As I was thinking about the economic outlook at the beginning of the year, I did a quick review of potential economic problems around the globe. That exercise revealed the importance of economic policies to mitigate current and future risk and market upheavals. It’s not that policies encouraging economic growth are passé – low central bank interest rates (in North America and much of Europe) and fiscal stimulus will continue to be important in 2011. But policy actions by governments and/or central banks that will prevent potentially troublesome issues from blowing up in 2011 and down the road will be the ones that make the difference this year.
An approach that focuses on preventing problems can also make the difference in planning for retirement. What we learned, or should I say relearned, from the global financial crisis is that policies of prevention are important. If there had been adequate policies in place, the crisis could have been avoided. We should take this learning to heart when it comes to retirement planning. Employing approaches and rules to avoid problems in retirement will increase the chances of your clients achieving the retirement they want.
Let’s take a quick glance at what will be required on the economic policy front this year to deal with three issues on three continents – and with three parallel and equally compelling retirement preparation policies to avoid things going wrong in retirement.
DEBT AND DEFICITS
No economic discussion can start without looking at the United States. The U.S. has a very large budget deficit and a huge amount of government debt. This is not a problem that can or will be solved overnight. What is needed is a five-year plan to reduce and ultimately eliminate the annual deficit. Only then can the U.S. begin to pay down its debt. The deficit-reduction plan must be sufficiently realistic about the necessity of both raising taxes and cutting spending that financial markets can believe it.
Bringing this down from the macro to the personal level, let’s look one topic that used to be ‘no-no’ in retirement. Personal debt. It used to be that you do not carry debt into retirement. Not any more.
The debt to disposable income ratio in this country is up to about 149% for all consumers, while 38% of retired Canadian respondents to Fidelity’s most recent Retirement Sentiment Survey said they carried debt of $5,000 or more into retirement. Six per cent had debt of $100,000 or more, 22 per cent had debt between $5,000 and $50,000, the rest in between. Is it wrong to carry debt into retirement? The answer is an unequivocal “it depends”. When people think about their expenses in retirement vs. pre-retirement, they usually think of expenses going down.
They also look forward to increased flexibility as to what they spend and where they spend it. Debt repayments are a firm contract – they must be made regularly. Ultimately, this means that a little debt is okay if you planned accordingly for it and are comfortable with all of the implications having debt entails. But having debt in retirement when you haven’t planned for it can cause major headaches. An additional cautionary note: most outstanding debt these days carries a very low interest rate. Rates are likely to rise in the future and so is the cost of debt.
For many types of debt, there is an equivalent asset (A mortgage is tied to a house for example). That asset could always be sold to reduce or eliminate the debt. However, this adds an additional risk in retirement: most markets for assets, whether financial or real estate, fluctuate. A retiree might not have the time to wait for a more favourable valuation/selling price.
There may also be emotional ties to the asset that one hasn’t given due consideration to when drafting a plan to sell that asset years in advance. The bottom line is that carrying debt into retirement may have some important negative implications for what you spend elsewhere. It is essential that anyone planning for retirement understand the implications of retiring with debt.
Rules and regulations to mitigate risk
Bad lending practices and insufficient liquidity in American and European financial institutions were part of the cause of the global financial crisis in 2008/2009. A big part of the public furor over what transpired was the realization that much of the mess could have been prevented. It could have been prevented if banks had followed their own guidelines, if some additional government regulatory rules had been in place, and if lenders were focused less on short term profitability and more on long term sustainability.
How might this apply to retirement planning? Have some personal rules around saving and investing for retirement and stick to them. The greatest benefit of pre-authorized, regular contributions to a retirement savings plan is that they put you on track and mitigate emotional risk. Another way is to earmark separate savings accounts, asset allocations or funds for different goals.
This form of mental accounting can actually be a good thing if it means we don’t spend the money we’ve set aside for health care when we are 80 on a vacation to the Caribbean when we are 60. Canadians have long heard the save for retirement message. One message that they need to hear more often is the importance of asset allocation. Unfortunately, many clients fail to keep up with asset allocation. They set it appropriately initially, but then fail to rebalance when market activity changes their allocation.
This is one of the fundamental reasons investors need to meet with their financial advisors at least once a year. Yet another risk is excess withdrawal rates. This is the concept that a retiree may withdraw too much from their portfolio early in retirement. Finding products and solutions that help to keep a retiree’s inflation-adjusted withdrawal rate at 4%-5% is optimal. There was tremendous pressure on newly-retired clients to raise their withdrawal rates when equity markets tanked in 2008, but those who stuck it out have seen their annual incomes come back and still have the likelihood that their portfolios will last as long as they need them.
Many emerging markets in Asia and Latin America are experiencing rising – and in some cases, already high – inflation. If not successfully checked, inflation will be harmful to these countries, and as the world becomes more interconnected, to the rest of the world.
Inflation – even low inflation – can be harmful to clients in retirement. Over a 25-year retirement, just two per cent inflation each year will take out 40 per cent of the client’s purchasing power. Investment strategies need to deal with inflation. Clients can’t control governments’ success in containing inflation.
Fortunately, clients in Canada have the benefit of living in a country whose central bank – the Bank of Canada – has a first-rate track record of keeping inflation to its two per cent target rate. My assessment of the Bank of Canada is that it will continue to do an excellent job of containing inflation. Even so, there can be temporary inflationary shocks such as the oil price spike of 2008 that will affect us all, at least for a while. And, some clients may chose to spend some of their retirement in other jurisdictions where inflation isn’t as well controlled.
What is the preventative retirement plan? It’s all about asset allocation and asset selection. Part of the plan might include some inflation-indexed bonds, although the market for these in Canada is admittedly small. More broadly, appropriate asset allocation might include enough equities with enough potential return to substantially outperform the Consumer Price Index (CPI) over a longer period. If you were to track a balanced portfolio and the Canadian CPI back to 1969, you would see that the return on the balanced portfolio was well over twice the rate of inflation – taking into account both the very high rates of inflation in Canada in the 1990s and the severe market correction in 2008.
If the appropriate economic policies aren’t put in place, we will see headlines about financial market uncertainty, much higher interest rates in some markets and slower economic growth around the world.
The failure of retirement planning to mitigate the risks around retirement might not gain the same sort of headlines. But they could make for much less-than-optimum retirements for many, ruin the relationship between financial advisor and client and, if the failure affected a large enough number of retirees, create a retirement income problem that could have some widespread, adverse economic effects.