Investors who are in, or near, retirement are in a difficult position. They need their investments to provide them with steady cash flow to live on, but they also need their wealth to last for a potentially long life.
Retirees who are caught in a bear market don’t have the time to wait out temporary dips in stock prices, even if they have a greater risk tolerance. Being forced to sell investments that have plummeted to provide money to live on could have a devastating effect on the sustainability of a portfolio.
Some investment advisors are mobilized to guide their pre-retirement clients out of equities and into bonds in an effort to offer income and stability. But, now that interest rates have reached historical lows, traditional bond portfolios will have a difficult time providing an acceptable level of income while protecting purchasing power over the next 25 to 30 years.
Structure your portfolio for both short- and long-term needs
You want to first meet your cash flow requirements for the first five (or ten) years of your retirement. There are several ways to do this. You can get consistent cash flow through some combination of pension income, a ladder of bonds or GICs that mature each year, interest from fixed-income investments and reliable stock dividends.
You can’t look at recent stock market performance and expect it to continue indefinitely.
Pre-retirees are wise to make more conservative assumptions about likely future rates of return.
Assume your stocks can fall by 40 – 50%. If the market continues to be strong that’s great. Take your profits and carry on. If the inevitable bear market occurs, this strategy gives you a longer time horizon with your equity investments, because you know you won’t have to sell any to meet your spending needs.
Investing for more income
Some investors may be tempted to increase their equity exposure because bonds are providing dismal yields these days. They may try to chase higher yields in the attempt to provide more income. This strategy can unnecessarily increase risk at a time when you can least afford it.
Resource and utility sectors typically pay out a higher than average yield, but, as many recently experienced with the oil sector meltdown, the dividends may not be sustainable and can be cut sharply, or even eliminated.
Generally, the more cyclical an industry is, the less reliable the dividend will be. Telecoms, utilities and pipelines are the most reliable as well as consumer staples (but these dividends tend to be low).
REITs and monthly income funds may return a portion of your own capital (ROC) to maintain their higher payouts. You might be okay with this and it can have some tax advantages. Just so you realize that you are not generating earnings of say 6 or 8 percent.
Stick with a balanced portfolio
Recent analysis suggests that a portfolio of about 50% stocks (mostly large cap equities) and 50% high quality government or corporate bonds has the best chance of achieving portfolio longevity (defined as the number of years a portfolio can sustain withdrawals of about 4-5% in real terms before all assets are exhausted.
The fixed income component should be in investment-grade bonds such as those issued by governments or companies with strong balance sheets, or GICs with terms of three to seven years.
Choose conservative stocks – mainly blue chip, dividend-paying companies with low debt that generate moderate, reliable and growing cash flows, rather than companies that may have higher yields but offer little potential for growth. Preferred shares are another income option.
Or, instead of a bunch of dividend paying stocks, invest in ETFs that pay monthly dividends such as iShares Canadian Select Dividend Index (XDV).
Outliving your savings
Many boomers have a fear of outliving their money.
If you are really worried about outliving your savings, one of the best things you can do is delay starting your government pension plans.
You can reduce the stress of uncertainty with a slew of products available for income. Some can be quite complex and have their own pluses and minuses. Research them carefully.
- Reverse mortgages
- Immediate annuities – monthly payout will increase the longer you wait to purchase these.
- Deferred income annuity – also known as longevity insurance. Instead of immediate income (like a regular annuity) the benefits don’t start until later, perhaps 10 to 20 years down the road. If bought at say age 65 in return for income that starts at 85 you can spend your assets over the first 20 years of retirement knowing you have guaranteed income thereafter. Because payments take place in the future you can buy a bigger benefit compared to a regular annuity. In this case, the younger you are when you make the purchase, the better the deal.
There is a great deal of uncertainty in retirement planning with so many unknowns, such as costs, length of retirement, and potential medical needs.
Many people on the verge of retirement think they have to make major changes to their portfolio, but this isn’t necessary. You don’t need to switch everything to bonds, but neither should you take on more risk by increasing your equity position in an attempt to gain more income.
There are many ill-suited financial products targeted at retirees. The sales pitches are designed to tap into deep-seated fears about the affordability of retirement. Don’t fall for high-pressure tactics, and certainly don’t take action until you are satisfied you have all the information you need to see if there’s a sure benefit for you.