How Will Your Retirement Plan Adapt To Investment Surprises?

This is the second article of a three-part series on planning for the unexpected life events that could disrupt the successful outcome of your plan. This article focuses on investment surprises.

Our objective is to accumulate wealth during our working years sufficient to generate an income stream in retirement that replaces our business or employment income. Those with a defined benefit pension plan may not be concerned as they can expect a guaranteed income indexed to inflation that in many cases covers lifestyle expenses. However, many individuals do not benefit from a guaranteed pension and are required to build their own. This can lead to much stress and anxiety—the fear of outliving your capital. The “what if” factor comes into play as investors worry about surprises that could derail their plan.

The ideal situation is to enter retirement knowing that the income stream alone from your portfolio is sufficient to cover your basket of living expenses, without having to draw on capital. The reality is that many of us are not that fortunate.

You may have a plan in place that provides you with a fair degree of confidence that you will not outlive your capital but then the unexpected happens:

You suffer investment losses
You are a victim of investment fraud

Investment Challenges:

Some of the challenges facing retirees these days include:

Longevity uncertainty. As John Klaas, Adjunct Professor, Rowe School of Business, Dalhousie University and long-time financial planning coach and educator says, “We are living longer and assisted care costs are becoming the norm in late retirement.” As they say, it would help to know when we will die and what our health will be like.

All-time low Interest rates.
Volatile equity markets.
An abundance of investor information that requires careful dissecting.
Lack of trust and confidence in financial advisors.

I am asked, “What are the key investment objectives for a retiree?” For many it is income and preservation of capital. Liquidity is important. Others want growth as well. Speculation should be off the table.

Risk mitigation is key but what is the real risk? Putting all of your money into “risk-free” investments such as GICs and bonds that pay an inadequate income stream might mean you erode your capital too early into retirement. Investors will say, “I don’t want equities because there is too much risk.” If good quality dividend stocks are paying a 4% dividend with a history of increases then we could conclude this strategy carries less risk as long as you don’t have to dip into the capital at an inopportune time. I was chatting with a colleague recently whose client just turned 100 and is 100% equities. She feels the time is right to take some profit. Should we be concerned that our common stocks or preferred shares are down in value if the income stream is maintained? Not as long as we don’t need the capital. Are you concerned that your rental property may have declined in value but your rent cheque continues to increase every year?

Considerations:

Do you know what rate of return (ROR) you need to achieve your goal? I can’t emphasize this enough. Do you have a cash flow and net worth projection that tells you with a degree of confidence what you need to make on average after fees? Is your asset mix too aggressive for your ROR need? Can you dial back the risk and still achieve your goals? My experience is that many investors can. If you can achieve your goal with a sleep-easy GIC strategy then go for it.
Calculate the projected income from your portfolio. Is the income stream net of fees enough to fill the gap that your fixed sources of income don’t quite cover? Or, do you need to draw on capital? If you need to earn 4% on average and your income yield is 3.0%, you are a closing in on your goal with minimal dependency on capital appreciation. Generally, a greater income stream from quality investments increases the probability of achieving your ROR goal.
If you rely on dividend income from equities, how will your plan be affected the next time there is a financial crisis and hence, a large market correction? Will your capital erode at a more rapid rate? More investors are leaning towards dividend-paying equities these days at the expense of GICs and bonds for yield enhancement. This may well be acceptable as long as there is not a requirement to draw capital from equities at a time when prices are depressed. To manage the risk, understand how much capital you need to draw down on annually and make sure funds are set aside in cash equivalents to cover you for the next few years in the event equities are depressed. Says Mr. Klaas, “Will you hang tough in a stormy market? How did you react during the last crisis?” Mr. Klaas goes on to stress the importance of having liquidity in the event that big ticket purchases come along. “If your plan has built in an appropriate level of flexibility, you might be able to choose to time the withdrawal of capital under more favorable market conditions”
Be careful when hunting for yield! A low grade bond might provide a better income stream but can be a blow to your plan if there is default risk.
On the other hand, don’t be afraid to take on some risk to enhance yield. For instance, with Canadian government 10-year bonds (at the time of writing) yielding just over 1%, consider quality corporate bonds or preferred shares that provide a better return.
Be mindful of currency implications. Will your retirement dollars be spent in Canada or the USA? You don’t want surprises when you decide to spend winters in the south and have to pay a premium on the dollar.
How will your portfolio react if interest rates eventually increase? Do you have a hedge to protect you should this happen? Many investors were caught off guard when interest rates fell last year and the price of floating-rate preferred shares suffered a significant decline. How did this affect your retirement plan?
Diversify!! I will repeat, diversify!!
Don’t rely too heavily on the equity in your home. You really don’t know its value until the for the sale sign goes on the front lawn.

Must Do:

Provide for the fact that retiree consumption is not constant through retirement. Says Mr. Klaas, “Research suggests that spending is greater in early years and starts to decline in your middle years. The implication is that many plans tend to overestimate the cost of retirement. This might allow you to accept a lower rate and less risk.”
Do you update your net worth and net worth projection annually? Are you still on track to achieve your goal? The fact that you are can be reassuring and can prompt you to stick to your long-term investment plan as opposed to changing direction unnecessarily
Run your retirement projection to age 95 as chances are you or your spouse will be dependent on your investments until then.
Make sure you rebalance your portfolio back to the target asset allocation. This is a key risk-mitigation strategy as your asset mix will drift over time and you want to make sure you are keeping the risk level in check.
Be mindful of investment scams or get-rich-quick schemes. Retirees are often preyed upon and can be vulnerable. If the quoted return is too good to be true then it likely is. Do your due diligence and remember that retirement is not the time to swing for the fences.
Do you know what you are paying in fees? With returns so difficult to come by, you need to know this as they can significantly erode your returns
Some have said to me over the years, “I don’t invest in stocks as they are too risky so I buy mutual funds.” Have you raised the hood of your mutual funds recently to see what your risk exposure is?
An area garnering more attention these days is annuities. Mr. Klaas points out that longevity annuities might be a solution that Canadian financial services firms should be looking at. “In concept it acts like fire insurance on your house—if it doesn't burn, you get no benefit. In the case of longevity annuities, if you don't live past age 80, there is no payout…but if you do, then it kicks in with the income you need for the rest of your life. What it does let you do is to dedicate the rest of your portfolio for income to age 80..a fixed period of time.”
Plan for the unexpected and monitor your plan on a regular basis. You may find that you sleep easier as you worry less about running out of capital or having to return to the work force.

Ross McShane, CPA, CGA, CFP, RFP, CIM is Director, Financial Planning at McLarty & Co Wealth Management in Ottawa, Ontario.