their parents or grandparents.
Interest rates on GICs and savings accounts are pitiful, companies no longer offer juicy defined-benefit pensions, and houses are so expensive that it is very possible that today’s home buyers could actually lose money over the next 20 years.
That isn’t a great starting point for a young person who wants to save for retirement, but millennials can still retire rich.
Here’s how it works
Investors can use their TFSAs to buy dividend-growth stocks and reinvest the distributions in new shares. This sets off a powerful compounding process that can turn a modest initial investment into a very large nest egg over time.
The secret lies in making consistent contributions and leaving the funds in place to let them grow.
Any Canadian who was 18 years old in 2009 now has a total of $46,500 in available TFSA contribution room. The current limit is set at $5,500 per year.
Let’s say you are 30 years old right now and decide to begin investing $5,500 per year and receive a compound annualized return of 5%.
After 35 years, you would have $528,000. That means a couple would be sitting on more than $1 million by the time they are 65 years old.
Is 5% reasonable?
Many of Canada’s top dividend-growth stocks have provided long-term compound annual growth rates that are much higher than 5%, and the Credit Suisse Global Investment Returns Yearbook says all Canadian stocks have averaged a real return of 5.6% since 1900.
So, 5% over the long haul is a reasonable, if not conservative, assumption.
Which stocks should you buy?
The best names are generally market leaders with strong histories of dividend growth.
Fortis owns natural gas distribution, power generation, and electricity transmission assets in the United States, Canada, and the Caribbean.
The company gets 94% of its revenue from regulated assets, which means the cash flow required to support dividend payments should be both predictable and reliable.
Fortis has raised its dividend every year for more than four decades, and management expects to increase the payout by at least 6% per year through 2021.
A single $10,000 investment in Fortis just 20 years ago would now be worth $179,600 with the dividends reinvested. That’s an annualized return of 15.5%.
Bank of Montreal
Bank of Montreal gets a significant part of its revenue from Canadian retail banking operations, but it also has strong wealth management and capital markets groups, as well as a growing personal and commercial banking presence in the United States.
The U.S. group provides a nice hedge against tough times in Canada and gives investors a chance to benefit from the strong U.S. dollar.
Bank of Montreal has paid a dividend every year since 1829. The company increases the payout on a regular basis, and investor should see steady growth continue.
A one-time $10,000 investment in Bank of Montreal 20 years ago would be worth $93,900 today with the dividends reinvested. That’s a compound annualized return of 11.8%.
The bottom line
Young Canadians can still retire rich by investing in quality dividend-growth names inside their TFSAs and reinvesting the dividends to let the power of compounding help them reach their savings goals.
It just requires a bit of discipline to make the contributions and enough patience to let the money grow.
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Fool contributor Andrew Walker has no position in any stocks mentioned.