Conversations with people heading into retirement reflect the stark reality of perennially low interest rates and the unique challenges to generating retirement income. The entire retirement income paradigm has turned on its head. Not too long ago, retirement meant generating a fixed interest income from investments and retirees would typically invest in all manner of interest bearing assets such as GICs, government bonds or bond mutual funds, with the latter being the most popular.
From the 1980’s and up until the great financial crises of 2008-09 a typical bond mutual fund in the US and Canada would comfortably generate a return that was over the annual inflation rate by an average of 3.0% (called a real rate of return). Today that real return is negative. Producing a consistent positive real rate of return only from bond funds would require some amount of financial engineering. Over the last 10-years yield on bonds barely cover for inflation, while people heading into retirement face a rising cost of living.
While the retirement planning process is naturally holistic, in the sense that it looks at all aspects of an individual’s cash flow needs and available assets (including unlocking equity from a home) we are concerned with a more practical problem: How to generate a required level of income from existing financial assets while limiting the risk of consuming capital?
The answer in dealing with this new reality lies in fundamental changes to asset allocation in retirement. A typical retirement portfolio as pointed out earlier invested 100.0% in bonds. What may have been ideal a decade ago now requires only a partial investment in traditional assets such as bond funds. Four other asset classes should be included – these would be preferred shares; large cap dividend paying common shares, REITs and alternatives assets such as Master Limited Partnerships (MLPs) and leveraged bond funds. For Canadian investors MLPs are available only in the US and should be held through ETFs.
This new asset mix undoubtedly raises the risk levels of a retirement portfolio above what is traditionally considered acceptable, though it beats the risk of having to consume capital if interest rates and more importantly real rates of return remain lower longer.