The novel coronavirus is targeting your retirement.
Granted, that is unlikely to be your biggest concern right now, as schools close and hospitals brace for a potential influx of new patients. But when the current pandemic eases – and it will – the conventional wisdom on retirement planning may be numbered among its victims.
The problem stems from the radically low interest rates that have resulted from the virus-induced rush to safety. Over the past week and a half, the Bank of Canada has cut its key interest rate twice, including a big emergency cut on Friday. The U.S. Federal Reserve has also slashed its policy rate, as have other central banks.
At the same time, nervous investors have stampeded to the safety of government bonds, driving the prices of those bonds to historic highs. Bond yields move in the opposite direction to bond prices, so soaring bond prices have driven down the corresponding yields to levels that investors would once have considered unthinkably low. At the moment, for instance, a 10-year Government of Canada bond pays out all of 0.8 per cent annually.
Think about what that implies. If a person has saved all his life, and amassed a $1-million nest egg to invest in safe government bonds, his seven-figure stockpile will now yield him all of $8,000 a year. Even with government stipends, this millionaire retiree is on track for a very modest retirement.
Worse, the real value of his portfolio is shrinking. Bond yields have been low in recent years, but have at least compensated investors for much of the bite of inflation. At today’s ultra-low levels, that is no longer true.
When a long-term government bond pays 0.8 per cent a year, and inflation is running around 2 per cent a year, as it is now, the purchasing power of a bond portfolio is shrinking by more than a percentage point annually. In real terms, this is a seriously negative rate – one that will gut your portfolio over the course of a 30-year retirement.
To be sure, the effect of those negative real returns can be potentially offset by incorporating stocks and other risky assets into your portfolio. Still, the drag from bonds is considerable. If you put half your money in bonds and half in stocks, a good portion of your stock returns are merely going to offset the constantly eroding purchasing power of your bonds.
All this calls into question traditional portfolio mixes, such as the popular 60-40 arrangement, in which you devote 60 per cent of your portfolio to stocks and 40 per cent to bonds. The role of bonds in a 60-40 portfolio has historically been to generate a little bit of real return while acting as a shock absorber against the ups-and-downs of stocks. But if bonds are losing you money in real terms, the logic of that arrangement isn’t so appealing.
Mind you, the alternative isn’t so attractive either. A portfolio composed entirely of stocks may generate good returns over time, but it is also subject – as the past few days have demonstrated – to stomach-churning volatility.
So what is an investor to do? Begin by reminding yourself that relatively low bond yields have been with us for a while, says David Aston, author of The Sleep-Easy Retirement Guide. “People have already done a fair bit of adjustment,” he points out.
Conventional wisdom, for instance, used to suggest retirees should hold a percentage of bonds in their portfolios equal to their age. Few people are so bond-heavy any more. Instead of keeping 70 per cent of her portfolio in bonds, a 70-year investor with a moderate risk tolerance is now likely to hold only 40 to 50 per cent in bonds, Mr. Aston says.
This strikes him as a sensible adjustment to the low bond yields of recent years. The problem, he says, is if today’s ultra-low rates become the new normal, with the seriously negative real returns they imply.
Unfortunately, that is becoming increasingly likely. The implicit message in today’s miserly bond markets is that ultra-low rates will be with us for a long time to come. Thirty-year government bonds in Canada are now yielding less than 1.3 per cent a year. When investors are willing to lend money for three decades for such a measly payback, they are signalling they do not expect to be able to take advantage of better rates any time soon.
The lack of safe, high-yielding bonds poses a particular challenge for traditional pension plans, which promise to pay their retired members a defined benefit – that is, a set amount of money – every month for life. Without the dependable anchor of relatively high bond yields to count on, they have had to venture into riskier areas, from conventional stocks to private equity deals.
Pension funds are still grappling with what risk really means, says Keith Ambachtsheer, director emeritus of the International Centre for Pension Management at the University of Toronto. In the short term, holding a supply of highly liquid, low-risk bonds ensures that a pension will be able to meet its immediate payout obligations. But in the long term, risk also means not being to sustain the level of returns required to meet objectives.
Mr. Ambachtsheer suggests that pension plans are going to reduce their reliance on bonds and focus more on building global portfolios of stocks with dependable dividends. He also suggests more pension managers will have to think about moving to “target benefit” arrangements, where the plan targets a certain level of benefits but can reduce them if actual investment results fall short of expectations.
If the coronavirus does usher in a prolonged period of ultra-low rates, expect retirement planning in Canada to become a far riskier affair.
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Ian McGugan