Investing for retirement is a topic that comes up frequently in any discussion about financial planning. After years of working and saving, people want to feel secure that they will have enough money to live comfortably in their retirement years. In fact, preparing for retirement is one of the main reasons people invest in the first place.
There is no shortage of articles on the Internet that talk about retirement planning. Unfortunately, many of these articles do not mention how investing has changed over the last ten years—and why recent actions by central banks and governments will radically transform the investing climate for many years to come.
If you are thinking about retirement—whether in five years, ten years, or 20 years—it is not enough to envision a number at the end of the road. The dollar figure you picture at the end of your working career will not be worth what it is today. To understand why, we have to look at inflation.
Assuming a 2% inflation rate, which is a common target for central banks, the rule of 70 tells us that it takes roughly 35 years for the value of a currency to halve. If annual inflation averages 3% or more—like it did in the United States between 1914 and 2019—the value of the dollar is cut in half every 20 years.
Central banks around the world have made it clear that inflation is one of their top priorities. In the United States, the Federal Reserve recently announced a major policy shift that will allow the central bank to overshoot its 2% inflation target. That means record-low interest rates could be here to stay indefinitely.
Most major central banks, including the Bank of Canada, are following the Fed’s lead, and have lowered interest rates back to zero in response to the Covid-19 pandemic. Zero-bound interest rates pose an opportunity and a risk for retirement planners and those already in the retirement phase of their life.
To maximize retirement income, investors need a smart strategy that balances risk and reward—while also accounting for inflation. This means investing not only in preparation for retirement but during retirement as well. This holds especially true for people nearing retirement who don’t want to see their lifestyle affected negatively by inflation.
For many years, financial planners advised their clients to keep a balanced portfolio composed of 60% equities and 40% bonds or other fixed-income assets. But, a series of bear markets (markets where share prices are continuously dropping, and have dropped at least 20% from recent highs) since 2000, and the continuation of record-low interest rates, have made this traditional 60/40 split undesirable compared with past decades.
Many of these traditional 60/40 portfolios lost more than 20% of their peak values during the March 2020 bear market.
Any well-balanced portfolio has a good mix of stocks, fixed-income assets, and other assets. In the current investment climate, portfolio diversification means relying more on alternative investments, which include hedge funds, private equity, real estate, private debt, and assets that provide collateral backing such as private mortgages and mortgage investment corporations.
Alternative investments are no longer niche products but mainstream financial assets that are being used to help investors prepare for and stay invested during retirement.
In 2020, global alternative assets under management reached $10 trillion and are on track to exceed $14 trillion over the next three years.
In past decades, fixed-income investments like government bonds allowed investors to live off the interest accrued on their principal. Inflation and ultra-loose monetary policy have made interest-based retirement plans more difficult to implement successfully, especially for investors who do not have excess capital.
Delving into the world of alternative investments, private mortgage investment corporations (MICs) have the potential to offer higher returns than many traditional fixed-income investments. Although they mostly assume greater risk than government bonds or GICs, mortgage investment corporations allow investors to capitalize on low-interest rates and rising property values—a common theme in the post-financial crisis world. MICs also distribute regular dividend payments from the interest and fees charged to borrowers.
A MIC is just one way that retirees can live off interest and dividend payments during retirement. A portfolio structured around dividend stocks is another way retirees can create an additional income stream.
MICs and quality dividend-paying companies are two ways investors can earn income while preserving capital. They can also provide an inflation hedge by letting investors generate income that grows and maintains the purchasing power of their portfolio.
To truly maximize retirement income, investors should take full advantage of retirement and tax-free savings accounts like RRSPs and TFSAs. This includes utilizing the full contribution limit each year and making catch-up contributions.
In Canada, the RRSP contribution limit is 18% of earned income up to a maximum of $27,230. The maximum TFSA contribution limit is $6,000.
Retirement planners have a lot of options when it comes to money management. They can adopt an active management strategy where they or their portfolio manager buys and sells assets to outperform the market. Active portfolio management gives investors the ability to generate higher returns—but this often comes at a higher risk premium.
Passively managed funds tend to be less risky because they are designed to track an underlying index or market. Although passive funds are usually associated with lower returns, alternatives like Mortgage Investment Corporations provide the possibility of higher yields.
Retirees and retirement planners will find advantages to implementing both active and passive strategies.
Alternative investments can provide retirement planners with additional avenues of capital growth and preservation that may be more difficult to source in traditional markets. Alternatives like hedge funds, private mortgages, and MICs tend to experience less severe drawdowns in bear markets when compared with other asset classes. They can also help generate better returns when traditional markets are idle.
People nearing retirement age should also weigh the opportunities of remaining invested for longer, especially as life expectancy continues to increase. Statistics Canada estimates that life expectancy at birth will increase from 86 to 90 for men and 89 to 93 for women between 2013 and 2075. A higher life expectancy means your portfolio still needs to grow long after you reach retirement age.
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