Staying in the game: Why it’s the best strategy for retirement

“The biggest risk that clients face is running out of money before they die,” says Frank Mullen, portfolio manager with EdgePoint Wealth Management Inc. of Toronto. “People fear volatility, but it is not a measure of risk. The biggest risk is erosion of purchasing power in the long term. The danger of outliving their money – that is the real risk for clients. History has proven that equities do the best job of providing long-term growth.”

Retirement issues are being complicated by a major demographic change. The fastest-growing demographic group is centenarians, according to Statistics Canada. A couple in which both partners are 65 years old face a 50% chance that one of them will live to the age of 91, and a one in four chance that one partner will live to 94, according to the Canadian Institute of Actuaries. These couples are looking at a retirement span of 25 to 30 years, which could amount to a third of their lives.

Meanwhile, interest rates are at historical lows, and returns on traditional retiree assets such as government bonds and guaranteed investment certificates may not even be keeping up with inflation.

An inflation rate of 3%, the historical average for the past 100 years, can take a big bite out of a retiree’s purchasing power. For example, if the client needs $40,000 of income in the first year of retirement, with 3% annual inflation they would need almost $84,000 by the 25th year – more than double the original amount.

Many items purchased by retirees have seen price increases exceeding inflation in recent years, including gasoline, health care, housing and a basket of basic groceries.

“Many people feel they can’t lose if their money is sitting in cash, but they are going poor slowly,” says Mullen. “They are kidding themselves if they think they are preserving wealth.”

Paul Delfino, director and financial advisor with Delfino Group, which operates under the ScotiaMcLeod Inc. banner in Kanata, Ont., figures his retiring clients need to see average annual growth in their portfolios of 6%-8% to meet their needs and keep up with inflation, particularly if those clients don’t have additional income from a work-based pension plan.

To achieve this, clients need a high percentage of equities, and the figure usually is a lot higher than the popular rule of thumb that says the percentage of equities to fixed-income in a portfolio should be based on 100 minus the client’s age, Delfino says. Many of his retiring clients have 75%-80% of their portfolios in equities, because that’s the best way to achieve the objectives of their particular financial plan.

“The gap between the growth and income people require in retirement and what they can get on guaranteed rates or treasury bills is massive,” Delfino says.

Delfino spends considerable time on educating potential clients at the outset of the financial advisory relationship, focusing on numbers that show the superior, long-term performance of small-cap and large-cap stocks relative to bonds and money market instruments.

He discusses the downside risk of stocks, but points out that the average bear market lasts 40 months from peak to peak. If a potential client does not feel he or she has the risk tolerance to handle the required portion of equities needed to meet their goals and stick to the mix through all kinds of market circumstances, Delfino is likely to forgo a relationship.

“A lot of advisors focus on bringing in assets, but I focus on developing an achievable plan,” Delfino says. “It might be a $1-million account; but if clients are going to outlive their money because they fear fluctuation, it’s not going to work. That’s like a client coming to you for acupuncture, then not letting you put the needle in.

“If the recommended plan is appropriate, but [clients] can’t execute on the right behaviour,” he adds, “they need another kind of advisor.”

Part of Delfino’s strategy in keeping his clients on track is to set aside enough in cash and short-term assets to provide three years worth of income. Take the example of a $1-million portfolio. If the client needed $50,000 of annual income (5% of the total), the portfolio would hold 15% in cash and short-term assets and 85% in equities.

Delfino refers to that 15% as the “financial bomb shelter” because it allows clients to avoid selling equities during downmarkets to meet their income needs. The equities portion, on the other hand, would be invested in broadly diversified, low-fee equity funds or exchange-traded funds (ETFs).

Every year, Delfino’s clients replace their spent income through a combination of selling of some mutual fund and ETF units on a systematic basis and reaping fund distributions from dividends and capital gains. If markets are down, clients have the flexibility to defer the replenishment of the bomb shelter for up to three years until prices move higher again. According to Delfino, it’s a limiting mindset that a client “must have all their acorns in the nest by retirement.”

That view is borne out by research by Seattle-based Russell Investments Group that found that clients who immediately go whole hog into traditional fixed- income securities at the commencement of retirement miss out on a lucrative period of growth that could surpass their portfolio growth rate during their working years.

The latest numbers from the Russell study show that 20% of income withdrawn from a retirement portfolio typically comes from savings invested during the working years, 35% comes from growth on those investments during those years, and 45% comes from further growth during a 25-year retirement. The suggested asset mix is a relatively conservative 35% equities and 65% fixed-income, which the Russell research calculates should produce an average annual return of 5.1% until age 90.

The Russell study assumes that continuous contributions are made to the retirement savings portfolio through 40 working years between the ages of 25 and 65, followed by a 5% withdrawal rate in the first year of retirement, with the annual dollar amount increasing by 3% to compensate for inflation.

“Growth in the retirement years is crucial to maintaining an income,” says Bob Leeming, director of client solutions with Russell Investments Canada Ltd. in Toronto. “You don’t retire from investing when you retire from work; you invest for retirement. Retirement is not a signal to go entirely into fixed-income. We are big proponents of a diversified exposure.”

Advisors able to convince their clients of the validity of this point may well have happier clients in the long term.

