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the long view

An online poll conducted for Manulife Bank of Canada indicates that 81 per cent of respondents said being debt-free at retirement is a top goal, but just over half were confident of reaching that goal.Nastco/Getty Images/iStockphoto

Beware the market mirage.

If you're like many investors nearing retirement, chances are the past few years have been golden for your portfolio. Bond prices and stock prices have shot up, and the loonie's recent swoon has added an additional jolt of currency gains.

But here's the problem: While your portfolio may be worth more than ever on paper, the amount of income it can reliably produce has tumbled.

Much of this reflects the plunging yields on bonds. At today's paltry yields, the fixed-income portion of your portfolio throws off next to nothing in the way of cash, especially if you account for the impact of inflation.

The result is an odd situation in which a mirage of apparent wealth isn't matched by any likely gains in retirement security. We're rich on paper, but no better off in terms of planning for our futures.

BlackRock, the investment management company, illustrates the situation using its CoRI Indexes, which are designed to estimate the cost of a future dollar of retirement income. While the CoRI Indexes are designed for U.S. investors, the trends they depict are broadly representative of what Canadians face.

BlackRock says its indexes show the cost of generating future retirement income soared more than 33 per cent over the past year. As a result, "despite double-digit gains in equity markets, workers in their 50s and early 60s are less prepared for retirement than they were 12 months ago," says Chip Castille, BlackRock's chief retirement strategist.

The median value of retirement nest eggs held by 55-year-olds jumped by about 14 per cent in 2014, to just over $280,000 (U.S.), according to BlackRock. The strong gains reflected a surging stock market and rising bond prices.

However, all those market profits and more were offset by the rising cost of generating income. BlackRock says a 55-year-old's typical nest egg, at today's rates, could produce $16,849 a year in annual retirement income at age 65. Surprisingly, that is almost $3,000 less – that's right, less – than a year earlier. Despite the portfolio's double-digit returns over the past year, the typical 55-year-old is effectively poorer in terms of retirement planning.

This is obviously not good news – but don't lose hope just yet. The counter-intuitive combination of bigger portfolios but smaller retirement income is simply the result of the dramatic fall in long-term bond yields over the past year.

Those long-term yields help to determine the prices for annuities, a common way to ensure retirement income. Lower yields mean annuities become more expensive. So the plunging payoffs from bonds translate into a much higher cost for buying a dollar of retirement income through an annuity.

The good news is that yields will eventually start moving off their near-record lows and offer better buys. Anyone seeking to buy an annuity can wait until then.

But here's where things get complicated: The catch is that a rise in bond yields will mean lower prices for bonds, because yields and prices move in opposite directions. So, when rates do move higher, you'll have fewer bucks in your retirement account, but you will get more bang from them.

In effect, that rise in yields – whenever it comes – will reverse the process we've seen during the past few years when falling yields have pumped up the price of financial assets and made us all feel wealthier. There will be gnashing of teeth when rates start going up, but the decline in our portfolio values will be largely meaningless if they're matched by a greater ability to wring income out of what remains.

Smart investors should avoid being swept up by the euphoria of their current portfolio values. They should also resist despair when rates start edging higher and some of their paper gains start fading away. The key, especially for those on the cusp of retirement, isn't how much money you have, but how much income that money will generate.