Three retirement strategies for a low-yield world

Farewell, bull market in bonds.

For 30 years, you've enriched our portfolios and simplified our retirement planning. But now it's time to wave goodbye.

With bond yields bumping up against generational lows, it's difficult to believe that fixed-income investments will provide anywhere near the same returns they did over the past three decades.

For retirees and for near-retirees, that poses an enormous challenge. A report last year from investment researcher Morningstar concluded that new retirees would need nearly 43 per cent more savings to dependably generate the same dollar income over 30 years as their predecessors enjoyed when bond yields were higher.

Thankfully, bond yields have risen a bit since the Morningstar report was written, but not by enough to make a huge difference. At current yields of around 2.05 per cent for a 10-year Government of Canada bond, an investor is deriving no real income from bonds after inflation and taxes are taken into account. This may be okay if you view bonds as simply an expensive shock absorber for times when the stock market swoons.

The situation today could scarcely be more different than the picture a generation ago. A Canadian investor lucky enough to have bought a 30-year government bond in early 1982, when yields were above 15 per cent, enjoyed decades of risk-free, lavish returns. People who purchase a long-term bond today, with rates around 3 per cent, will be fortunate if they can merely preserve their purchasing power.

The problem hits retirees with particular force since most retirement plans envisage safe, dependable bonds as the core holding in seniors' portfolios. A popular rule of thumb holds that the bond proportion of your portfolio should be roughly equal to your age. A typical retiree who hews to that notion would head into retirement with at least 60 per cent of their portfolio locked up in bonds and other fixed-income investments.

The obvious alternative would be to load up on stocks – but that poses risks of its own. If you happen to retire just as the market tanks, you could wipe out a big portion of your savings.

So what should a retiree who wants to draw a steady, constant income from their portfolio do? Here are three notions:

Look, Ma: No bonds!

The simplest way around bonds' low yields is to avoid them.

"I think annuities can replace bonds in many retirement portfolios," says Wade Pfau, professor of retirement income at American College in Bryn Mawr, Penn.

His suggestion: Construct your retirement portfolio out of annuities and stocks.

Annuities can provide you with a better income stream than bonds, because the money of annuitants who die first helps to subsidize the returns of those who live longer. Stocks, meanwhile, can offer you the potential for capital gains as well as protection from inflation.

In a 2012 paper, Prof. Pfau looked at the best combinations of assets for investors who want to draw a steady, inflation-adjusted income equal to 4 per cent a year of their initial portfolio. He found the most effective combinations tended to be blends of annuities and stocks, or even an all-annuity portfolio.

Which mix is best for you? Prof. Pfau suggests you begin by looking at your essential expenses and calculating how much of your portfolio you would have to convert into annuities to cover those unavoidable costs. The remainder of your portfolio could then be directed into stocks.

Of course, buying annuities at today's low rates poses issues of its own (you can read more about that here on the Web: http://tgam.ca/EEQh).

Buckets of fun: Many financial advisers suggest you think of your retirement savings as a series of buckets – one for the money you'll need over the next couple of years, the second for the funds you'll require in the medium term, and the third for assets you won't be tapping for a decade or more.

The first bucket is filled with cash, GICs and money market accounts. If the stock market tanks, this money won't be affected, ensuring your immediate needs are covered and giving you peace of mind.

The second bucket is heavily invested in bonds, while the third bucket is tilted more toward stocks. As they throw off cash, you use that money to replenish the first bucket. Simple, right?

Well, not really. You're still faced with the question of when to harvest gains and replenish that first bucket. You're still exposed to stock market risk as well as paltry bond yields.

In fact, the bucket approach doesn't change the asset allocation of a balanced portfolio all that much. But it is an effective psychological tool that can allow you to stay calm when markets are melting down.

By segregating your cash holdings and earmarking them for the next couple of years, you avoid the panic attacks that can afflict many investors. That, in turn, can allow you to live comfortably with a higher allocation to stocks.

The U-shaped path to riches: Most financial planners believe retirees should take less risk as they age. That means a constant or even increasing proportion of bonds in their portfolios.

But the opposite strategy might make more sense. In a recent paper, Prof. Pfau and Michael Kitces, director of research for Pinnacle Advisory Group, make a strong case for what they refer to as a U-shaped "glide path" for the equity portion of your portfolio.

This means beginning your retirement with relatively little of your portfolio invested in stocks – say, only 30 per cent. Then, as you age, your stock exposure gradually grows, topping out at 60 per cent or so in your 90s.

The beauty of this strategy is that it reduces the biggest risk to retirement portfolios – the possibility that a stock market crash early in your retirement will gut your portfolio. By having relatively little invested in stocks during the first few years of your retirement, you ensure that any such downturn will inflict only limited damage.

It's true that this strategy will result in your having a higher exposure to stocks in your 90s than in your 60s, but the proportion of stocks never grows above the 60 per cent level that is common in many balanced portfolios. If history is any guide, this strategy also gives you a better chance of winding up with a large portfolio than either keeping your exposure to stocks constant or tapering it with age.

So which approach is best? Prof. Pfau suggests it's a matter of how much risk you feel comfortable taking on.

Individuals who lie awake at night worrying about market volatility and wondering if they will have enough to cover their living expenses might want to think about the stocks-and-annuity approach.

Those who are more comfortable with market volatility, and want to play the odds in a smart way, should look at a U-shaped strategy. A bucket strategy is somewhere in between.

The one thing that does seem clear is that retirees and near-retirees will have to become more inventive in a world of low yields. But, as these strategies suggest, there are still plenty of smart ways to enjoy a prosperous retirement.

Globe app users click here for an infographic outlining your retirement bucket list