Central bank rates and retirement

(July 2007) Interest rates have been a big news story in recent weeks. The financial press writes massive amounts of copy on potential changes to short-term interest rates by central banks. For the most part, their analysis is short term. However, those of us involved in retirement planning need to take a longer-term perspective. We need to pay attention to what the Bank of Canada, the U.S. Federal Reserve and other central banks around the world do — or don’t do — to short-term interest rates because the central banks’ policies play a crucially important role in how your clients plan for, and live in, retirement.

But helping clients understand the connection between current central bank policies and healthy retirements in the future requires some forethought and understanding by financial advisors.

First, some perspective.

The interest rate hikes by many central banks around the world in recent months (the Bank of Canada and the U.S. Federal Reserve being the exceptions up to late June) have been in response to concerns about rising inflation. Bond yields have also been reacting to the same concern. Yields on the 10-year Government of Canada bond have increased by about 50 basis points since April of this year, reaching their highest level in nearly three years.

Not that inflation rates have been rising all that much or are, in fact, terribly high. What matters is that they have been a little above either the specific target rates set by central banks such as the Bank of Canada, or above the unpublished “comfort zone” employed by central banks such as the U.S. Federal Reserve.

A little goes a long way when it comes to inflation. And what seems like a little now can rapidly change to a lot if left unchecked. If financial markets or the general public suspects even for a moment that a particular central bank is no longer adamant about keeping inflation in check, they will act in such a way that almost guarantees inflation will rise.

So interest rates are rising in order to keep inflation in check. What’s the connection with retirement?

It’s not the interest rate increases per se, even though almost anyone in retirement is happy to see rising bond yields; rather, it’s what won’t happen to inflation. Keeping inflation down will mean a happier retirement for your clients. Inflation hurts people on fixed incomes by reducing their purchasing power, and the higher the inflation, the more their purchasing power diminishes.

But don’t expect inflation to disappear. The Canadian Consumer Price Index has risen on average by a little over 2% per year over the past decade. Two per cent is the centre of the Bank of Canada’s inflation target band and I, for one, am quite confident that the Bank will achieve this goal over the next decade.

Just because inflation is likely to be kept low, this doesn’t mean your clients don’t have to plan for it. Even a relatively low annual inflation rate of 2% (much lower than in the 1970s, 1980s, and early 1990s) will cut a retiree’s purchasing power nearly in half during a 25-year retirement. The chances of inflation being lower than 2% anytime soon are slim.

What the central bank actions and the rising bond yields are not likely to do is provide much support for income from the bonds that almost every retiree likes to have in his or her portfolio. Even at the 4.67% yield on the Government of Canada bond that prevailed on June 22, 2007, the income isn’t terrific. Subtract an annual 2% rate of inflation, and the retiree is left with real income of a little more than 2.5%.

It is not likely to be a temporary problem. Because central banks now act proactively to keep inflation from rising, they are close to having done their job, and rates are not likely to rise much further. The current consensus among economists is that the Bank of Canada will raise its benchmark rate by 50 or perhaps 75 basis points in the next few months. As the perceived risk of higher inflation dissipates, bond yields are likely to stop rising.

In the longer term, low interest rates are likely to be the norm. The aforementioned low inflation, global liquidity and increasing demand for long-term bonds by pension funds are all factors that are likely to restrain long-term interest rates in the years ahead.

What this all means is that the central banks are looking after the fundamentals — keeping inflation low — to help retirees. But it will be up to advisors to work with their clients to establish the trade-off between risk and return to determine the asset mix that will give the required retirement income.

One way of doing this is to take advantage of the global trends that are helping to keep interest rates low in the first place. The global economy grew by an average of 3.5% per year from 1980 to 2006, while the U.S. economy grew by 3.0% and Canada by 2.8%. More recently, global growth exceeded that of the U.S. by close to two percentage points per year. Good investment managers can find good investment opportunities in those strong global growth rates.

Peter Drake is vice-president, retirement & economic research for Fidelity Investments Canada. With over 35 years experience as an economist, he leads Fidelity’s research efforts into examining retirement in Canada today. He can be reached at peter.drake@fmr.com.

(07/05/07)

Peter Drake