The Downside of Negative Rates and the Coming Pension Crisis

A week does not go by on Berman’s Call where we don’t get a handful of emails or calls asking how retirees can get a safe 4-6 per cent yield in their portfolios. The source of this question stems from the Zero Interest Rate Policies (ZIRP) and Negative Interest Rate Policies (NIRP) that central banks have chosen to use to stimulate current demand and economic growth. The safer (lower volatility, higher yield) return of the traditional higher weighted fixed-income portfolio in retirement years no longer exists! In order to get the historical average return of 7 per cent in a balanced portfolio with bonds yielding about 1 per cent globally, equities need to return about 14 per cent, which is extremely unlikely for the foreseeable future given current equity market valuations. Remember, past returns do not equal expected returns.

While ZIRP and NIRP have helped economic growth a little, they might be doing far more damage to retirement savings and pension funds (and future spending) than good in the long-run. A simple average of global interest rates is about 50bps and most pension funds require 5-7 per cent to remain fully funded in the long-run.

You simply cannot replace your fixed-income portfolio with dividend paying stocks unless you can handle significantly more volatility in your portfolio. When the markets are stable or rising, everyone can handle a 100 per cent equity portfolio. But when markets are not rising and stress levels are high, panic often develops and investors sell when they should be buying. The first graph shows the 10-year history of the entire US bond market (AGG) versus the entire US stock market (VTI). You can see that over the period of falling rates bonds have had a pretty stable return with low price volatility compared to stocks, which fell over 60 per cent from the 2007 highs to the 2009 lows. During that period, bonds rose more than 10 per cent, though both fell significantly when Congress voted to write a trillion dollar check to help the economy. Today, a trillion dollar in deficit spending is the norm.

Going forward, however, bonds will not likely provide the same protection given how low yields are making them more volatile too—bond volatility goes up the lower the coupon yield.

We receive lots of questions about high-dividend focused and covered call ETFs that have some enhanced yields versus other holdings. The charts we are looking at show eight of the highest yielding equity/pref/REIT based ETFs compared to the Canadian bond market. There is significantly more volatility in equity based ETFs than in bond based ETFs, so the answer is simply that you will have to be comfortable with higher portfolio volatility to generate a 4-6 per cent yield as long as governments choose low rate policies.

As always, diversification can help. If we combine all of these ETFs together, we can generate a good yield and somewhat less volatility. Bottom line is that low interest rates are a problem and insurance companies and pension funds will struggle to deliver returns going forward. Your retirement savings are your pension fund and insurance for a safe retirement.

We are likely in the late innings of the economic expansion cycle too, so equity market risk is increasing and returns for the next few years are likely to be challenging. You may not like the yield in a short-term corporate bond portfolio, but you will like the volatility when equity markets go through their next major market correction.

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