Finding returns in softer markets

The search for yield has forever been the holy grail of financial markets.

But yield is only one portion of the returns in your portfolio. You need to consider the total return of the investments, which includes factors beyond market performance.

Inflation and risk

While inflation and interest rates have both run near historic lows for many years, it’s never good to become entirely complacent about this aspect of income risk.

Even at the meagre inflation rates seen over the past 20 years, a Bank of Canada calculator shows you’d need $28,706.70 today to purchase what $20,000 bought you in 1995. And, when rising global demand does eventually push up interest rates, inflation impacting consumers will increase alongside.

While there’s no perfect solution for generating the amount of assets needed to provide income when the time comes, there are strategies that can protect you from worst-case scenarios – such as unexpected future inflation.

First we’ll need to ascertain how much volatility you can sustain while developing an investment strategy. If you can take some volatility now, you’re likely to improve your standard of living later.

Plus, during the accumulation stage, stock market volatility may be less concerning as long as the portfolio’s properly diversified. You’ll have time to recoup market dips.

A conventional portfolio of 60% equity and 40% fixed income should conservatively achieve a 4% real rate of return, prior to tax. And expectations for retirement income should be based upon the total expected return from investments, not just the yield.

No matter how you calculate it, though, you’ll need to come up with a number equalling how much income will need to flow into your bank account to cover spending (over and above what you’ll get from CPP and OAS).

And we’ll need to factor for what happens if markets drop substantially just before you plan to retire.

Diversification techniques don’t always help when that happens, so if you want to generate income it’s important to avoid withdrawing funds from asset classes that are declining in value.

If luck’s against you and you retire when markets are softening, your capital can deplete at an alarming rate. Worse, this depletion reduces a portfolio’s chances of generating net spendable income for your remaining retirement years.

Plan for cash

It’s impractical to plan retirement around the possible performance of the stock market.

That being the case, one strategy to protect capital and ensure you have enough to live on is to invest one year’s worth of the income you’ll need to supplement CPP and OAS in a high-interest investment savings account. You’ll spend that money in the first year of retirement.

Then, invest a second year’s needed income in either a one-year bond or GIC.

Place an additional year’s needed income in a two-year bond or GIC.

Don’t use bond funds or mortgage funds for this strategy, since they can fluctuate with changes in interest rates—as interest rates rise, bond yields and mortgage fund values decline.

The balance of your investments remains in a growth portfolio, with an asset mix based on your investment policy statement.

Drawing down

You’ll spend your investment savings account during the first year you’re retired.

If, during that year, market performance produces enough returns to let you draw income directly from the growth portion of your portfolio, then use that cash to replenish the investment savings account for Year Two of retirement.

The GIC, since it’s not used for income, can then be reinvested for another two years.

But, if markets don’t do well, the matured GIC can be cashed to replenish the investment savings account.

Setting up this rotating reserve means that when markets decline, you’ll have the comfort of not having to dig into your capital for at least three years. So, provided the downturn doesn’t last longer, you can avoid pulling funds from a portfolio that’s declining in value.

Five years out

It’s important to review a portfolio five years before retirement to make sure it will line up with retirement income objectives. (And having at least three years’ worth of desired retirement income in fixed-income vehicles is a key part of that review.)

That way, if the stock market performs poorly five years before retirement, you’ll have those years to recapture some growth before having to take money from your portfolio to generate income.

In years when markets earn extraordinary returns, this growth should not just be used for income purposes. Funds should also be shifted from the growth account into fixed-income to rebalance the portfolio.

The biggest benefit of this strategy is that it lets you feel more comfortable with market volatility, and not make bad investment decisions when markets soften.

So, while yield is an important part of any portfolio, how the income is generated is more critical.