income-concept

The search for yield has forever been the holy grail of financial markets. And as yields on traditional investments remain historically low, many investors are grasping at higher-yield common stocks and corporate bonds, even at the cost of capital protection. They don’t realize these investments can, and will, fluctuate over time.

It’s important to realize yield is only one portion of the returns in your client’s portfolio. A majority of Canadians will need to spend a significant portion of their assets to generate their desired income level over their lifetimes.

Unfortunately, most Canadians don’t have the luxury of living solely off the earnings in their accounts.

Indefinite inflation

The most critical aspect in planning for retirement income is inflation, or the real rate of return. For example, if the rate of inflation were 3%, in 20 years you’d need approximately $36,122 to buy what you can buy today for $20,000.

There is no yield product that can sustain this type of growth. It isn’t good enough just to generate a steady stream of income. You also need to increase income avenues for your retiree clients in order for them to maintain their standard of living.

It’s important to develop a strategy that allows clients to generate their desired after-tax and after inflation income through their retirement years. There’s no perfect solution.

People investing strictly in term deposits and government bonds have seen their incomes drop dramatically as interest rates have been kept artificially low to deal with today’s economic realities. This doesn’t mean there’s no place for yield investments—just that they aren’t the be-all and end-all when designing a retirement income strategy for clients.

Riding risk

The first step you need to take is to ascertain how much volatility your client can sustain when developing an investment strategy. If your clients can’t tolerate higher volatility, they will likely be forced to a lower standard of living.

Once you’ve decided how much risk your clients can absorb, you need to estimate how much income they can generate through their expected lifetimes. A 100% fixed income portfolio would likely achieve a 2% real rate of return, and a portfolio comprised of approximately 40% equity and 60% fixed income would provide a 3% real rate of return.

Similarly, a portfolio with 60% equity and 40% fixed income should achieve a 4% real rate of return. It’s important to remember real rate of return takes a complete market cycle to achieve.

When you’ve analyzed your clients’ risk-and-return objectives, you can decide how much money they need to generate in retirement. It’s a mistake to decide on an investment without analyzing longterm implications of the strategy.

With any retirement income strategy, you need to contemplate when withdrawals will be required and in what amounts. Your clients can lose a lot of money when they have to redeem funds or make decisions at inappropriate times.

The strategy I use for generating income in retirement is based upon the total expected return from a client’s investments, not just the yield. Clients’ total returns will be used to generate their desired retirement income.

When clients are working and accumulating retirement savings, stock market volatility is not a concern as long as the portfolio is properly diversified. One of the greatest risks in retirement planning is having the stock market drop substantially just before or after a client retires.

Proper diversification techniques do not always help at this stage. In generating an income during retirement, do not withdraw funds from an asset class declining in value.

If your clients are unlucky enough to retire when the stock market is performing poorly (and they need to generate income from their portfolio), they could deplete their capital at an alarming rate. Ultimately, this reduces the portfolio’s chances of generating the required net spendable income throughout the remaining retirement years.

Here’s a plan

It’s difficult (and impractical) to accurately plan retirement around the possible performance of the stock market. In my opinion, with proper retirement income strategies, an initial withdrawal rate of up to 5.5% is sustainable.

Here’s the strategy I’d recommend: invest a year’s income in a money-market account to be used in the first year of retirement. Invest another year’s income in a one-year bond or GIC, and also invest a whole year’s income in a two-year bond or GIC.

It is important for clients to own fixed income (bond or GIC) directly. You don’t want the current market to influence this portion of the pie. Both bond funds and mortgage funds are unsuitable for this purpose.

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