Investing to minimize risk in retirement investment portfolios and facilitate a sustainable withdrawal rate from those portfolios is critical for clients during retirement, but there are no set rules for determining an optimal asset mix to achieve those goals.
That’s largely because of wide variations in individual circumstances and clients’ risk tolerance. These two factors determine whether you can pursue aggressive, moderate or conservative investment strategies to ensure your clients obtain a sustainable stream of income for as long as they live – without depleting their assets.
The traditional approach to asset allocation during retirement is to increase exposure to bonds and reduce exposure to equities to minimize risk. However, this is not feasible in the current low interest rate environment, says Steven Belchetz, president and chief investment officer with T.E. Investment Counsel in Toronto: “We live in a different world today [with negative real interest rates].” Thus, an overweighted position in fixed-income securities just won’t cut it, he adds.
Asset-allocation decisions are linked directly to a client’s desired withdrawal rate. In general, the higher the level of income desired from the retirement portfolio, the more risk the client will have to assume in the investment strategy.
In making asset-allocation decisions for retirement portfolios, Douglas Nelson, president and portfolio manager at Winnipeg-based Nelson Portfolio Management Corp., uses an “income first” strategy.
That is, he determines what sources of income during retirement are available to the client to create a safe and consistent income stream. Then, Nelson assesses the tax implications, with a view to determine whether there’s a more efficient way to lower taxes.
Nelson typically takes a balanced approach to constructing portfolios, with a 50% allocation each to equities and fixed-income investments, with the goal of facilitating a withdrawal rate of 3% or better.
For fixed-income assets, he uses a layering approach, which involves guaranteed investment certificates on the conservative side and investment-grade corporate bonds, with a yield to maturity of 3%-5%, on the aggressive side. The equities component is composed mostly of preferred shares and blue-chip, dividend-paying stocks.
Belchetz also suggests using balanced asset allocation during retirement, but with a mix of 60% equities and 40% fixed-income to allow for a 3%-4% withdrawal rate. The precise mix would depend on a client’s risk profile.
For example, a more conservative client portfolio would hold more stable equities, including dividend-paying, blue-chip equities and preferred shares for both income and capital growth; the fixed-income mix would be composed primarily of higher-yielding corporate bonds.
Heather Holjevac, senior wealth advisor with TriDelta Financial Partners Inc. in Oakville, Ont., recommends holding at least a 50%/50% split of equities and fixed-income, based on the individual risk tolerance of clients.
Clients must be mindful of both their withdrawal rate and the underlying tax implications, she adds: “In declining markets, you have to be reactive in selling securities and holding cash.”
Although most financial advisors would determine an asset mix for clients prior to retirement, particular attention should be paid to market conditions and the timing of retirement, says Ahad Ali, portfolio analyst with Octane Capital Inc. in Toronto.
For example, if clients begin retirement during a market downturn, they would start making withdrawals from a lower capital base, putting them at risk of either having to accept a lower than anticipated withdrawal rate or outliving their money, he says.
“Advisors must pay attention to sequencing the [return] risk of assets in clients’ portfolios, which is a function of [market] volatility,” Ali says.
This strategy calls for making asset-allocation decisions to minimize risk and facilitate withdrawals over clients’ retirement lifetimes, he adds.
The biggest risk to a withdrawal strategy is market volatility, says Nelson. A client’s portfolio might never recover if it declines in value and withdrawals are made at the same time, he notes.
In such a case, a significantly higher rate of return would be required to sustain the desired withdrawal rate, which, in turn, increases the risk the client must take – the client might be required to invest in a greater percentage of equities to grow the portfolio’s capital.
What’s important to note is that the withdrawal rate is less important for clients who have a high dependency on their RRSPs for their retirement. That’s because once those clients convert an RRSP to a RRIF at age 71, the rate of withdrawal is set by a standard formula determined by the Canada Revenue Agency. For example, a client who is 71 years old must withdraw a minimum of 5.28% from his or her RRIF – and this withdrawal rate increases with age.
“That’s where income and tax planning comes in at an individual level,” says Ali. Advisors, he adds, should take all sources of income into consideration when making asset-allocation decisions.
Belchetz advises clients to hold off increasing withdrawals during periods of market appreciation.
This strategy is primarily to prevent asset depletion during good times and preserve assets for bad times in order to facilitate a relatively stable withdrawal rate.
This is the second article in a three-part series on decumulation.
In the November issue: Financial products for retirement
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