Re-thinking retirement income portfolios as rates decline

Does overweighting fixed-income still reduce risk?

A central theme in portfolio management is risk-adjusted return - weighing potential upside performance against downside variability.

Most investors understand the performance side of the equation. Simple arithmetic: Set an objective, determine the time horizon, and calculate the required rate of return.

Risk is more subjective. We can measure risk by calculating a portfolio’s variability over a specific period. But knowing a portfolio could experience x% downside variability sheds no light on how investors are likely to react.

Notionally, we can use questionnaires to determine an investor’s risk tolerance. The reality: Measuring risk tolerance ex ante is like trying to guess Wayne Gretzky’s next move based on his latest trajectory. It might be better than a blind guess, but not by much.

The all-important question of risk

The risk question is especially relevant for income portfolios. Having its own nomenclature with risk being defined as the “age of ruin,” it comes down to how long the portfolio can fund the investor’s needs and wants before it runs out of money.

Income mandates are conservative, because they appeal to retired seniors who, by definition, have a low tolerance for risk. Conservative income portfolios are typically overweighted in fixed-income securities (i.e., bonds and preferred shares) with a limited allocation to equities.

But does an overweight bond allocation reduce risk? Bond prices move inversely to interest rates. Rising rates mean lower bond prices, declining rates mean higher bond prices! When interest rates were at or near zero during the Covid pandemic, it was hard to imagine any scenario where bonds would reduce risk within a portfolio. In fact, fixed income-assets – i.e., bonds and preferred shares – could be categorized as the highest-risk asset class within a portfolio. Risk increased incrementally on a sliding scale that corresponded to the term to maturity.

Ballast in bonds

Much has changed with the unprecedented spike in rates as global central banks attempted to slow an inflationary spiral. In the current market, where rates are expected to decline over the next 18 months, bonds and preferred shares now represent the ballast that reduces risk within income mandates.

The challenge for income seeking investors is to balance the underperformance of traditional income mandates against the surge in growth assets that typically reside in the momentum camp. Developing sustainable income portfolios in the current growth environment means altering one’s perception of risk – looking past stock price performance while focusing instead on income sustainability. But that’s easier said than done!

Extended periods of underperformance, which has been the hallmark of income mandates, can be catastrophic, often leading to bad decisions based on emotions…notably fear and greed. However, an income portfolio that may produce upside share price performance, with minimum price variability, that is unable to generate stable cash flow will lead to principal drawdowns that in the long term, will negatively impact the age of ruin timeline.

We can manage bad behavior caused by short-term price swings by recognizing that variability varies by time (i.e., the length of time you hold an investment). Looking at long-term performance data makes short-term aberrations seem inconsequential. The key is being comforted by the knowledge that solid blue-chip value stocks will recover in time. More importantly, stocks in this group typically increase dividends, which not only supports their stock price but also provide the required income that meets most if not all, of the initial income objective.

Next time: The impact of principal drawdowns on retirement portfolios.

Richard Croft is Founder, Chief Investment Officer, and Portfolio Manager of R.N. Croft Financial Group Inc.

Disclaimers

Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Investment funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently, and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

R N Croft Financial Group Inc. is a Licensed Discretionary Portfolio Management and Investment Fund Management company serving investors and investment professionals across Canada since 1993.

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