What rising interest rates mean in retirement
An extended period of falling interest rates, coupled with a general lack of confidence in volatile stock markets, has led many older Canadians investors to load up on bonds in recent years.
Investors typically retreat from riskier assets in the years before they retire, slowly shifting their portfolios from stocks to more conservative fixed-income portfolios.
And they’ve been rewarded for doing so. Bonds have done nicely over the past five years with the better bond funds in Canada delivering a solid five per cent annual compound return.
But that party is pretty much over, warns CIBC Asset Management in a recent report, noting that two thirds of Canadians approaching retirement seem unaware that rising interest rates can actually erode the value of these investments.
Bonds are designed to serve as ballast, steadying the ship during stock market storms. But leaning heavily on fixed income — particularly long-term government bonds or the funds that invest in them — can disturb that balance when interest rates rise.
Most economists don’t expect the Bank of Canada to start raising rates until next year. But it’s hard to find someone who thinks they’ll remain at these levels much longer than that. And that’s going to hurt many cautious investors.
As rates rise, the interest rates on bonds with a longer maturity end up being locked in at a lower rate for a longer period of time. As a result, their value to buyers — i.e., their prices — falls off when rates rise.
Generally speaking, in a bond portfolio that has an average of 10 years in maturity, you’ll see a 10 per cent price drop with a one per cent rise in rates.
You can take steps to diminish the impact of rising rates by moving to bonds with shorter maturities. To mute the impact, look for a bond fund with a low duration, or average maturity, of less than five years.
Looking ahead though, you may find that a bond-heavy portfolio — unless you’ve really been able to set aside a lot of retirement money — isn’t going to get you where you want to go.
Funding a 25-year retirement will likely require a more aggressive investment strategy than you might think since your portfolio has to pay you regularly, settle up with the government, and keep up with inflation.
Most Canadians will find they need a low double-digit return. And that’s probably only going to happening if a fair chunk of your money is invested in stocks.
But that’s not what you see with most packaged investment products, cautions Mark Yamada, whose Toronto-based firm produces institutional quality portfolios for individuals.
Take target-date or lifecycle funds, for instance.
These programs, increasingly the backbone of many defined contribution pension plans, move money from riskier investments such as stocks to more conservative alternatives like bonds — a process commonly called the fund’s glide path — as you approach retirement.
Can such an approach actually provide enough income to last through long retirements? The fund companies think so, but Yamada isn’t so sure.
While they simplify decision making, target-date funds are rather blunt instruments when dealing with market risk and personal goals, he maintains.
One problem is that not everyone with the same target retirement date actually shares the same risk tolerance or investment goals.
Plus, some investors will clearly end up retiring when the markets are producing losses and the consequences of this timing, something known as the sequence of returns, could be severe.
Looking at the existing TDF marketplace, Yamada calculated the probability of running out of money when drawing four per cent of initial capital annually (adjusted for inflation) in a low to rising interest rate environment for various stock/bond mixes.
The results suggest that systematically reducing risk toward a retirement date by increasing bond exposure, as is the current practice for virtually all TDFs, may mislead investors into thinking they’re better protected than they are.
Assuming the typical bond exposure of between 60 and 70 per cent you’d find in most TDFs, by the time it comes to retire, you’d end up with a 24 per cent to 33 per cent chance of exhausting capital prematurely, Yamada warns.
To combat this, a more dynamic glide path that might actually tilt towards more stocks and fewer bonds in retirement may make more sense, he suggests.
If market returns are poor in the early years, you’ll dollar cost average at cheaper and cheaper valuations; and if markets are good — well, you’ll have to find something else to worry about in retirement.
Got a question about investing, saving or retirement? Send Gordon an email and we might answer your question in a future column.
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