Generate money for retirement

By the time we’re 50, most of us know how much money we’ve saved, can estimate how much more we’ll be able to save before retirement and have a good idea of how much we’ll need on an annual basis to support our desired lifestyle in retirement. The big question now is what should we do to ensure our savings will last through retirement.

While we all know it’s important to choose winning investments — ones that go up in value and/or generate a solid stream of income — how you divide your portfolio among various types of investments — that is, asset allocation — is just as important.

There is no one right way
The first thing I have to say about asset allocation is that there is no one right way to allocate your financial assets. It all depends on your personal situation. If I had so much money I could finance my retirement with interest income from bonds, I would do so and relax. In reality, that’s just not possible for most people.

The first decision you must make concerning asset mix is how to split your investments between bonds and equities, and the two most important factors in this decision are your need for a higher uity-like return and your level of risk tolerance. Bonds are less volatile than stocks, but they can still lose money, especially over the short term.

Asset allocation starts with measuring how much you’ll need against the ability of your portfolio to meet those needs. Most estimates of retirement income, including those garnered from the retirement-planning calculator put out by your brokerage firm, bank, credit union or mutual fund company, require the user to provide four numbers: your retirement pool of capital, your income requirement in the first year of retirement, an estimated rate of inflation and an estimated return on your investments. For example, if your first-year income retirement is $50,000 and assuming a six per cent return on bonds, three per cent inflation and 35 years to be spent in retirement, you would need $1,125,000 invested entirely in bonds to satisfy your income requirements. And that doesn’t leave a nickel for the kids and grandchildren!

If, however, you invested totally in equities and achieved, on average, an eight per cent return each year, you would need $790,000. Since equities have historically provided more like 10 per cent per annum over extended periods of time, eight per cent is a good conservative estimate of future equity returns. Note that, mathematically, this exercise shows no money left over for your estate, but in reality, there is a cushion since it’s quite likely your spending needs will diminish when you are much older.

Review your assumptions
If you anticipate needing more than an eight per cent annual return, I suggest you review your retirement income assumptions. You may have to scale down your expectations and find ways to reduce your income requirement. You may earn more than eight per cent on your equity investment, but taking a conservative approach, you can realistically expect to earn only two to three per cent more than you would from investing bonds. And if interest rates go up, don’t automatically assume you can move from equities to bonds; it may be that inflation is also rising or is expected to rise in the near future, and your inflation-adjusted income requirement will increase also.

From your total income requirement in the first year of your retirement (or this year if you are already retired), deduct any annual pensions — such Old Age Security, Canada Pension Plan and employer-sponsored plan benefits as well as any income you expect to receive from other sources. The balance is what you must generate from your investment portfolio.

Next page: Benchmarks for planning

The accompanying table provides some benchmarks for retirement planning and can help determine your ability to reach your income goals. The calculations assume three per cent inflation and that you’d earn six per cent return on bonds, eight per cent on equities and seven per cent on a balanced portfolio split evenly between bonds and equities.

In this example, the investor wants an inflation-protected, pre-tax annual income of $50,000 with no money left over. Note that because the taxes on capital gains and on dividends are lower than tax on interest income, $45,000 pre-tax from an equity portfolio would produce approximately the same after-tax income as $50,000 from interest income.

Dealing with the ups and downs
Remember that market volatility can’t be eliminated, but it can be controlled. Since none of us has a crystal ball to tell us where and when to invest our money, there is really only one way to try to capture that eight per cent-plus return on equities with a minimal degree of volatility. The key is diversification: by country, by investment style and by market capitalization.

While this level of diversification may be difficult to achieve with a portfolio of stocks unless you have a great deal of money, mutual funds offer an efficient alternative. Mutual funds offer efficiency because it’s relatively easy to get all the information you need to identify investment style and average market capitalization of any equity fund and because foreign investing, particularly non-North American, is often best left to the experts.

Geographic diversification is straightforward. International investing for a portion of your portfolio also makes sense as the Canadian and U.S. markets are so closely tied, there isn’t a lot of diversification achieved by being exclusively in those two markets. International markets are not as closely correlated and, therefore, may provide some protection when North American markets are declining. As well, if you’re planning on spending winters in the warmer U.S. states, U.S. equities are a natural as they provide protection against a further deteriorating Canadian dollar.

