Call it the Goldilocks dilemma. A portfolio can’t take on so much market risk – too hot – that it could experience large capital losses. But it can’t be so conservative – too cold – that returns are negligible.Getty Images/iStockphoto
Retirement finance ain't what it used to be.
At one time retirees could fall back on good pension plans combined with decent yields from bonds, and even GICs, to get them comfortably through the golden years. Taking on stock market risk was a luxury in many cases rather than a necessity.
How things have changed.
"It's not that the old ways don't work," says Dona Eull-Schultz, portfolio manager and president of Leon Frazer and Associates in Toronto.
"The challenge for investors has always been staying ahead of inflation, but it's even more important today because people in their 60s need to plan for at least a 30-year retirement."
What's more is that bond yields are low, outpaced by inflation. And interest rates seem to be on an upward trend, so bondholders also face the risk of capital losses to their fixed-income holdings as newer issues pay higher interest thus making the bonds held in their portfolio less valuable.
So what's an advisor to do for clients closing in on retirement or already there?
Call it the Goldilocks dilemma. Their portfolios can't take on so much market risk – too hot – that they could experience large capital losses. But they can't be so conservative – too cold – that returns are negligible.
"This is the largest financial challenge of our times," says Tyler Mordy, chief investment officer with Forstrong Global Asset Management in Toronto.
"Many investors are turning to equities, replacing the bond component of their portfolios with high dividend-paying stocks."
The problem is dividend-yielding equities have become a crowded investment since 2008-09, after which central bankers slashed interest rates to historic lows – and in turn, yields on so-called "risk-free" government debt became a losing game after taxes and inflation.
As more investors seek dividends in lieu of fixed income, yield stocks become more expensive, "so you're no longer adequately rewarded for risk," says Jeff Tiefenbach, chief investment officer with Greystone Managed Investments in Regina.
The strategy still has merits because yields are often more than double what's found in publicly traded fixed income. But being a discerning stock picker is arguably more important than ever.
Mr. Tiefenbach says advisors should consider strategies seeking stocks with upward momentum because their "dividend is improving over time" from increasing revenues and decreasing capital costs.
Many blue-chip companies with long histories of dividend growth are a good fit because they often expand their businesses steadily over several years rather than in fits and starts.
"Buying good companies that have these long abilities to pay and increase dividends is one of the best components of a strategy to ensure you have enough money to live on," Ms. Eull-Schultz says. "But what everybody now has to accept is there are market fluctuations."
Stock values and their dividend yields will rise and fall. And advisors must prepare clients for this volatility by providing them with increasingly detailed retirement income planning, she says.
"It's a careful combination of looking at investments in terms of what's the timeline for using these assets, investor objectives and asking whether they will have enough cash flow so most of their clients' money can remain invested."
She also contends many investors are best off with their portfolio remaining largely focused on the Canadian market. "Once we start taking a step outside our home country, we take on currency risk, and currency is the toughest area to have any success in."
Moreover many large Canadian firms have revenue from outside Canada. Better those companies address risks like currency than individual investors, Ms. Eull-Schultz adds.
"After that, there are sectors that we don't have in Canada and investing in those makes sense," she says.
"My first look would be into the U.S, but the stocks still have to pay a dividend, and they have to be businesses that you could own for 100 years."
Expanding into other markets helps spread the risk around, the idea being that when one market is down another is up.
"Compared with pursuing a narrow North American-focused, high-dividend-payer strategy, this more globalized approach does not compromise the only free lunch in investing: diversification," Mr. Mordy says, adding exchange-traded funds (ETFs) offer exposure to foreign markets at low cost.
"We can now access countless asset classes: international REITs [real estate investment trusts], emerging market debt and, yes, high-dividend paying stocks from around the world."
This strategy is not without its warts, says Bob Stammers, director of investor education at the CFA Institute in New York.
"There are a lot of people out there who say because of globalization diversification is reduced."
Markets are more correlated today than in the past.
"There is marketing speech that geographic diversification dampens volatility," Ms. Eull-Schultz says. "Can you tell me one market that didn't go down in 2008 and 2009?"
Diversification is still necessary, Mr. Stammers adds. But the scope needs to be expanded – like including alternative assets in the portfolio, such as real estate and infrastructure. Alternative assets often involve private equity and debt opportunities, not traded on public markets. Consequently, they frequently require large initial investments, a higher level of due diligence and are less liquid than public market securities, making them more suitable for high-net-worth investors.
"So investors are giving up some ability to buy and sell daily on these securities, but the offset is a better longer-term upside," Mr. Tiefenbach says, adding some mutual funds and ETFs do offer this exposure to retail investors.
Another plus is alternative assets are less correlated to equity and bond market risks, providing stability to a well-diversified portfolio.
"If you're creating a traditional portfolio with a little bit of bonds and equities, you're not going to be able to protect against those long tail risks like another global financial crisis," Mr. Stammers says.
"Hopefully with alternatives the risk profile is different enough to provide a return even if traditional assets fall."
Still investors are often best served, when trying to balance capital preservation with growth, by sticking with core strategies that have worked well for decades – like buying shares in strong companies with long histories of growing earnings and rising dividends, Ms. Eull-Schultz says.
"Investors have to be careful not to chase returns – that next shiny penny – to meet their objectives," she says. "They have to be very focused on inflation, what's happening with interest rates, and not taking on a lot of risk to meet their long-term objectives."