The pros make their single pick for retirement

Warren Buffett, chairman of Berkshire Hathaway Inc. and known as the world’s most successful investor, likes to buy stocks to hold indefinitely. Instead of trading, the investment sage prefers to buy superior companies that dominate their business niche, then watch them expand and produce profits.

“When we own portions of outstanding businesses with outstanding managements, our favourite holding period is forever,” Buffett once wrote in a letter to shareholders. “We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint.”

Buffett’s long-term, Rip Van Winkle approach to investing is meant to endure a variety of unpredictable economic and market conditions, and could make sense for a piece of a retirement portfolio, given that Canadians are spending an increasingly lengthy period of their lives in the retirement stage.

Investment Executive conducted an informal survey, questioning a handful of Canada’s top investors and fund portfolio managers to see which single investment they would tuck away for a retirement that could last 30 years or more. Their suggestions:

> Martin Ferguson, director and portfolio manager, Mawer Investment Management Ltd., Calgary

Selection: Constellation Software Inc.

Constellation Software Inc. of Toronto has a strong business model with sustainable competitive advantages, Ferguson says. As an international provider of market-leading software and services, Constellation has assembled a portfolio of specialized, vertical software companies with expertise in specific market niches (as opposed to horizontal market software, which meets the needs of a variety of industries). Ferguson says Constellation’s strong management team has expertise in acquiring, managing and building industry-specific software businesses and is able to provide “mission-critical” software solutions. Constellation has grown rapidly through a combination of acquisitions and organic growth, and its network of companies serves a large, diverse customer base comprising more than 30,000 customers operating in more than 30 countries around the world. Constellation maintains a database of more than 10,000 software companies, some of which could be acquisition targets in the future.

> Ned Goodman, chairman, Dundee Corp., Toronto

Selection: gold bullion

In choosing an investment for a 30-year retirement, Goodman suggests packing some gold bullion bars away in a safe. He would shun gold-based exchange-traded funds, certificates, gold trusts or any other gold-based paper securities for which the actual gold cannot be accessed by the investor.

The risk of committing to any company for 30 years, he says, is that even a good business could be hurt by a change in management.

“Throughout history, gold has continually proven to be a store of value,” Goodman says. “Gold is biblical; it’s been around for thousands of years and you can count on its value.”

Goodman is concerned about the large amount of paper currencies being printed by various governments around the globe, particularly in the U.S., and the potential for devaluation of fiat currencies and the return of inflation.

Hard assets such as gold, agricultural land and prime real estate properties are “long-life assets” that will increase in value over time, he says, and creating investment vehicles to hold these kinds of tangible assets is a strategic focus of Dundee Corp.

> Michael Lee-Chin, executive chairman, Portland Investment Counsel Inc., Burlington, Ont.

Selection: Northland Power Inc.

Northland Power Inc. of Toronto is an independent power producer specializing in clean natural gas and green energy such as wind, solar and hydro. Senior management owns 39% of the company’s outstanding shares, ensuring direct and substantial alignment of management and shareholder interests, Lee-Chin says, as well as a focus on long-term growth rather than on quarterly performance.

The company has a healthy dividend yield of 6.5% and is committed to paying a sustainable dividend. It has a long record of dividend payment, even during periods of heavy capital expenditures.

Cash flow is diversified across projects in various geographical and regulatory regions in Canada, Europe and the U.S. The company has a pipeline of projects under development, including interests in the Gemini and Nordsee offshore wind farms in the Dutch North Sea, where Lee-Chin sees significant upside potential.

> Sandy McIntyre, director and co-CEO, Sentry Investments Inc., Toronto

Selection: RioCan Real Estate Investment Trust

RioCan REIT of Toronto is the largest REIT in Canada, with ownership interests in more than 350 retail properties throughout North America. McIntyre says most pension funds have “a sleeve of commercial real estate” as part of their diversified portfolio, and retail investors would do well to follow the same strategy and hold some hard assets.

RioCan’s holdings of retail-oriented commercial properties stand to benefit significantly from expanded transportation systems and increasing density in urban areas, McIntyre says.

This REIT has a yield of more than 5%, and McIntyre expects to see a steady uptick in the dividend, which will help income investors keep up with inflation. “My vote for a retirement investment would be well located, income-producing commercial real estate,” McIntyre says. “I expect RioCan to increase continually both the quality of its properties and the value of its dividend.”

> Alex Sasso, CEO of Calgary-based Hesperian Capital Management Ltd. in Toronto

Selection: FirstService Corp.

FirstService Corp. of Toronto is a global leader in the real estate services industry, generating more than US$2.3 billion in annual revenue. The firm manages more than 2.5 billion square feet of space in residential and commercial properties through three platforms: Colliers International, a global player in commercial real estate services; FirstService Residential, North America’s largest manager of residential communities; and FirstService Brands, a provider of property services delivered through both company-owned operations and individually branded franchise systems.

FirstService also owns American Pool Enterprises, the largest commercial swimming pool and recreational facility manager in North America. Significant insider ownership aligns the interests of its management team with those of shareholders.

“FirstService has one of the best management teams of any mid-cap company in Canada,” Sasso says. “It has the ability to allocate capital efficiently into growth opportunities. Looking out 30 years, it will be a steady grower that will also grow its dividends.”

© 2014 Investment Executive. All rights reserved.