Tough choices

“The challenge is not just that we are living longer as a society, but that as individuals, we don’t know exactly how long we will live,” says Moshe Milevsky, associate professor of finance at York University’s Schulich School of Business in Toronto. “Advisors need an arsenal of strategies to deal with a variety of client contingencies.”

To help meet this challenge, retirement investment portfolios are being broadened to produce a diversified income stream and may include a mix of dividend- paying stocks, growth-oriented equities, alternative strategies, hard assets, corporate bonds and emerging-markets securities. An effective financial plan also might include a slice of guaranteed income through the use of annuities or guaranteed minimum withdrawal benefit products.

But advisors must offer more than investment expertise. A growing number of clients who are 65 and older are choosing to work longer or part-time, and you can add value in helping these clients maximize the timing of their income from sources such as the Canada Pension Plan or their RRSPs. Putting together a patchwork quilt of solutions is a creative endeavour requiring asset allocation, investment management, estate planning, tax solutions and income-withdrawal strategies that need monitoring and tweaking along the way.

The silver tsunami of aging Canadians will only get bigger. The Office of the Chief Actuary projects there will be 12,000 centenarians by 2020, 20,000 by 2030 and 50,000 by 2050. By 2030, half a million Canadians are expected to reach their 90s, and 2.6 million will hit their 80s.

“Aging is a rolling target,” says Peter Drake, vice president of retirement and economic research with Fidelity Investments Canada ULC in Toronto, who at 71 is enjoying full-time employment. “The longer you manage to survive, the greater your chances of living a long life. Unlike other stuff that happens, we can see this coming.”

On average, almost 40% of 50-year-old males and 50% of 50-year-old females are expected to live to age 90, according to the Office of the Chief Actuary. With today’s average retirement age of 62, many retirements could be 30 years or longer in duration.

Despite these statistics, clients’ perception of their potential for long lifespans have not caught up. A recent survey conducted by Sun Life Financial Inc. of Toronto found that Canadians aged 55 to 72 expect to live to an average age of 80 years. A separate Sun Life survey of advisors revealed the average lifespan that advisors use when creating financial plans for clients is 88 years. These surveys indicated that both advisors and their clients are underestimating potential lifespans.

“Advisors must build in rising life expectancies to the financial plan, and our recommendation is that they plan for clients to live to 100,” says Rocco Taglioni, senior vice president, distribution and marketing, individual insurance and wealth, with Waterloo, Ont.-based Sun Life Financial (Canada) Inc. in Toronto. “Advisors must go beyond investing and help clients develop solutions for a variety of challenges, including health, inflation and longevity.”

Clients who are no longer working are anxious about preserving capital, and their natural inclination is to lean toward fixed-income investments. But there are dangers in investing too conservatively. For one, bond yields are meagre. For example, the 10-year Government of Canada bond yields slightly more than 2%, which is reduced to virtually nothing after inflation and taxes.

And inflation is one of the biggest risks faced by retirees, as it steadily eats away at the purchasing power of fixed assets over time. Annual inflation has averaged 3% during the past 100 years, but even a low inflation rate of 2% would reduce purchasing power of our currency by 40% during a 25-year retirement.

Furthermore, bond investors are vulnerable to a rise in interest rates, which would erode the value of any bonds paying interest at today’s low rates. Corporate bonds and emerging-markets bonds usually offer a higher-interest coupon but often come with lower credit ratings and higher risk.

There is a variety of strategies to cope with rising interest rates, including laddered bond portfolios and floating-rate notes, but some strategies require a trade-off of lower income. Still, despite bonds’ lower long-term returns relative to stocks, the former have an important place in a retirement portfolio. Bonds typically are more stable than stocks, they react differently to changing economic circumstances and they provide some ballast at a time when equities markets plunge. (See story, page B12.)

Drake says it’s crucial that retirement portfolios also hold enough equities to provide retirees with both the growth and income they need to survive what may turn out to be three decades and to keep up with inflation. Once an appropriate equities allocation, suitable to each client’s risk tolerance, has been established, the key is to stick to it. Attempts to time the markets and jump in and out of equities to avoid losses are damaging to your clients’ wealth.

