|So, often as a society, we are told that in retirement we must hold a lot of bonds, gics and other fixed income investments because they are safe, low risk and provide steady income.
Compared to the stock market, much of this is true.
But compared to a guaranteed pension, it is not. Read on.
In 2013, interest rates paid on term deposits, GICs, government bonds and corporate bonds are at some of the lowest rates in half a century. A retiree who was used to getting 5% return on term deposits seven years ago now is lucky to get 2.5%. And it has been this way for four years, expected to last longer.
This means a retiree who had $500,000 in GICs earning 5% ten years ago was receiving $25,000 a year in pre-tax cash flow. That’s more than $2,000 a month to buy food with.
- But today, that same $500,000 may be generating just 2.5% return a year, or a measly $12,500 a year or only $1,040 a month! A retiree faces a 50% reduction in quality of life thanks to much lower interest rates on their savings – what is so safe about that???
- By converting some or all of these interest bearing investments to a guaranteed pension for life, the retiree can take advantage of a process of smoothing the impact of interest rate changes over decades – this process serves to provide a pension that offers cash flow yields that can exceed 6% a year for life for retirees over age 60. This pension blows away bonds and GICs in terms of providing a higher cash flow than bonds or GICs can.
Interest earned on safe, fixed income investments is the highest taxed form of investment return. Your tax rate could be as high as 46% on every dollar earned and this significantly reduces the amount you have to spend over 40 years of retirement.
- A guaranteed pension pays you a mix of principal and interest combined together for an effective tax rate that can be significantly lower that your normal marginal tax rate. With the potential for a much higher after-tax cash flow yield from some pension payments, you can have far more money in your pocket every year in retirement.
Interest earned on safe, fixed income investments does not protect you against inflation. Each year our cost of living rises, meaning the price of milk, cost to heat your home and your phone bill goes up. Inflation has been 2% to 3% a year in recent years in Canada.
- If you buy a bond or GIC that is paying you a 2% interest rate for several years, you actually are getting a negative real return of -1% (3% inflation – 2% GIC interest return) and your standard of living is declining as a result.
- Over ten or twenty years in retirement, this will add up – trying to live off the safety of a fixed interest rate bond investment may see your cost of living double in twenty years. Since your investment returns are not keeping pace, each dollar you have now only buys half as much. You would be 50% poorer in twenty years if this was the case.
- Pension payments can protect you against the effects of inflation – the pension payments can be structured to rise each year by the annual inflation rate. This ensures that your payments will increase over time to keep pace with the rising cost of living. This is an essential planning point when desiring retirement cash flow to last for forty years or more. If you think that the price of gasoline or your utility bills will rise over time then you cannot afford to ignore inflation.