Investment options are much greater for those lucky enough to have largely risk-free sources of retirement income.BrianAJackson/Getty Images/iStockphoto
Millions of Canadian investors should consider dumping some – maybe even all – of the bonds in their portfolios.
These are people who are members of defined-benefit pension plans, where you don't have to worry about stock market declines because your retirement income is based strictly on years of service and salary. If your employer has a well-funded DB plan that promises a generous retirement benefit, you may not need to protect your own personal retirement investments by including bonds or bond funds.
"In investing, people tend to not look at their other assets – they look at everything in isolation," said Clay Gillespie, managing director at Rogers Group Financial in Vancouver. "But including your defined-benefit pension plan in your investing strategy makes all the sense in the world."
Bonds are a means of reducing risk in your investments. It's true that the price of bonds and bond funds would fall if interest rates rose. But as long as they're issued by financially viable companies and governments, bonds keep making interest payments twice a year and then pay your money back when they mature. This predictability is what causes money to flow into bonds whenever the stock markets tank.
If you have a defined-contribution pension (where your retirement income depends on the performance of your pension investments), or lack any sort of a pension, then bonds should absolutely be included in your personal retirement account. But bonds may be dispensable if you're fortunate enough to have a DB plan.
About 38 per cent of workers were members of a registered company pension plan in 2012, the latest data from Statistics Canada show. DB plans are steadily declining in number, but they still accounted for just over 70 per cent of total pension plan membership and covered 4.4 million government and corporate employees.
The key benefit of a DB plan is having a predictable flow of life-long income. Less well understood is the investing flexibility that DB plan members have in their tax-free savings accounts and registered retirement savings plans. If they're okay with stock market risk, they can invest all or mostly in stocks to focus on generating higher long-term gains. And if they'd rather avoid stocks altogether, they can do that, too.
It all depends on how much of a person's retirement income needs will be met by a combination of a DB plan and any applicable Old Age Security and Canada Pension Plan benefits. Each of these income sources is a reliable source of income for life. If together they produce income equivalent to 50 to 70 per cent of your salary in your late retirement years, then there's a case to be made for avoiding bonds and focusing on stocks in an RRSP or TFSA. "Optimally, you might as well take more risk," said Alexandra Macqueen, co-author of the book Pensionize Your Nest Egg and a certified financial planner (CFP).
The payoff for this aggressive investing stance is the potential for building more wealth than you would with a mix of stocks and bonds. To be exact, we're talking here about wealth generated over the long term, say 10 years and up. The more money you have in stocks, the greater the risk that a stock market correction could cause a short- to medium-term setback in the value of your portfolio.
The all-stock retirement portfolio is theoretically suitable for people with DB pensions, but there are important details like your personal risk tolerance to consider. Mr. Gillespie said his clients with DB pensions typically have 70 per cent of their own portfolios in stocks because a full weighting doesn't fit their risk profile. "There are very few people who would be comfortable with 100 per cent of their portfolio swinging wildly with the stock market," he said.
If you're a confirmed stock market hater, then DB plans afford you the luxury of avoiding stocks altogether in your personal retirement investments. Again, it comes down to whether your pension income, CPP and OAS cover all your living expenses. If so, then you don't need to take any risks with your personal investments. A return of 1 to 2 per cent with no risk may suffice.
"With a defined-benefit pension plan, you can take addition risk with your investments and, from a financial and math standpoint, you should," Ms. Macqueen said. "But from a risk-tolerance standpoint, if you don't need to, then don't."
DB pensions offer more security than defined-contribution plans, where your retirement income depends not only on investment returns in your working years, but also on how effectively you generate investment income after you leave the work force. But let's not exaggerate the safety of a DB pension. If an employer goes bankrupt and its DB plan isn't fully funded, employees may end up with less monthly income than they expected.
What if your DB plan isn't fully funded and you worry about your employer's long-term viability? In projecting how much income you'll get in retirement, consider discounting the amount of your expected pension payments. "You might say, well, I'm supposed to get $50,000 a year from this plan, but I'm going to assume I'm going to get $50,000 less 25 per cent," Ms. Macqueen said.
If your reduced pension won't cover your living costs, then you'll need some bonds in your personal retirement savings to insulate against stock market gyrations.
A quick final thought on what to invest your own money in if you have a DB pension that you expect to cover your retirement income needs. Mark Yamada, president and CEO of PUR Investing Inc., suggests a broadly diversified portfolio of exchange-traded funds from Canada, the United States and the rest of the world. "Keep it low cost and keep it broad," he said.
Globe app users click here for a graphic showing portfolio-building for people with DB plans.
Rob Carrick