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How low interest rates have changed retirement planning

Since the financial crisis hit in 2008, it’s been great to be a borrower but lousy being a cautious saver.
Central banks’ zero interest rate policies have resulted in “real” (net of inflation) returns of zero or even less-than-zero after income tax, except for outliers like Russia. In December, Switzerland even began charging savers for the right to deposit funds. Canadian savers receiving 1% or 2% on their GICs well know the phenomenon of “financial repression,” which tempts them to embrace riskier stocks. These offer the allure of more attractive real rates of return, but with the very real prospect of capital losses.
Most pundits predict rates will finally start to rise again in mid 2015, but the recent surprise rate cut by the Bank of Canada (from 1% to 0.75%) suggests how futile trying to predict the timing of such a change can be. Every year since 2009, experts have predicted that “rates have nowhere to go but up,” only to be confronted with what seems to be perpetually low rates.
Financial repression has changed retirement planning. Those with some risk tolerance embrace quality stocks that pay high dividends. A typical Canadian bank stock pays 3% or 4%, and some U.S. telecom stocks and utilities pay 5% or 6%. Big pharma and consumer staples stocks are halfway between. As Markham, Ont.-based portfolio manager Robert Smith notes, many have a history of growing their dividends or seeing their stock prices rise, delivering capital gains in addition to income.
Because Canadian dividends receive more favorable tax treatment than interest income or foreign dividends, advisers put Canadian dividends into taxable portfolios and U.S./foreign dividends inside RRSPs. The tax-free savings account is well suited to hold both interest income and Canadian dividends, but causes some tax leakage in foreign dividends: hence the recommendation to put the latter into RRSPs instead.
Other higher-yielding securities attracting fixed-income refugees are real estate investment trusts (REITs), high-yield corporate bonds and convertible bonds. The latter are bonds listed on stock exchanges that can be converted to shares if the shareholder chooses, says Christopher Cottier, investment adviser at Richardson GMP.
The older the investor and the closer to retirement, the more they will still want some interest-bearing investments, so they can sleep at night.
When choosing an asset allocation with which you can live, financial repression and zero interest rate policies tend to push the allocation to cash and bonds down a bit. So instead of a traditional mix of 60% stocks to 40% bonds/cash (common in pension funds and balanced funds), it’s tempting to push the mix to 70/30.
But even if you’ve pushed the fixed-income part of your portfolio down a tad, there remains the problem of generating at least a little income that doesn’t come from risky stocks. The pundits calling for an “imminent” rise in rates steer investors away from “long bonds,” i.e. bonds maturing in five or 10 years or more, since they are more apt to suffer losses if rates start rising than would short-term instruments.
Young investors have experienced only ever-declining interest rates. This had the pleasant byproduct of producing ever-rising capital gains on bonds: not only did investors get the annual income (or “coupon”), but they also benefited from capital gains as interest rates kept falling.
The ultimate nightmare for the bond market is the reversal in rates that’s now widely projected to occur (finally!) in 2015. If rates stay low or start to rise gradually (likely increments of 0.25% a quarter), bond investors may suffer losses on the values of their longer bonds even as they receive only minuscule interest income.
The fear of this reversal is why advisers recommend “staying short” with their bonds. A tactic suggested by Cottier is to “ladder” maturities “so you can safely climb to higher interest rates whenever they show up.”
Robert Smith worries about both rising interest rates and inflation, noting low interest rates are often further reduced by high management expense ratios (MERs) on bond mutual funds and bond ETFs. “Often, the MER can eat the entire coupon rate of a bond, or more, leaving clients with little-to-no upside but lots of downside risk if interest rates rise.” Instead, Mr. Smith puts fixed-income clients into one to three year GIC ladders within CDIC-insured limits.
Alternatively, you make the fixed-income part of a portfolio work harder. Instead of switching to high-yielding equities, you can push credit risk and embrace higher-paying corporate bonds instead of government bonds. A diversified bond ETF eliminates single issuer risk. Some look outside Canada or behind the Iron Curtain, seeking global bonds in a different part of the rate cycle that may pay more. Or they may add “junk” bonds to the mix.
To lower inflation risk (admittedly still tame), consider inflation-linked bonds: real return bonds in Canada or Treasury inflation-protected securities in the U.S. Both are available via ETFs. Mr. Smith also likes floating-rate bonds or ETFs holding them, where the coupon rises, thereby preserving principal.
If 2015 is indeed the year rates rise, it’s logical to stay in the shortest fixed-income vehicle of them all: treasury bills. Then the game will be to wait an unknown number of months or years in order to reinvest the short-term money into longer-term vehicles once rates have risen appreciably.
Then the guessing game will resume. But we have plenty of time to revisit that one.
Jonathan Chevreau runs three web sites dedicated to financial independence, including the Financial Independence Hub.