Extending retirement funds

Nostalgia for the good old days is often unwarranted.

If you were born in Canada just a century ago, you could expect to live only about 50 years. Currently, Canadians’ average life expectancy at birth is more than 81 years—almost 79 years for men and more than 83 years for women.

Longer life expectancies aren’t a bad thing. But they do complicate financial planning. When post-retirement is measured in decades rather than years, many Canadians are rightly concerned their retirement portfolios will not last as long as they do. These worries are only compounded by the current investment environment.

Pension woes

A further cause for concern is that the burden of retirement planning is shifting to the individual.

Today’s average 50-year-old is looking at another 25 or 30 years of investing, which means the traditional, conservative retirement portfolio will be at a very significant disadvantage. But the good news is that living longer has some benefits when it comes to investing for a long retirement.

Income generation and returns are real possibilities even in retirement. But this means considering risk asset classes and a redefined approach to asset allocation.

The new longevity requires a close assessment of how quickly retirement funds are drawn down. For instance, the practice of increasing withdrawals every year to keep up with inflation ensures you don’t have to give up any creature comforts. But it also ensures your retirement funds deplete quickly, and the cumulative effects of withdrawal rates can be dramatic.

The chart (below) illustrates a hypothetical $1-million portfolio whose holder retired in 1972. At a withdrawal rate of 8%, it was reduced to zero in just over 10 years. By contrast, a modest 5% withdrawal rate meant the portfolio lasted for more than 20 years. A 4% withdrawal rate resulted in the portfolio appreciating over the next 30 years. Sticking to a modest withdrawal rate or a fixed percentage throughout retirement significantly increases the chances the portfolio will live as long as your clients.

Dividend payers offer yield and growth potential

Income based on a $100,000 investment in the S&P 500 index and the Merrill Lynch Domestic Master Bond Index

Economic concerns

Investors today are nervous. Global economic uncertainty, faltering confidence in financial institutions and volatility in the stock market have conspired since the economic crisis of 2008-2009 to push investors toward cash.

But inflation, even at the current relatively low rate of 3%, will reduce the purchasing power of cash by nearly half over a 20-year retirement.

In today’s low-yield environment, traditional cash investments are unlikely to be effective instruments for extending an investor’s portfolio over a 20-or even 30-year retirement. A diversified portfolio has a far better chance of lasting longer in retirement than a predominantly cash or fixed-income allocation (see “Over-allocating to cash may cause you to outlive your assets”).

The longer view of retirement requires investors to consider higher-yield assets such as equities, corporate debt and commodities, while managing risk and volatility over the long term.

On the equity side, dividend-paying stocks are standard elements in most retirement portfolios. And as people live longer, the importance of earning income while building wealth is a common theme.

Today’s low-yield environment presents some compelling dividend opportunities. Just like individual and institutional investors, many high-quality companies around the world are now sitting on piles of cash, and as a result are paying out historically low percentages of their revenues in dividends. Even so, dividend yields on many stock markets are still exceeding those of government bonds.

And, getting consistent returns with dividends does not mean you have to sacrifice growth. Low payout ratios suggest potential for substantial dividend growth in the future, not to mention the opportunity for capital appreciation. Also, dividend growth has historically outpaced inflation, so reassessing the allocation of dividend stocks in a retirement portfolio could present an active way to hedge against the adverse impacts of longevity.

Over-allocating to cash may cause you to outlive your assets

Value of a $500,000 portfolio with 5% inflation-adjusted withdrawal

More investment options

Another option is low-beta stocks, which typically don’t exhibit excessive volatility relative to the broader market. Diversified products like minimum-volatility ETFs can fine-tune risk in a portfolio by smoothing out its performance, especially on the downside.

On the fixed-income side, yields on safe-haven government bonds are at historical lows, but there are other options, like corporate credit. Many companies are turning to the debt markets to raise capital, thanks to low borrowing costs and the continued tightness of bank lending. Even with low coupons, however, yield spreads for corporate debt over government bonds remain at historical highs, even though in many cases company fundamentals look good. This presents opportunities for investors to boost income.

Diversification over longer time horizons is key. The recent banking and debt woes in developed western economies should encourage investors to reassess the potential of emerging markets. They have higher growth prospects, lower debt levels and more fiscal room to stimulate their economies than much of the developed world.

Emerging market debt, for example, offers attractive yields. This certainly moves us up the risk-tolerance curve, but the past few years have demonstrated that sovereign debt of developed countries is subject to unforeseen shocks. Over the long term, emerging markets could be an important place to spread risk through geographical diversification.

In the new low-yield environment, the traditional conservative approach to asset allocation faces a significant challenge when it comes to making a retirement portfolio live as long as the retiree. With the right strategies for managing volatility and market exposure, it is possible to turn longevity risk into a longevity benefit—and for an investor to retire happy.

Comparing withdrawal rates

Noel Archard is managing director and head of BlackRock Asset Management Canada Limited.