One of the many government responses to the pandemic was to lower the cost of money through conventional monetary policies and quantitative easing (a new initiative in Canada but familiar in most developed markets). The goal of low, and potentially even negative, real interest rates is to encourage economic growth: by lowering hurdle rates for investment and improving household balance sheets, with lower mortgage rates, for example.
As was the case after the Global Financial Crisis, it is likely that stocks will significantly outperform safe assets such as cash and government bonds. This near-term boost to equities, however, could mask the challenges that lie ahead for long-term investors. Although higher stock prices feel good, they are deleterious for compounding wealth over a long time horizon. Investors benefit much more from low prices (and higher earnings yields) than high prices (and lower yields), as it is re-investment rates that determine long-term investing success.
There will be pressure to keep rates low, even if inflation pressures eventually re-emerge, as this is an effective way to diminish the real value of high debt burdens. However, while a low (or negative) real interest rate environment is great for debtors, it is bad for long-term investors saving for retirement. But rather than lamenting on the fact that we do not live in better times, those of us hoping to retire some day can proactively re-examine the most important variables in retirement planning and understand that we have significant control over the outcome.
Savings rate – Many workers have seen their expenses drop substantially during the pandemic, with less money spent on gasoline, meals, clothing, entertainment and travel. Granted, we are all eager to resume some activities we once enjoyed, but we’ve also learned what we can live without. Permanently cutting some expenses is an effective way to increase one’s savings rate. Saving more is also a rational response to lower interest rates, although this could lead to shrinking aggregate incomes if this strategy is taken up en masse.
Retirement income target – Spending less is the other side of the “saving more” more coin. Making sustainable reductions in your spending now may also allow you to target a lower retirement income level, reducing the aggregate amount of saving required before retirement. This is not about needless austerity, but rather concentrating consumption in areas that substantially improve life.
Retirement date – Many people my age or younger (seeing their parents as an example) have come to believe they can work for 30 or 35 years, and then retire and live a life of leisure for another 30 years. Like many things we took for granted before the pandemic, this assumption should be scrutinized. Starting conditions might not be good enough to repeat the post WW2 experience. Delaying retirement by a few years has an especially powerful effect on retirement income due to a longer saving period combined with a shorter drawdown period.
Asset allocation – Investors can increase their equity allocations to partially fill the expected return gap. This approach should be carefully considered, especially by those near retirement age, when returns (and losses) matter the most.
The following table illustrates how changing three of these variables could impact one’s hypothetical retirement income. Consider a 40-year old earning a $100k salary. They plan to retire at age 60 and live until age 90. They currently have $250k in savings and target a savings rate of 10% of income. We assume the return on equities will be a conservative 6% per year, and that bonds will return 1.5% per year.
RETIREMENT INCOME (INDEXED TO 2% INFLATION)
|Base case retirement income at age 60
|1) Increase equity allocation by 10%
|2) Increase savings rate to 15%
|3) Delay retirement from 60 to 65
|Make all three changes
By making all three changes, income increases to more than double the base case.
The pandemic has revealed many of society’s vulnerabilities but also our resiliency. Although retirement plans might presently be challenged and face future stress, there are plenty of straightforward ways in which investors can adjust their strategies with great effect.