Ever since the groundbreaking research of Gary Brinson, Randolph Hood and Gilbert Beebower identified asset allocation as the primary determinant in the variability of portfolio returns, thoughtful investment advisors focus on asset-mix composition as the building block of portfolio construction. The goal has been to construct optimally diversified portfolios that seek the highest return relative to their risk as measured by volatility.
For retirees, however, risk is not defined by volatility per se, but by the portfolio’s ability to fund a desired level of consumption over the lifetime of the portfolio’s owner and spouse or the spouses’ joint lifetimes. In this context, optimal investment strategies minimize both the probability of a shortfall in the target real return needed to fund future expenditures and of a mismatch in the timing of cash inflows relative to outflows. With asset-mix design for retirees centred on funding a future stream of liabilities, asset/ liability management becomes an advisor’s principal function.
Unfortunately, just as baby boomers are swelling the ranks of retirees, asset/liability management has never been more difficult. Historically, the core tool of asset/liability management has been sovereign investment-grade bonds, as these can fund future nominal liabilities with certitude. However, with the yield of 10-year Canadas barely above 1%, the ability of bonds to fund future liabilities is minimal – particularly in a world in which core inflation is around 2%. Long-term real-return Canada bonds, which can satisfy future inflation-adjusted liabilities, offered an almost non-existent yield of 0.28% on Sept. 30.
Although high-quality investment-grade bonds play an important role in containing volatility, as well as acting as a source of liquidity during periods of market stress, their utility in long-term liability funding has been seriously compromised. As a result, the traditional portfolio composed only of bonds and stocks no longer meets the needs of retirees.
Canadian pension plans that have grappled with the funding challenges imposed by ever-lower interest rates point the way to asset mixes that are better suited to the needs of retirees. The asset mix for members of the Pension Association of Canada had allocations of 12.8% to real estate and 8.2% to infrastructure on Dec. 31, 2018. This combined 21% allocation to real assets has more than doubled in the past dozen years.
Real estate and infrastructure are tangible, long-life assets with contracted income streams that generally increase over time with inflation. Fortunately, a growing number of ETFs and mutual funds focus on these asset classes.
Finally, minimizing the tax drag on investment returns is critical. Funds that focus on Canadian listed REITs and infrastructure offer significant benefits to Canadian investors’ taxable income. A significant portion of the cash flow from Canadian REITs typically consists of non-taxable return of capital, while Canadian infrastructure companies that are resident corporations pay dividends that are eligible for the enhanced dividend tax credit.
Michael Nairne CFP, RFP, CFA, is president of Tacita Capital Inc. of Toronto, a private family office and investment counselling firm.