Retirement planning: Ways to keep your capital intact, even in a slumping market

By Andrew Allentuck
Globeinvestor Magazine Online, July 23, 2008

The sinking feeling you get when you look at the stock market – any market – is understandable. Global equity values have been plummeting.

For investors in their 30s or 40s, the downturn may be a forgettable blip. But for investors who are heading into retirement, the golden coach that their advisers promised is turning into a pumpkin.

The problem facing folks who plan to retire in the next few months are even more grave. With the markets mired in pessimism, investors will have less money to buy fixed income contracts like annuities or bonds that promise payments of defined sums of money.

Here are a few ways to keep your capital intact, even in a slumping market.

CASH

The baseline for any plan is cash: In insured bank accounts, there is no risk of loss, but interest rates at 3 per cent at most in high-interest accounts barely pace inflation. In taxable accounts, the net return will be less than the rate of inflation.

TERM DEPOSITS OR CONVENTIONAL BONDS

Interest for these products is higher than for savings accounts and, if held to maturity, should produce the target sums specified at time of purchase. But some term deposits are locked in until maturity. As well, all conventional bonds lose market value before maturity if interest rates rise, making their fixed-interest payments unattractive. Then the bonds fall in price until their yield, which is their coupon interest divided by market price, equals the yield on new bonds issued at higher interest rates.

However, term deposits, even those that have a link to stock markets, and conventional bonds have limited upsides. At maturity, they can never pay more than face value. Real return bonds, which adjust payouts to rising inflation, keep up with rising prices, but they are expensive in relation to conventional bonds and can create large tax bills for investors who hold them outside of registered retirement savings plans.

SEGREGATED FUNDS

It is possible to get both upside and downside protection with segregated funds, which wrap conventional mutual funds into a life insurance contract.

Most seg funds have a 100-per-cent return guarantee, though some promise only 80 per cent. Seg fund fees add a surcharge of an average of 75 basis points (there are 100 basis points in one percentage point) to underlying fund fees, notes Derek Moran, who heads Smarter Financial Planning Ltd. in Kelowna, B.C. “If the investor takes money out before the 10 years are up, the guarantee does not apply,” he says.

BUILD YOUR OWN

Rather than pay a segregated fund fee, you can create your own portfolio with a guaranteed return of capital.

Say that you are going to retire in 20 years and have $100,000 to invest.

With $45,500, buy June 1, 2028, Government of Canada strip bonds that pay 4 per cent to maturity. Invest the rest ($54,500) in a diversified portfolio of stocks. Stock markets typically rise by 8 per cent a year on average, so after 20 years you’ll have $254,000 of stock and the matured value of the strip bond, $100,000, for a total of $354.000. You may do better or worse, but you cannot walk away with less than $100,000.

BEAR ETFs

For a purer form of equity insurance, you can take a chance that the bear market will continue. Horizons BetaPro exchange-traded funds come in bull and bear versions. For the present market, assuming gloom persists, the bear funds could generate substantial profits. Various BetaPro funds, which are bought and sold like stocks through investment dealers, are rigged to provide gains equal to twice the decline of the S&P/TSX 60, the S&P 500, the Nasdaq 100, Canadian bonds and the 10-year Government of Canada bond. There is also a U.S. dollar bear fund that rises in value as the Canadian dollar declines.

BetaPro management fees, at 1.5 per cent of net assets for each fund, are higher than average for ETFs, where 30 to 50 basis points are more common. The minimum investment for each bear fund is $5,000. But watch out, if you buy a BetaPro bear fund and the market rises, you will lose twice the daily move of the fund’s underlying asset.

MUTUAL FUNDS

The mutual fund industry has a variety of asset allocation plans to increase the odds that a client will have anticipated capital at retirement. Most of the plans are automatically balanced, raising bond holdings and lowering stock holdings over time. A few promise to return 100 per cent of the money they have in accounts, but not 100 per cent of money originally invested. Losses still accrue to the investor.

A bear market does not have to cripple a retirement plan. With the right investments and a plan that recognizes that the market can be depressed just as one’s retirement is beginning, it is possible to protect retirement income.

Special to The Globe and Mail