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Rate of return risk

Preparing financially for retirement requires putting money aside now, to use later. That money is often invested in financial products generating investment income that will be used when you retire. Those investments each have their specificities and their level of risk This link will open in a new window..

The rate of return risk is directly associated with the uncertainty of returns on investment income. It is therefore not only associated with a loss of income, but also with possible variations in investment income. It is therefore important to take into consideration the rate of return risk when preparing for your retirement.

There are 3 ways to manage the rate of return risk :

  • avoiding the risk, that is, not investing your savings or investing your savings in vehicles with a lower but guaranteed return
  • transferring the risk, that is, having it covered by a party other than yourself, by an insurance company, for example
  • controlling the risk, by choosing the level of risk that suits you best.

To manage the level of rate of return risk, you can choose an investment strategy :

  • secure, which is made up of a greater proportion of fixed-income investments (guaranteed investment certificate, obligations, etc.) and a lower proportion of variable-income securities (for example, Canadian, American and international shares)
  • balanced, which is made up of equal shares of fixed-income investments and variable-income securities
  • growth, which has a greater proportion of variable-income securities.

Therefore, your investment strategy can include various types of investments, and the weighting of each of them will change throughout the accumulation and withdrawal period, before and after retirement. Obviously, even the best investment strategies have years of poor performance.

To illustrate how savings change throughout the accumulation phase, Table 1 below shows, for a person age 60, an accumulation period of personal savings over 30 years, based on 3 different investment strategies, that is, secure, balanced and growth, and periods of different returns, that is, low, average and high. In the example, the annual savings deposit is $5000.

It is important to remember that the annual deposit can vary based on your income and the income replacement goal you have set for yourself for your retirement, including income from your pension under the Québec Pension Plan, income from the Old Age security pension and income under a supplemental pension plan, for which you do not have to assume the rate of return risk. You must also remember that the sooner you start saving, the higher your savings will be.

Table 1: Accrued amounts, based on different investment strategies and rates of return, for a person age 60, over an accumulation period of 30 years

Return Strategy
See the description of Secure See the description of Balanced See the description of Growth
Low ($) 228 000
See the description of i = 2.6 %		241 000
i = 2.9 %		245 000
i = 3.0 %
Average ($) 276 000
i = 3.7 %		332 000
i = 4.7 %		395 000
i = 5.7 %
High ($) 339 000
i = 4.8 %		456 000
i = 6.5		634 000
i = 8.2 %
Secure strategy=75 % of fixed income, 25 % of variable income, annual deposit of $5000.
Balanced strategy=50 % of fixed income, 50 % of variable income, annual deposit of $5000.
Growth strategy=25 % of fixed income, 75 % of variable income, annual deposit of $5000.
Note: the invested capital is of $150  000  (30 x $5000)
i=represents the expected return according to the chosen strategy.

Over an accumulation period of 30 years, with average returns and a secure investment strategy, you could accumulate $276  000 (that is, $150 000 in capital and $126 000 in returns). With a balanced or growth strategy, it is respectively $332 000 and $395 000 that you could accumulate with the same invested capital. In the case of a growth strategy, it is nearly twofold.

Therefore, the strategies with more variable-income securities provide a higher return (5.7 % vs. 3.7%), but with increased risks. In a period of average or high return, those strategies provide higher accrued amounts, whereas taking additional risks can result in almost identical returns (3.0 % vs. 2.6 %) in periods of low returns.

To illustrate how savings change throughout the withdrawal phase, Table 2 shows the age at which an individual will have exhausted his or her personal savings based on his or her investment strategy and different periods of return.

Table 2: Age at which an individual will have exhausted his or her savings, based on different investment strategies and periods of return, for a withdrawal period beginning when the individual is age 60

ReturnStrategy
See the description of Secure See the description of Balanced See the description of Growth
Low80 80 80
Average83 86 91
High86 97 >110
Probability for an individual to exhaust
his or her savings before age 90 		100 %73 %48 %
Secure strategy=75 % of fixed income, 25 % of variable income, annual deposit of $5000.
Balanced strategy=50 % of fixed income, 50 % of variable income, annual deposit of $5000.
Growth strategy=25 % of fixed income, 75 % of variable income, annual deposit of $5000.
Note: It is presumed that an amount of $100 000 was accumulated when the individual is age 60, that the annual withdrawal beginning at that age is $5000 and it is increased each year by 2 %.

By retiring at age 60 and by choosing a secure investment strategy, with average returns, you could have exhausted your personal savings at age 83. Thanks to a balanced strategy, you would have savings until age 86  (+ 3 years) and, thanks to a growth investment strategy, until age 91 (+ 8 years).

However, if returns are lower, you could have exhausted your personal savings at age 80 by using one of the 3 strategies. The lower returns could therefore move up the age at which you could have exhausted your personal savings from 3 years (secure) to 11 years (growth) compared to a period of average returns.

However, if returns are higher than the average returns, you could have exhausted your personal savings at age 86 (secure) and at more than age 110 (growth). The high return could therefore postpone the age at which you could lack savings from 3 years (secure) to 19 years (growth) compared to a period of average returns.

It is also important to note that the probability of exhausting your savings before age 90 is 100 % with a secure investment strategy. It drops to 73 % with a balanced investment strategy and to 48 % with a growth investment strategy.

In conclusion, the investment risk is often perceived as being negative, but the longer your investment horizon is, the more a growth strategy is beneficial in both accumulation and withdrawal periods. However, the strategy you choose is very personal and it remains your choice. You must be comfortable with your choice as well as with the level of return risk it provides.

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