Retirement portfolios are designed to provide a lifetime of income. But over a lifetime, they face the treacherous storms of a continually shifting investment climate.

In recent months, dark clouds have been gathering on the horizon — inflation, a slowdown in global economic growth and downside market volatility. And after a five-year bull run, the Canadian stock market stumbled severely this past summer, causing many clients to rethink their tolerance for volatility.

However, there are a number of financial strategies and products that can protect the value of retirement investments. Ensuring that a client’s portfolio has the proper mix of assets — depending on his or her goals, risk tolerance and other factors — is one crucial strategy. And using products such as hedge funds, options, principal-protected notes or mutual funds with high cash components can also be useful in ameliorating risk and smoothing the volatility in client holdings.

For Adrian Mastracci, portfolio manager with KCM Wealth Management Inc. in Vancouver, an appropriate asset mix is one of the best ways to reduce risk. He is vigilant about portfolio rebalancing when a client’s target allocations get out of whack. He believes that most clients need to have at least a portion of their RRSPs in equities if they are to achieve real growth in the face of inflation, but he recommends they stick to quality companies and blue-chips.

“Strong companies will usually get you through if the market gets a haircut,” he says. “They may be affected by negative market sentiment but will stand up again sooner or later, while smaller, weaker companies may not hold up as well.”

On the fixed-income side, Mastracci’s clients’ portfolios are typically a mix of stripped bonds and shorter-term bonds and money market paper. He keeps clients away from terms of more than four years because of the unpredictability of inflation and interest rates, and because of the danger of being locked in to today’s low rates for the long term.

For clients who are particularly worried, Tony De Thomasis, president of De Thomas Financial Corp. in Thornhill, Ont., suggests adding about one-third more than usual to their cash positions by selling down some of the Canadian and international stocks that have done well during the bull market. Then, he suggests, dollar-cost average back to the original target asset allocations over the next couple of years.

“If there is new money to be invested in the RRSP, look for mutual funds that have a high cash position and let the fund manager decide when to get back into the market,” says De Thomasis. “Some of these funds may not have had great one- or two-year numbers because of their high cash positions. But that’s the price you pay for safety.”

Funds that are currently high in cash include Mackenzie Cundill American, with 57% of assets in cash; Cundill Canadian Security, with 28%; Mackenzie Cundill Value, with 48% (all sponsored by Toronto-based Mackenzie Financial Corp. ); and Toronto-based Chou Associates Management Inc. ’s Chou Associates Fund, with 48%.

Advisors are also becoming more open to hedge funds, although there is still some reticence because of high management fees and a lack of transparency regarding some of their complex portfolio machinations. The benefit of hedge funds is that they are allowed to sell securities short, which can help generate positive returns even in deep bear markets. But not all hedge funds are eligible investments for RRSPs, so it’s important to check the structure and eligibility of the fund.

As well, most hedge funds require a minimum investment of $150,000 or so unless investors meet provincial accredited inves-tor requirements.

Recently, several mutual funds acquired the ability to sell short to a limited degree, and these funds could be a way for small investors to venture cautiously into the short-selling arena. The concept is that during a market decline, the fund manager can make profits by shorting some securities, offsetting losses that might be experienced on other holdings.

For example, Dynamic Mutual Funds Ltd., Sprott Asset Management Inc., Front Street Capital Inc., Guardian Group of Funds Ltd. and C.I. Investments Inc. (all of Toronto) have the ability to sell short in certain mutual funds up to a limit of 10% or 20% of the asset value, depending on the fund. There is also a family of exchange-traded funds run by Toronto-based BetaPro Investment Management Inc. that offer investors the opportunity for either short or long exposure in a variety of categories, including gold, bonds, Canadian stocks and the U.S. dollar. The exposure of the Horizons BetaPro ETFs is leveraged by 200% to magnify returns, both negative and positive. For example, if a client owns a lot of energy stocks, he or she can keep the stocks but hedge against falling oil and gas commodity prices by owning the bear version of the Horizons BetaPro crude oil fund, which will gain if commodity prices drop.

@page_break@Options strategies may be appropriate for some RRSP clients to achieve similar downside protection, says Stephen Polonoski, assistant branch manager for Wellington West Capital Inc. in Kitchener, Ont. For example, if a client owns a particular security, such as a stock or an ETF representing a market index, he or she could buy a “put” option, which would give the client the right to sell the security at a predetermined price within a set period of time.

