Low yields are 'new paradigm' for long-term investors

Crisis presents hard choice between taking on risk to achieve retirement goals and getting caught in sharp downturn

Low yields are 'new paradigm' for long-term investors

Investors saving for retirement will have to shift their long-term thinking because of a low-yield environment that could last until well after 2023.

That’s the view of Todd Mattina, chief economist and senior vice-president at Mackenzie Investments, who believes low yields are the new paradigm for long-term investors, rather than just a cyclical bump in the road.

He said the current crisis has simply sped up the ongoing shift towards a “lower-for-longer” yield environment. This is especially challenging for retirement savers who need to make hard choices between taking enough investment risk to achieve their retirement income goal versus the risk of a sharp drawdown in asset valuations during retirement.

Mattina said: “With a commitment to keep interest rates at the lower bound of 0-0.25%, the Fed has signalled to investors that it will maintain an aggressively expansionary policy stance until inflation and economic activity recover.

“Based on swap markets, investors expect that the Fed’s policy interest rate will stay around zero until well after 2023. The combination of low nominal rates anchored by the Fed and gradually rising expected inflation imply that low real yields could persist until well after the economy recovers.

“While low risk-free rates are supporting the economic recovery, ‘lower-for-longer’ yields will be a headwind for long-term savers.”

So how can investors cope with this environment and position themselves well for retirement? Mattina believes that employing a laddered portfolio of nominal government and inflation-linked bonds is a useful benchmark for retirement portfolio planning. This “Minimum Risk Portfolio” (MRP) is a theoretical portfolio that provides inflation-adjusted cash flows in retirement, allowing investors to smooth lifetime spending.

He explained: “Designing portfolios relative to MRP enables investors to shift their focus from asset-only performance - returns relative to benchmarks - to returns relative to growth in their future retirement income needs - i.e., ‘surplus risk’.

“However, funding the MRP requires high savings rates and does not hedge key risks, such as outliving your retirement nest egg due to longer life expectancies and unexpected spending needs.”

Therefore, a shift is required in the focus on retirement planning because, frankly, lower interest rates have made saving for retirement more expensive, and hence the planning much more challenging.

While saving enough assets to implement the MRP is too expensive for most investors given “lower for longer” interest rates and the MRP may not take enough risk to cover increased longevity and unexpected expenses in retirement, prudent exposure to equities will likely remain necessary for many long-term savers in addition to significant fixed-income duration exposure, he said.

“However, retirement savers still need to manage surplus risk, or the volatility of investment returns relative to retirement income needs, to avoid the “risk of ruin” in retirement. Smart portfolio construction can help reduce surplus risk and the tail risk of large stock market downturns.

“Alternative investment strategies with absolute return objectives and low correlation to traditional stock market returns as well as outcome-oriented asset allocation strategies with downside protection using options could play a useful role.”