By investment style, I’m referring mainly to a manager’s approach to picking stocks. The two main investment styles are value, whereby a manager seeks companies whose fundamental value has not yet been reflected in its share price, that is, stocks that are undervalued; and growth, an approach that places more emphasis on the growth potential of a company than its current share price, that is, stocks that have more growth potential. In recent years, there has been a dramatic divergence in the performance of value-oriented and growth-oriented equity mutual funds. Through the late ’90s, growth stocks, including the technology stocks in particular, were producing huge double-digit gains while value stocks languished. After the tech bubble burst in May 2000, growth stocks hit the skids while value stocks performed very, very well.

Next page: Rebalance regularly

Owning a combination of growth and value stocks directly or through mutual funds means you wouldn’t have attained all the big gains made by markets in the late ’90s, but you also wouldn’t have given it all back over the past two years. Similarly, there are times when very large company stocks generally outperform smaller company stocks and vice versa. Over time, the performance differential of value versus growth and large companies versus small companies is small. Diversification doesn’t necessarily increase returns, but it definitely reduces portfolio volatility.

At the same time, the major strength of diversification is also its major weakness. By diversifying your investments, you are unlikely to experience dramatic losses of capital, but if you have diversified properly, one area of your portfolio will always significantly underperform another area. And while human nature says sell the one that is under performing and buy more of the one that is doing well, market history on the other hand says sell the one that is outperforming and buy more of the underperformer.

Rebalance regularly to maintain established ranges
Since good timing is almost impossible on a consistent basis, the best way to protect yourself from succumbing to human nature is to establish asset mix ranges, and when one element of your portfolio reaches the upper limit of its range as a result of performing better than the other areas, take some profits to bring that area back to the midpoint of its range and reinvest the proceeds in the areas that are at the lower end of their ranges.

For example, if your portfolio was 50 per cent bonds and 50 per cent equities two years ago, and your asset mix ranges were 40 per cent to 60 per cent for both asset classes, relative performance has likely changed those weightings; today, bonds would account for very close to 60 per cent of your portfolio and stocks have dropped to 40 per cent. Rebalancing back to a 50/50 split would mean selling bonds and buying equities. Sound foolish? Consider this: if I took this example back four years, your 50/50 split in 1998 would have moved to 60/40 in favour of equities by early 2000, and your disciplined rebalancing approach would have required you to take profits in those wonderful winning equity funds or stocks and buy bonds which had actually lost close to three per cent in 1999. 

Next page: How to win at investing

How to win at investing
Sell high, buy low … it’s that simple, right? It sounds like a given, but for most investors, the strategy of selling high and buying low is difficult to contemplate, let alone practise. At market bottoms, fear takes hold and you end up selling at or near the bottom — witness the fast pace of redemptions in mutual funds during the most recent market downturn.

At market bottoms, all the news is bad news, all the media coverage warns investors to be leery of the equity markets, and irrational selling of very good companies at very attractive prices becomes normal. At market peaks, fear is replaced by greed. The returns are so high and appear so easy, investors commit more and more of their investment dollars to equities. At market peaks, the news is all positive, the media print stories of great wealth accumulation and investors rush to buy over-priced securities. 

We may occasionally be astute enough to pick a market top or a market bottom, but there have been 17 tops and bottoms altogether since 1958, and chances are no one has picked them all. It’s only through a discipline of establishing ranges and regular portfolio rebalancing that most of us can break the habit of buying high and selling low. While equities have and should continue to produce better returns than bonds, emotional and irrational buying and selling of equities can destroy the longer-term returns available from equities.

Lower expectations if necessary
If you can’t see yourself being disciplined enough to make the difficult decisions, it’s far better that you stay out of the equity market totally, even if it means lowering your expectations for your retirement lifestyle. Finally, I recommend that you always have a written statement of investment guidelines and review them regularly (your financial adviser can help you with this process). Stick to these simple rules, and you increase your chances of a financially worry-free retirement.

Rules for financial fitness in retirement

• Know your needs and your risk tolerance.
• Stay disciplined: Review your portfolio at least once every three months.
• Rebalance when an asset class reaches its upper or lower limit.
• Never hold more than five per cent of your portfolio in one stock nor more than 30 per cent in one industry.

Rob Bell is president, R.S. Bell and Associates Ltd., an independent consulting firm providing investment direction and performance measurement to high net worth individuals, estates and foundations. He is also senior vice-president of Morningstar Canada, a leader in mutual fund research and analysis.