• Retirement risks in the context of key global and demographic changes, by Tariq Ali Asghar

    Jun 05, 2013

    The objective of this article is to put retirement risks in the perspective of key global trends and changes. The economic collapse of 2008 left us pondering on the key question: can we control the timing of retirement? This event demonstrated the fact that the new economic realities warrant a great bullet proof strategy for retirement. The key risk faced by majority of baby boomers boils down to: would they be able to retire on time in an investment world awash with volatility and unpredictable markets?
    The key risk is longevity:
    With medical advancement, your risk of mortality is much lower. In contrast, your risks of morbidity and longevity are much higher. Recent statistics point out that the average male lives to 76 and the average woman lives to 82. It is no surprise that these figures will improve in future as medical technology makes advance strides.
    Health costs should be tied to retirement:
    The risk of death has decreased but the risk of not living healthy has ironically increased. Again statistics point out that 1 in 3 Canadians will get some type of critical disease. Health costs are increasing and so is the incidence of viral and bacterial diseases. The health systems are constrained by domestic demands and the latest trends point to global solutions to circumvent long wait times. All this points to an ever increasing health bill? How do you cover yourself under two different conditions? First you could be confronted by a temporary disability which does not let you work. Second, you could be confronted with an unexpected medical emergency, including major surgery or treatment. In this case, your need is not to replace the temporarily lost income but to get an appropriate lump sum payment for the treatment. In the world of insurance, the former case is of disability insurance and the latter points to critical insurance.
    Insuring against disability or critical insurance is absolutely critical. Why? If you do not have adequate protection, you will dip into your savings, including RRSP, to get money. This could be very costly if you cash out any portion of your RRSP due to serious tax implications. Any retirement plan must hedge the risks of health care costs by creating a contingency plan or buying disability and/or critical insurance.
    Procrastination and retirement
    Recent statistics have revealed that 2/3 of Canadians aiming to retire by 2030 are not contributing substantial money to actualize their retirement goals. This situation is exacerbated by the fact that the only thing certain in the next decade is uncertainty of the capital markets. Investing without any financial advice can lead to a badly structured portfolio. This would gravitate into procrastination of retirement. What are some other factors which lead to misjudgements about the timings of retirement?
    – Reliance on the Canada pension plan and old age security is not a good idea; and conservative analysis would typically exclude CPP from calculation of pensions.
    – Most employees have historically moved from defined benefit towards defined contribution model; which puts more responsibility on the potential retirees than the company itself.
    – You don’t pay yourself first and therefore not maximize RRSP.
    – Demographics play an important role in shaping the retirement industry. The surge of baby boomers ahead will underscore demand for capital preservation amidst highly volatile capital markets. The key challenge is volatility and the main need is preservation of capital. Investors will demand downside risk management as much as returns. The ensuing volatility stems from three key factors: First, the low interest rate has created potential bubbles. Second, huge sovereign debt would cause macroeconomic instability. Third, the shift from the US to BRIC countries will be accompanied with increased volatility of capital markets.
    Most retirees don’t have the expertise and bandwidth to put their retirement goals in the perspective of key global trends. The economic crisis of 2008 emanating from the real estate bubble and mushroom growth of highly leveraged esoteric products points to the fact how fragile the world economy is.
    The world is undergoing a sharp structural change. Global trade is most probably poised to shrink in the next decade due to three key factors: first, China and India will lead the way for strong economic and population growth as well as robust savings rates which together will help these nations build an internal mechanism of demand for their exports. This will reduce dependence on Europe and the US to absorb exports from China and India. Second, rising energy and commodity prices will reduce mobility of trade goods and localize most factors of production. Third, labor costs in developing high growth economies will rise leading to less advantage to outsourcing many of these services.
    Another key demographic trend is $3.7 trillion baby boomers industry in Canada which will dampen purchase of stocks in the next decade. Also, the lower level of consumer spending will dilute GDP growth.
    The best case scenario is underpinned by sideways volatile stock markets driven by persistent demand for the dividends stocks. The worst case scenario is deflation of the economy due to the busting of various bubbles like housing, oil, gold and stock market. The latter will keep the bond market afloat while shifting the centre of gravity to emerging markets fixed income securities.
    China and India will rise as significant economic powers in future. Their stocks will perform stronger than that of the US. This will do one thing for sure: drive up the prices of energy based commodities and natural resources. This would have positive impact on the economies of Canada and Australia.
    The retirement risk is the key risk
    The key risk for a great number of Canadians is the retirement risk itself. They are shy to put money in the markets with the fear of losing money. As pointed out by the data of statistics Canada, this inaction has resulted into $491 billion of unused RRSP contributions. This situation could be exacerbated by four alarming trends. First, the surge of baby boomers will greatly strain the government sources of help like the CPP. Second, employers are putting responsibility on their employees. Third, stock markets can potentially stay volatile and sideways due to great demographic transition in North America and the BRIC countries. Fourth, persistent low interest rate will create more bubbles which will only lend more volatility to the markets. The worst form of this instability could potentially lead into hyperinflation as the money supply continues to grow unabated.
    Prudent course of action
    There could be many strategies to retire wisely. Here is a recap of four key strategies:
    1. Diversification is the key area of focus. You must diversify across geographical areas, stocks & bonds as well as variety of assets for retirement.
    2. Hedge against volatility in the stock markets. Apply 60/40 rule of investing 60% in equities and the remaining 40% in stocks.
    3. Create alternative assets. For example, combine real estate investments to permanent insurance strategies and create a powerful combination which does three things: first, permanent insurance as a conservative investment balances your aggressive portfolio. Second, it allows tax-advantaged build-up of cash reserves inside your policy; and potentially hedges any risks of downturn in your real estate holdings. Third, permanent insurance while diversifying your portfolio also ensures efficient transfer of estate to the designated beneficiaries. Specifically, it covers loses from taxes and probate which cut onto the value of estate during estate transfer to beneficiaries; as well as hedges risks against creditors.
    4. Cover up longevity risks by creating diversified assets. For example, if you have exhausted your retirement funds by age 65, you run the risk of longevity and living through the age of 85. How do you live in those twenty years, in particular when health costs are increasing as well? One potential solution is a combination of permanent life insurance and critical insurance. The former can build cash value to attend to the longevity risk while the latter can take care of unexpected medical emergencies most likely to occur in old age.