Over the past few years, retirement planning has undergone a major shift. Advisors used to tell people to get more conservative as they got older, which was fine when fixed income yielded strong returns.
Now, though, with bonds barely offering any income anymore, advisors need to come up with other ways of making their clients’ income last for a lifetime.
“A sustainable level of cash flow is becoming paramount,” says Scott Plaskett, a CFP and CEO of Etobicoke, Ont.-based Ironshield Financial Planners, “but there are a lot of headwinds against you today.”
According to Connor, Clark & Lunn Private Capital Ltd., in 1995 you could earn an annual average of 7% by holding 34% stocks and 66% bonds. You’d get that return with about 6% volatility. (Meaning you’d never do worse than 1% and returns wouldn’t exceed 13% in any given year.)
To get that same return today, clients would have to hold 82% of their assets in stocks and 18% in bonds. That combination would result in a 13% volatility risk, so the range of returns would now be minus 5% to plus 20%.
Plaskett wants that mid-single digit return for his clients, but he wants it with bond-like stability. You never know when the market might sour, he says, so reducing risk — but not returns — is critical. The last thing retirees want is to eat into their capital.
“You can’t afford to slow down,” he says. “Start eroding the principal and the math doesn’t work in your favour.”
To get decent returns while keep volatility low, advisors and investors will have to get creative. One option for well-heeled Canadians is to buy into infrastructure or commercial real estate projects.
These investments tend to pay higher-than-average dividends — about 5% to 6% — and have a 20% to 30% correlation to the stock market, says Michael Flux, a senior vice-president and portfolio manager with CC&L.
One way to buy into this market is to buy into a pooled limited partnership, which CC&L sells. Essentially, several high-net-worth investors put their money into the pool and then the company buys hard assets with that money.
The main drawback is that it’s difficult for investors to get their money in and out of these funds. CC&L allows people to withdraw quarterly, but other funds are of the closed-end variety and have a fixed exit date.
It is possible to get between 8% and 11% returns, though, with much less volatility, says Flux.
Another option, says Plaskett, is to buy whole life insurance. These products come with a guaranteed return — Sun Life’s guarantee is about 6.75% right now, he says.
This option works because unlike the mutual fund business, insurance companies can engage in “smoothing,” a process of amortizing investment gains and loses over a number of years in order to maintain more stable annual returns.
While some of these policies can come with higher fees and restrictions, ultimately they’re more stable than stocks and still produce better-than-bond returns in our low-interest-rate world. The other advantage, besides the guaranteed return, is that investors will never have a negative year, says Plaskett.
Advisors with more ambitious investors could also invest in market-neutral funds, which implement market-neutral strategies such as a pairs trade. In this situation — the pairs trade is one of the most common market-neutral strategies — an investor would go long on one stock and short another, but similar, stock.
For example, an investor who believes financial company A will do better than financial company B would go long on the former and short on the latter. If that turns out to be right, the investor will end up pocketing the difference between the two stocks.
“In essence, market risk has been removed,” says Plaskett. “Even if both stocks go down you can still make a profit as long as [stock A] does better than [stock B]. Market direction, though, is no longer important.”
When it comes to stocks themselves, Plaskett prefers working with value managers (he’s not a stock picker himself) because discounted companies have a higher margin of safety built in. Generally, an undervalued stock won’t fall as hard as a company trading at a premium during a downturn.
No matter the approach, keeping risk low without sacrificing returns is critical if clients want to outlive their money. “You really can maintain a diversified portfolio that doesn’t increase and doesn’t reduce your return potential,” he says.