Stock market turmoil always brings — often in unwelcome ways — reminders of the trade-off between risk and safety. While short-term bonds are one of the few asset classes to have withstood the ravages of volatility, they may not yield enough to fund a retirement adequately, not with deflating yields.
But what does?
Certainly the current recession lays bare the risks of what were once thought of as havens; even traditional defined benefit pension plans are under pressure, not just from market losses but also from the prospect of bankruptcy.
The current recession also reveals — in very broad strokes — a generational difference. It is said that childhood experience conditions future outlook, perhaps in ways unexamined by modern financial theory. That theory, call it rational expectations, is based on the life-cycle income hypothesis articulated by Nobel Prize winner Milton Friedman, among others.
The idea is that people rationally average their income over a lifetime, using debt at the beginning to finance income-yielding assets, such as education or a house, saving during their peak-earning years to build a kind of annuity and drawing down their savings as they approach mortality.
There is some predictive power here. After all, inflation targeting — a grand success in Canada — is based on the related idea that if people are conditioned to expect inflation, they act accordingly. They’ll have a lifetime perspective that spurs them to bargain for higher wages, take on debt that will be paid off in dollars that have lost value and so on.
But here’s where rational expectations collide with behavioural finance. For most of us, anchored expectations frame our outlooks: we expect the future to be very much like the past. Those of us who grew up in hard times fear debt. Those who grew up in more affluent circumstances have a propensity to think the dollars will look after themselves.
Perhaps they will. But all of this raises the question: what price safety?
To be sure, safety has one very real price: constant vigilance. Vigilance can take the form of monitoring a retirement plan to make sure it’s on track. But it also means paying attention to spending, not just now, but with a nod to retirement too. In the earlier market meltdown, many pension funds were hit hard. That’s because they’d shifted more and more of their investments to equities from bonds. There was a kind of “equity illusion,” the idea that, if held long enough for the long term, equities provided a relatively riskless return. But this was based on the notion that, over any 10-year period, stocks had not lost money.
Indeed, this notion was the underpinning of Wharton School finance professor Jeremy Siegel’s popularStocks for the Long Run. The contrary position, articulated by MIT pension expert Zvi Bodie, was that stocks were riskier — that there is no time diversification, meaning that time in the market is no guarantee of profit. To fund a retirement, therefore, one should set aside a strip bond portfolio, with the remainder, perhaps, invested in an index-linked instrument to garner an uncertain upside.
What this brings into relief is exactly how costly an assured retirement is. Canadian pension expert Keith Ambachtsheer has suggested that, for a retirement savings scheme to deliver 70% of earnings, it would be prudent to contribute 25% of salary.
These are stark alternatives. While stocks do deliver more than bonds over the long term, they introduce a level of uncertainty that becomes more crucial the closer the investor is to retirement.
Equity markets, thus, provide no free lunches for retirement income.
Oddly, this also provides some reassurance. Actuaries and social policy researchers have long noted RRSPs are ineffective vehicles for low-income earners. Withdrawals will probably be taxed away and, indeed, result in a clawback of income-tested state pension benefits. Hence the tax-free savings account. Still, the OAS-GIS-CPP system does set a floor on retirement income, roughly $24,000 a year for a couple.
That may well be enough for some people. But advisors generally deal with clients who have higher salaries — and higher retirement income expectations. How high? That’s a tricky question, since the top income decile begins at $64,000 for a single earner and $124,000 for a couple. For a couple, state benefits would gross around $33,600, assuming a maximum CPP payout.
That gives a baseline scenario: something to work with. Of course, achieving something beyond that baseline involves a recognition of taxes. Ideally, registered retirement savings produce an income that attracts a lower marginal tax rate than a salary does. That’s the calculation behind an RRSP. For most people, RRSP withdrawals, which are fully taxed as income, will result in lower taxes than if there had been no RRSP savings. But that’s not true for everyone, most especially not high-income earners, as it depends on the size of their RRSPs.