“The client is able to lock in the selling price. But, as with any insurance, there is a cost to that protection,” says Polonoski. “Options can be used as a rolling strategy during periods of extreme uncertainty and volatility.”

Other products that can preserve value in declining markets include principal-protected notes and segregated funds, both of which offer a guarantee of principal if the investment is held until its maturity date.

The performance of a PPN is usually tied to an underlying investment, such as a basket of stocks, commodities or a market index or mutual fund. The fees are higher than they would be for owning the security outright because of the guarantees offered by the note. Although the guarantees vary from product to product, a typical PPN guarantees the principal amount invested after a holding period of five to eight years, and also pays the investor a return based on the performance of the underlying securities.

Segregated funds offer guarantees on most or all of the assets invested, provided the client holds the funds for 10 years. Many offer “lock-in” features that allow the client to lock in gains along the way and reset the 10-year clock on the guarantee.

“Segregated funds can make sense for someone who feels jittery about the stock market,” says Bill Bell, president of Bell Financial Inc. in Aurora, Ont. “Some people simply feel better knowing their money will be there in 10 years and are willing to pay the premium in fees. I usually explain that instead of being up an average of 8% in 10 years, they may be up 7% because of the fees. Some people are willing to make that trade-off.”

Bell says many investors are their own worst enemies, and investor behaviour — not product performance — is the biggest cause of poor returns. Many people are emotionally motivated and want to add to their holdings when stocks are expensive and run for cover when they’re falling.

“Proper management of client accounts involves behaviour modification,” Bell says. “I try to build a balanced portfolio of quality investments, so clients aren’t tempted to do anything when markets are volatile. Wrap accounts are good for keeping people in the right place with an automatically rebalanced portfolio.”

Although a pickup in inflation would erode purchasing power, it can actually be beneficial for some types of securities — particularly those tied to hard assets such as gold, resources commodities and real estate. Many advisors are putting a slice of gold in their client portfolios through mutual funds, stocks or ETFs representing ownership of either gold bullion or a basket of mining companies. Others like to have some assets in real estate investment trusts or mutual funds that focus on real estate, either through real estate securities around the world or through the ownership and management of a portfolio of land and buildings.

“Gold does not move in step with stock markets and can be a good portfolio stabilizer,” says Reg Ogden, vice president at Canaccord Capital Inc. in Vancouver, joking that “the only perfect hedge is in a Japanese garden.”

Although an economic slowdown could moderate inflationary forces, Ogden suggests that putting 10%-20% of assets in gold is a good insurance policy or “hedge.” He says gold is “playing catch-up” after several years of being overshadowed by other resources commodities.

The need to adopt some of these strategies may come sooner rather than later. U.S. central bankers came to the financial system’s rescue by lowering interest rates and keeping the money supply flowing. Ultimately, however, a loose money policy could sow the seeds for future inflation problems.

“Through their easy-money policies,” says Michael Hart, chief bond trader at Friedberg Mercantile Group Ltd. in Toronto, “central banks have a will and a way to deflate the value of currencies and erode their purchasing power.”

Inflation in Canada stands at about 2.5%, but even at that moderately low rate, the value of an RRSP can seep away during the 25 or more years that many people will spend in retirement. At an annual inflation rate of 2.5%, an item that costs $10 today will cost almost double — $18.54 — in 25 years. A higher rate of inflation would lead to even greater deterioration in purchasing power.

Many economists believe printing more money will be the most expedient way for the U.S. to deal with its massive debt obligations and an annual budget deficit that seems to be spiralling out of control. But this could fan the flames of inflation. Meanwhile, problems in the U.S. housing market have not gone away, and slowing economic growth or liquidity problems in the global financial system could be the shot that triggers a prolonged stock market retreat.

Bear markets have come around on average about every five years, which is roughly the lifespan of the current bull market. The last bear market, between 2000 and 2002, took the Toronto Stock Exchange composite index down by almost 50% from peak to trough, a severe drop that requires a 100% uphill slog just to get back to break even.

“We’ve had a long bull market, and one or two good data releases could propel it even higher,” says Mastracci. “But no bull market can last forever. Someday, it will get tired. Simply said, you need a lot of performance to overcome a large loss. So, try to keep a lid on the downside. That’s your best payoff.” IE