Monday, February 2, 2009

Retirement Lasts Longer Than Market Corrections

It might be an obvious statement to some, but it's one I feel needs to be made: a person's retirement will last longer than this market correction — much, much longer. It might be hard to think about this right now, given how much the markets have dropped, but it is important to keep perspective in these times. It's perspective that people need, and generally people have responded in an appropriate manner. If you can understand that your investments will rebound during their lengthy retirement, you will pull through the market adjustment.

There are five key risks to retirement income: longevity, inflation, withdrawal rates, asset allocation and health care. The purpose in identifying these risks was to help advisors develop retirement income plans for their clients. While it defined them in a bull market, they continue to be just as important in helping shape people's thoughts on retirement planning in today's volatile markets. Let's take a look at each of the five key risks taking into account the current market volatility.

The simple fact is that retirements are getting longer. In some cases, they can be as long as your working life — 25 years or more for many people. But as retirements increase, so do the risks, and so should the planning. The longevity of Canadians is not going to reverse just because markets are volatile and the economic outlook is uncertain. There has been a substantial increase in life expectancy at birth over the last 25 years, but it may be even greater in the next 25 years. So even if some of you choose to retire later than you had planned, the length of your retirement is likely to be just as long as if you didn't delay your retirement.

Inflation was a hot topic a few months ago, but you don't hear much about it at the moment. Instead, deflation — widespread falling prices — is the topic du jour. Deflation isn't likely to happen, because governments and central banks are aware of the conditions under which it could happen, have the tools to prevent it, and will use them as necessary. Although it seems remote at the moment, concern about inflation will again emerge, probably sooner rather than later. It might result from a resumption of growth in global commodity prices, or from a resumption in global growth. Regardless, it is highly likely to occur in the next several years.

Similarly to the situation for deflation, central banks have the tools to keep inflation low and inflation expectations well contained. The Bank of Canada has done a good job on inflation in the past decade and has a strong commitment to keeping it under control in the future. Nevertheless, you can expect an average annual inflation rate of at least 2% per year going forward. In real numbers as they’d affect a retirement income plan, inflation at 2% annually over a 25-year period reduces the purchasing power of your income to approximately 60% of its original value. Interest rates on short-term government securities and longer-term government bonds may rise a little over the next few years as investors move away from the safety of government securities and back to other types of securities in search of higher returns, but interest rates on government securities are not likely to rise enough to provide the protection against inflation that most retirees are looking for. Therefore, clients need to look beyond the current urge to be in "cash" and consider the role equities should play in their retirement portfolio.

Withdrawal rates
Most clients have been reasonable about their incomes from their portfolios. Some people may be thinking of raising their annual withdrawal rates in order to maintain specific income streams from portfolios that are valued less than they were a few months ago. Yet research has demonstrated time and again that for people in their mid-sixties, an inflation-adjusted annual withdrawal rate of 4% is the ideal rate to extend portfolio life to its maximum.

This raises the very basic question of how clients can keep their withdrawal rates down when their portfolios are also down. There aren't any easy answers, though it has to do, in part, with how quickly markets recover. For clients who are counting down to retirement, depending solely on the whims of the markets over the next couple of years does not make sense. In this case, a thorough examination is in order: of clients' other sources of income, projected expenses in retirement, flexibility of retirement date and whether clients are candidates for working during retirement. Depending on their specific situation, an increased monthly contribution to retirement savings may be required. Both increasing their monthly contribution and investing it at a time when markets are volatile may require some pretty thorough discussions. But I am convinced that much as investment performance is important, so too is the amount contributed by clients.

Asset allocation
The fourth risk to retirement income is asset allocation. There are some basic rules for asset allocation that apply to almost everyone — equities, fixed income and cash. Research has shown that having equities in a portfolio is likely to result in the longest portfolio life.
It also takes into account the differences in appropriate asset allocation for average markets and extended down markets. Clearly the correct answers tend more toward the latter than the former, at present. The mistakes made most often in asset allocation are having too much of one asset category — a mistake especially to be avoided at the moment. But moving from a general discussion to what is appropriate for a specific client absolutely must consider the client's situation, especially risk tolerance.

I have said many times before and I repeat now that many people simply don't understand what risk is. The challenge now is try to put some perspective on market risk so that clients are not driven to the risk-averse end of the spectrum at the expense of the returns they need. Obviously, this particular discussion must be wide-ranging and include all sources of income, specifically which ones are guaranteed (CPP, OAS, pension, annuities).

Health care
The fifth risk to retirement income is health-related expenses, particularly out-of-pocket health costs, but also age-related costs such as the help that may be required for housing and daily care in the later years of retirement. Like longevity, the need to prepare for health-related expenses doesn't change just because markets are volatile. What volatile markets — and the accompanying increase in uncertainty about retirement income — may accomplish is to help people realize that they should give some serious thought to these costs, and to their choices now and as they age.
Another specific planning area to consider is to consider a Long Term Care Plan, or to build a separate 'health-care' fund.

None of us can control the markets, but there is a great deal we can control and this is the time to do just that. Knowing all sources of retirement income and their characteristics, facing various economic and market prospects head on and preparing to be flexible enough to react to events as they unfold are likely to improve your prospects in a big way.

No comments: