Among the legends of the Algonquin First Nations people, none was more terrifying than Wendego. According to the fable, Wendego lurked in the deepest, most remote forests of the land, emerging in mid-winter to devour men, women, and children, and satiate its endless taste for human flesh before withdrawing to the nether regions again with the arrival of spring. Stories of the ravenous beast were exchanged around campfires for generations, growing more bloodcurdling with every telling. Fortunate victims, it was said, died of fright at the mere sight of Wendego. Others were eaten alive by the beast.
Wendego represented cannibalism, brought on by waves of starvation among the Algonquin, and the tales were a warning against failing to prepare for years of poor harvest, bad hunting, and extended winter. Our modern Western society doesn’t fear a beast prepared to wander into town, devouring whatever it takes to satisfy hunger. Instead, we have inflation.
Canadians, and people in the world’s industrialized regions generally, have managed to avoid the worst aspects of inflation for almost 30 years, an unprecedented achievement. The concept of guaranteed bonds paying 18 percent annual interest and home mortgage rates rising past the 20 percent level appears incomprehensible today. But it happened, and a similar event is almost certain to happen, perhaps as soon as 2012.
Inflation will be one of the costs of bailing the world out from the 2008–2009 economic crisis. The simplest definition of inflation is “too much money chasing too few goods,” driving up the prices of commodities and manufactured goods and later pulling interest rates, real estate values, and other critical components up as well. Massive government expenditures in Europe and North America in 2008 and 2009 flooded economies with cash. Most of it was used to fund near-insolvent businesses, especially financial and automotive. Soon, this money will begin driving consumers to purchase goods and services, generating excessive demand. At that point, Wendego emerges from the woods.
Governments have learned how to deal with inflation, and with the promise of new, more effective international co-operation on global economic policies, we can expect to see effective cures applied. These would include hiking interest rates, imposing wage and price controls, and perhaps even linking currency levels to a gold standard, which would prevent governments from manipulating currency values. Few cures are painless and free from side effects, however, and we would be wise to prepare ourselves for both the disease and its treatment.
For example, two things susceptible to serious damage by high inflation are cash and long-term bonds. While interest rates on savings accounts will be adjusted upward in inflationary times, they are not likely to keep pace with rising prices and the resulting devaluation of currency, and the result will be a net loss to account holders. Longterm bonds are also to be avoided; a 10-year guaranteed bond paying 6 percent annually sounded like a very good deal in 2009 when quality bond rates hovered between 2 and 3 percent. Should you buy one (assuming you could locate it, an unlikely event) with the plan of holding it to maturity, you would not be happy if and when inflation hits 10 percent or higher within a few years.
Stock market shares should rise at a similar rate with inflation but that’s not always the case. High inflation affects business performance in various ways, few of them positive. One result could be stagflation, when interest rates rise along with unemployment levels while the value of real goods remains unchanged.
As with all crises, opportunities may emerge among the carnage. Long-term bonds purchased at the height of an inflation curve become highly attractive when the curve has passed.
A more likely opportunity lies with real-return bonds (RRBs) that deliver just what they suggest: interest adjusted upward year by year to account for inflation. The mechanics are a little complex, but the returns can be rewarding. Here are the calculations for a $10,000 RRB paying a nominal 3 percent interest encountering 5 percent inflation in the first year and 6 percent in the second year:
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In Canada, the federal government issues RRBs, providing the assurance of a government-backed guarantee along with inflation protection.
The principal drawback to RRBs concerns maturity dates. While a secondary market exists for the bonds, you may not be able to dispose of them as easily as guaranteed strip bonds from the same issuer if you want your cash back before the bond matures. And holding them outside a registered portfolio is not a good idea; the interest earned will be taxed annually at 100 percent (versus 50 percent for capital gains), making them best suited for RRSPs, RESPs, and RRIFs.
You could invest in a mutual fund dealing in RRBs, but most have an unacceptably high MER. One exception is the Real Return Bonds Index Fund from Barclays Canada, with an MER of just 0.35 percent. Still, if your horizon is long-term, owning the actual bonds may be a better choice.
RRBs represent an attractive method of building a fortress foundation for your RRSP to fight market meltdowns while offering inflation protection. Remember, however, that they are best held to maturity and may not prove liquid if you try to sell them at an earlier date. For that reason, keep a substantial portion of your bond position in more easily cashed strip bonds or laddered GICs. Laddered means a fifth of the GIC value matures in one year, another fifth in two years, and so on; every year another fifth (or 20 percent) of your GICs is cashed and another five-year GIC is purchased with the proceeds. It’s an effective means of steadying wild fluctuations in GIC interest rates.
Building Blocks for Walls and Watchtowers
Let’s review the materials needed to construct a fortress to protect our retirement savings plan from market meltdown while generating growth to counter inflation and improve our anticipated lifestyle in later years.
We begin with two basic ingredients: equities and fixed income investments. Together, they should represent 90 percent of your portfolio’s total assets.
Until age 60 or 65, the percentage of your RRSP portfolio in fixed income investments should equal your age. These can consist of guaranteed strip bonds maturing in five years or less, and perhaps five-year laddered guaranteed income certificates (GICs).
Most or all of the strip bonds should be government guaranteed. You may want to purchase blue-chip corporate bonds to boost the lower government-guaranteed bonds, but these should probably not make up more than 20 percent of your total bond holdings.
Many investment commentators suggest extending the age-equalspercentage formula all the way to age 90, when RRSPs (converted to RRIFs at age 71) must be collapsed. That may be a little overly conservative, especially if you trust your judgment or that of an effective advisor to build a solid equity base. Bonds, remember, are for preservation, equities for escalation. You may want more asset growth opportunity from 65 to 80 than others; if so, keep your equities between 30 and 40 percent, assuming you’ve chosen carefully.
Should you reach age 80, you’ve beaten the actuarial odds. Along with this good news comes more good news: Annuities are now worth considering.
An annuity provides a fixed amount of income in exchange for a lump sum from the original beneficiary or annuitant. Hand over $100,000 or more from your RRSP or RRIF to a company providing the annuity (usually an insurance company) and it hands you back a cheque each month. The amount is fixed; once you do the deal, you can’t change the payment. You can, however, choose among various options, such as a Joint and Last Survivor, the usual plan chosen by a married couple, which guarantees payments as long as one of the partners remains alive. Choosing an annuity with no guarantee means the monthly payments are higher but they cease at death. Men receive a larger annuity than women because their shorter lifespan means fewer projected payouts from the same initial investment.
Here are examples of the payments available for every $100,000 invested in a Single Life, Male, No Guarantee annuity as of June 2009. Note how the monthly payments vary widely among the insurance companies supplying the annuity:
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As you can see, it pays to shop around. At age 60, the annuity (male, with no guarantee—once the annuitant dies the payments cease) yields as low as 7 percent annually ($578.12 ×12 = $6937.44) from company F. Hang on for 20 years and the same $100,000 brings you almost 14 percent annually from company H and barely 11 percent annually from company B. Two of the companies don’t even want you to darken their door at age 80.
Summing up: Manage your RRSP/RRIF to age 80; pay attention to diversity, preservation of capital, and controlling costs and fees. At age 80, use all or most of your retirement assets to purchase an annuity (joint-survivor guaranteed is preferred, if you have a spouse or chosen beneficiary), collect cheques every month, and let others worry about wheeling and dealing.
Equity investments are still needed to generate asset growth from age 65 to 80. The U.S. investment industry dedicates enough effort in maintaining its records of performance to impress the most dedicated historian in the Vatican. It has tracked the annual returns on equity investments back to 1825, through the euphoric years, the disappointing years, the blah years, and the Oh-My-God! years.
For those investors who remain concerned about the potential for loss yet crave the opportunities for long-term growth, a breakdown of the 183 years between 1825 and 2007 reveals some encouraging facts:
• For 129 or 70 percent of those years, the markets produced positive growth.
• In five years—1862, 1879, 1885, 1933, and 1954—the markets scored between 50 and 60 percent growth. They have never fallen by a similar amount in any given year.
• For another five years—1843, 1863, 1928, 1935, and 1958— the markets delivered between 40 and 50 percent annual returns. In only one year—1931—did they fall that far.
• For a remarkable 15 years—including 1975, 1980, 1985, 1989, 1991, 1995, and 1997—the U.S. equity markets scored between 20 and 40 percent growth. They fell that far only in 1937.
• In over 84 of those 183 years, or 46 percent of the time, the American equity markets returned annual gains of 10 percent or better. In only 25 of these years, or less than 14 percent of the time, the markets lost 10 percent or more.*
If you’re calculating odds, the chances appear better than 2 to 1 in any given year that you will post a gain rather than a loss from your equity investments. With this revelation comes the sobering insight that these performance figures are measured across the entire equity universe within the U.S., surely another argument for investing in broadly based index funds with minimal charges.
A few caveats are worth noting: Neither Dow Jones nor Standard & Poor’s existed back in 1825, so the benchmarks employed in the early years (S&P dates back only to 1945) are unknown. And while today Canada’s stock markets reflect most moves in the United States, this was not always the case prior to the Second World War, suggesting that a true parallel needn’t apply.
Providing a Canadian viewpoint, Warren Baldwin, a Toronto-based financial planner, delved into files to report that bear markets occurring in the 50 years between 1958 and 2008 lasted about 14 months and prices bottomed out at a 25 percent loss. Bull markets, in contrast, lasted about 48 months and saw prices climb an average of 148 percent.
It’s all a very convincing argument for staying in equity markets, assuming you are able to hold on to as many of your gains as possible in the face of unforeseen down markets and excessive fees and commissions.
What of Allison Godden, who, as we saw in Chapter 5, abandoned equities entirely? Allison was converting past investments into fixed income. Growth in her retirement account balance was desirable but not as critical as 5 or 10 years ago.
From 1994 to 2009, Canadian equity markets, measured by the S&P/TSX, averaged an 8.60 percent annual return; Canadian fixed income investments averaged 6.06 percent annually. Extend the period from 1989 to 2009, and the gap narrows: 7.73 percent for equities and 6.70 percent for fixed income. The relatively small 1.03 percent difference over 20 years becomes significant with the impact of compound interest. Also, as we saw earlier, fixed income investments steady your account against volatility. Until age 80, it’s still wise, however, to retain some quality equity investments.
Holding on to More of Your Money
The best solution remains ETFs invested in a broadly based index such as the S&P/TSX Composite. ETFs should represent 80 percent of your equity portion. The remaining 20 percent or less could be filled by dividend-paying shares of blue-chip domestic firms in industries such as finance (those sly money-making chartered banks), utilities (oil and gas pipelines are always busy), cash-rich consumer staples (Loblaws, George Weston, Couche-Tard—people have to eat), and health care (people also grow old). If you insist on adding a little spice to the mix, perhaps 5 percent could be in gold producers or emerging market funds, but expect volatility and remember to take profits from time to time. The following charts show examples using the traditional triage approach for age 60 to 71 RRSP investors.
Let’s be clear: None of these portfolio models offers total protection against market meltdown. Each is a method of balancing growth against risk, and each can be easily tracked to assess growth and capital preservation. Each also can be assembled and held at minimum cost in commissions, management fees, and trailer fees.
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Perhaps the Most Important Protection against
MassiveSized Losses: Good Investment Advice
The most outrageous falsehoods told by the investment industry to Canadians concern costs and risks. Too many financial advisors respond to client questions about mutual fund MERs, commissions, and trailer fees as though they are being queried about their sex lives. Someone should remind them, from time to time, about the ownership of the money they are intent on managing.
The industry’s treatment of investment risk is just as outrageous. Yes, all investment involves risk. Risk, however, is not a cousin to the legendary Wendego, some hairy beast that emerges out of the darkness and defies any attempt to hold it at bay. Risk can be managed. It’s done every day by untold thousands of specialists around the world, odd people who track pork belly futures and oceanic currents to measure the likelihood of bond defaults, and price them accordingly. On a more down-to-earth level, your own local bank or credit union branch assesses risk when granting you a personal loan or mortgage, as does your insurance company when pricing a policy on your home, car, or life.
Remember: Risk can be managed. The next financial advisor who shrugs at concerns over massive, unexpected equity losses suffered by a client by muttering, “Markets go down as well as up” and “All investment involves risk” deserves to be locked in a room for 24 hours and harangued with these words by a choir of economists bellowing through a PA system whose volume level is cranked up to 11.
Real Ideas You Can Begin Using Now
Time to summarize:
• If you haven’t opened an RRSP account yet, get started. Now. You can no longer count on anyone but yourself to provide an adequate retirement income.
• If you have an RRSP, keep contributing. RRSPs are not perfect, but this is after all an imperfect world. From a tax situation, they represent the most attractive and least painful of all the practical alternatives.
• Establish an investment strategy with your spouse and/or your financial advisor. This may include establishing a balance between equity and fixed income investments; setting a goal to achieve in five years or at your presumed retirement date; choosing or rejecting investment sectors such as gold, foreign investments, emerging markets, and so on.
• Limit the number of mutual funds in your portfolio. Most investors do not need more than three or four: Two large-cap domestic equity funds, each with a different investing style (value stocks versus growth stocks and so on), an international equity fund, and perhaps a specialized fund investing in certain commodities or geographical areas. Or invest exclusively in ETFs (see below).
• Investigate exchange traded funds (ETFs). Think about placing at least one broadly based ETF reflecting the Canadian market generally, in your portfolio, plus perhaps 5 percent each in a global and an industrial sector fund.
• Consider adding shares in selected blue-chip companies with a long record of paying dividends. Among the candidates: Canadian chartered banks, pipeline and energy companies, large gold producers, large retailers.
• Learn the cost of every investment in your portfolio. The MER of mutual funds, commissions on common shares and bonds, administration fees, and so on.
• Always know where your money is and how well your investments are performing.Check your statements as soon as they arrive to (1) confirm that you authorized any transactions since the last statement; (2) compare the performance of your investments with the economic situation generally; and (c) note any subject you should raise in the next conversation with your financial advisor.
• Avoid leveraged investments. Your RRSP or RRIF doesn’t need the risk.
• Rebalance your portfolio from time to time. Set a profit target for each investment. When it is achieved, sell a portion to crystallize your profits, perhaps investing the funds in strip bonds. Also, until age 65 at least, match the percentage of your portfolio in fixed and guaranteed investments (bonds, GICs) to your age.
• Avoid investing in anything you do not adequately understand. This rule should be inflexible.
• Keep your guard up against fraudsters. Not everyone you encounter who offers investment advice or opportunities is dishonest, but if they are crooked, you can’t tell until it’s too late.
• Take pride in your independence and your ability to manage your financial future.You may not have as much in your RRSP as you wish when you retire—few people do—but every penny in your plan is yours to own and control.