According to research provided by Fidelity, if $1 had been invested in the Canadian stock market on Jan. 1, 1975, it would be worth $53.06 after 39 years – an annualized return of 10.7%. But if just the 10 best months in that 39-year period were missed, the return would drop to 7.7%. Missing the 30 best months brings the return down to 3.5%, and missing the 50 best months brings it into negative territory.

“Equities represent the residual value of the productivity of mankind,” says Jim Morrow, portfolio manager with FMR LLC (aka Fidelity Investments) in Boston and manager of three Fidelity yield-oriented funds available to Canadians. “That’s why they outperform over time.”

However, equities are volatile. The reality is that retirees and other clients close to retirement have less time to recover from market downturns. That’s why balanced portfolios make the most sense. In addition to individual securities, a wide selection of foreign and domestic asset classes are available through mutual funds and exchange-traded funds (ETFs) that allow you to create broadly diversified portfolios for your clients.

“Portfolio construction is both an art and a science,” says Patrick French, director of client depth with Mississauga, Ont.-based Edward Jones. “In theory, all portfolios should hold a portion of equities. It’s the only financial asset class that can produce growth in a portfolio after tax and inflation.”

But, French stresses, clients’ risk tolerance also must be considered. If a client has a low tolerance for volatility, there will be a tendency to sell at the wrong time, and doing so can compound that problem.

“For the highly risk-averse kind of client who can’t tolerate stock fluctuations,” French says, “you may have to come up with other strategies, such as working longer, investing more or spending less.”

Many clients were so spooked after the financial crisis that they fled to the safety of bonds and cash, which was detrimental to portfolio performance over the next five years. A Fidelity study provides an interesting look at how a balanced portfolio performed in the wake of the 2008 financial crisis, as compared with a bond portfolio. A client with a $100,000 portfolio made up entirely of bonds based on the FTSE TMX universe bond index on Jan. 1, 2009, would have seen his or her holdings grow to $124,228 by August 2014, while a balanced portfolio of 50% Canadian stocks, 35% bonds and 15% treasury bills would have grown to $163,561.

If stock market volatility is a concern, your clients can target their exposure to more stable products, such as blue-chip, dividend-paying stocks, preferred shares, “low-volatility” mutual funds or ETFs. There also are option strategies, such as covered calls, to enhance income and smooth returns. Many dividend-paying stocks are generating higher yields than are 10-year government bonds, and a company with a record of consistently increasing its dividend payout over time offers inflation protection and growth. In addition, dividends received outside of an RRSP offer tax advantages.

Although some of the covered-call and so-called “low vol” strategies offer returns that are less than that of the broad market over time, Robert Armstrong, vice president and head of managed solutions with BMO Global Asset Management Inc. in Toronto, says that’s a trade-off some clients and their advisors are prepared to make.

“Clients must participate in equities to reach their long-term goals,” Armstrong says. “And a lower-volatility product may keep [clients] from rushing to sell in a negative market.”

In addition, the withdrawal rate for assets is a crucial determinant in the viability of a retirement plan. (See story on page 12.) If a retiree’s portfolio is depleting too quickly, that client may have to make some mid-retirement tweaks, such as living on less, renting out or refinancing part of his or her house or working longer. According to Sun Life’s 2014 Canadian Unretirement Index Report, only 27% of Canadians expect to be fully retired at age 66, a big drop from 51% in 2008.

For clients without DB pension plans, you may want to consider an annuity. In return for a lump sum paid to an insurance company, annuities provide protection against longevity by spinning off a guaranteed lifetime income. (See stories on page B16.)

According to the Canadian Unretirement Index Report, 70% of respondents surveyed said a guaranteed retirement income for life was “very important.” However, more than 60% of respondents said they don’t understand what life annuities are or the benefits they provide, which, says Taglioni, indicates that there is an educational opportunity for insurance-licensed advisors.

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