Senior Living: Inflation and your retirement funds

How can you reduce the effects of reverse dollar cost averaging to your portfolio?

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Last week we discussed the effects of reverse dollar cost averaging (RDCA) to the average Canadian’s retirement portfolio. Most retirees should expect to endure at least three to five downward swings to the equity markets during their retirement. If your retirement income is withdrawn from a fluctuating asset class such as equities, it is not unreasonable to expect to lose between 20 to 50 per cent of your portfolio over a typical retirement time horizon of 25 years.

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Once you do your hard-stop to working, your investment portfolio converts from a savings plan to a distribution plan. Market swings during routine withdrawals create permanent and unrecoverable losses to your retirement portfolio.

The problem arises when investment shares are sold to create income and therefore are no longer in the portfolio to participate in the recovery. Add to this the current problem of rising inflation, and you have a toxic mix. Retirees will soon need to withdraw more than they originally anticipated due to reduced purchasing power. There are two ways that inflation hits a retirement portfolio:

1) The need to withdraw more from investments to meet the higher priced living expenses.

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2) The central banks increase interest rates, which pushes down share prices and reduces the value of a retirement equity portfolio. The net effect is that the retiree is forced to withdraw increasingly larger amounts from their investments and must do so from a constantly shrinking asset base. So, what should you do?

The following are different retirement income strategies that you could consider with your advisor to create a “lifelong income” to reduce the risks of RDCA and the current rising inflation.

I want you to consider these options that I believe will minimize or in some cases, even eliminate the harmful effects to your portfolio (they are at least worth a conversation with a professional).

1. Set up withdrawals from money market funds only. Do not choose fluctuating investments such as equity funds, income trust funds, balanced funds or even bond funds.

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2. Distributions from mutual funds, income trusts, dividends and interest payments from bonds should accumulate in a money-market fund instead of being reinvested. Periodic withdrawals should come out of this money market fund only.

3. RRB-Real Return Bonds are fixed income assets which provide inflation protection. Discuss this option with your advisor to make them part of your asset mix.

4. Consider Annuities. Life annuities and a simple investment portfolio is considered to be the “perfect mix” formula for retirement lifelong income.

5. Avoid rebalancing your portfolio too often. Frequent rebalancing causes significant damage to your portfolio.

ATML TIP: If your withdrawal rate if five per cent or less, it is better to rebalance once every four years (preferably at the end of the U.S. presidential election year).

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6. Discuss withdrawal rates with your advisor and what you will need to do if your portfolio suffers a 5 per cent, 10 per cent, or even 20 per cent loss. Make sure you understand the products you are in to determine not just their potential but also their risk. Consider separate managed accounts (SMA) products.

7. Indexation and management costs will increase over time and will inevitably put pressure on the portfolio to have increased gains to break even. Keep this in mind when discussing alternative products with your advisor. Determine how the advisor/firm are paid and work out what this cost is annually. Make sure it’s worth it.

Once you enter retirement and you switch to a distribution portfolio, the tendency is to choose low income and ultra-safe investments. In reality, you need to have significantly higher gains to break even when you are taking money out of your portfolio. That is because not only does a retiree need to recover the market losses, but they also need to recover the differential losses between the original plan and the actual portfolio value.

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When it comes to your retirement and securing your finances, try not to spend too much during the early years. Your mission must be to preserve capital and live more modestly than you did when you were working. After all, by the time you get to retirement, you should have very little to buy because you should already have everything you need.

Make sure you retire without debt. Do not take on any large renovations, big-ticket purchases, or unnecessary expenditures that eat away at your base capital.

— Christine Ibbotson has written four finance books, including the bestseller How to Retire Debt Free & Wealthy.


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