Tuesday, 25 May 2010

The Retired Investor - Real Return Bonds for Essential Living Expenses

Prior to retirement during the accumulation phase of investing, the main consideration for selecting investment assets and setting each one's target percentage of the portfolio is the optimal mix of return and risk characteristics, in other words to make the most money with the lowest risk.

When retirement starts and income withdrawals are required from the portfolio, it is important to align the portfolio with income needs in terms of:
  • income amount
  • regularity of payments
  • reliability of the income stream relative to the need for the income
  • special financial risks during retirement
Real return bonds (RRBs) are bonds issued by governments whose interest payments and principal are continually adjusted to keep pace with inflation. RRBs are very useful to retirees to pay for the most essential, basic living expenses for several reasons:
  1. Government guarantee - It may be disappointing if you lose your holiday money but losing your grocery or heating bill money is calamitous. The Government of Canada has the highest possible credit rating of triple A so you get the most assurance that the money, both interest and principal, will be paid, will not be defaulted and will not be delayed. The guarantee is doubly important considering the next factor, how long the bonds will be outstanding.
  2. Long-lived investment - Current RRBs have maturity dates (the date when the money will be paid back to you the investor) extending as far out as 31 years to 2041. Since retirement can easily last 30 years nowadays with better health and increasing longevity, such long maturities can be very helpful by matching time horizon of the investment with the retiree's life. Putting in place reliable investments like RRBs that do not need to be monitored are an additional convenience feature.
  3. Inflation protection - Inflation is one of the most surreptitious and pernicious wealth destroyers in the long term. Even the current Bank of Canada target 2% inflation rate will steadily and drastically reduce buying power over many years. Retirees can much less afford to lose their purchasing power since they cannot necessarily go back to work. RRBs are adjusted for inflation according to the CPI, which is as good a gauge of inflation for seniors as everyone else according to CanadianFinancialDIY.
  4. Capital preservation - As a bonus, the guarantee and the inflation-protection of RRBs enable retirees to set aside a legacy of real value if they wish to do so.
How to Use RRBs to Fund Essential Living Expenses
Step 1 - Budget: estimate spending for your most essential needs on an annual basis
Step 2 - Other Income: Add up other sources of equally reliable inflation-indexed income, notably CPP (current maximum payment is $11,210 per year), OAS (about $6,200 per year) and any defined benefit pensions. Subtract that from your needs to see what amount would need to come from the investment portfolio after tax.
Step 3 - Taxes: If the income will be coming out of a registered account as is suggested below, estimate the pre-tax income required by adding back an amount for income taxes. Take your marginal tax rate when retired (see tables by province at Taxtips.ca) - many middle income brackets are in the 30-40% range - and add it back e.g. to get $1000 after-tax at a 30% rate, you will need $1000/(1-0.3) = $1428.57 pre-tax.
Step 4 - RRB Income: Create a spreadsheet like the one below to figure out how much to buy of various potential RRBs to produce the required income. Essential inputs are:
  • Prices and coupon rates for the various RRBs, obtained by phoning your discount broker. There are currently only five issues of RRBs by the federal government, all maturing on December 1st and paying interest twice yearly on Dec. 1st and June 1st. The maturities are 2021, 2026, 2031, 2036 and 2041. Only Quebec and Manitoba issue RRBs and their returns are higher, though of course that comes with slightly less sure guarantees.
  • Index Ratios for each bond - updated every month on this page by the Bank of Canada.
With those two inputs, it is possible to figure out exactly what an individual RBB, or combination of several in a bond ladder, will pay in interest today. Forever thereafter till maturity, the RRB will pay exactly the same amount adjusted for inflation.

In the example, the target income amount is $6000 per year. It is obtained by plugging numbers of purchases of the face amount of bonds (the cells in yellow), which are sold in multiples of $1000, typically with a $5000 minimum. The real yield column - the discount broker will tell you this number when they quote the price - tells us that three issues, the 2031, 2036, 2041 bonds have better yields or returns than the shorter maturities, which is why bigger amounts have been placed into these issues in the example. Note how the current inflation-indexed principal value of the bonds at $184,821 is much lower than the total price today required to buy them, $250,146. The reason is that you will receive much more interest over the life of the bond than the going rate, which is the real yield. To compensate for this, the price is higher.

When the 2021 bond matures, the principal will be paid back to the investor and the $591 in semi-annual interest will stop. The investor will have a choice to repurchase other new RRB issues to gain interest or to buy shorter term GICs, T-bills, money-market funds or keep the money in cash to fund living expenses, where the inflation effects will not be as harmful for the short term. If the principal of maturing bonds is used for spending, the income level can rise substantially - as the table below shows, from 2041 to 2046, the pre-tax annual income from spending the capital of the last bond is $11,225. Would you want to spend it all at that point, and not re-invest any, considering that after 2046 there would be no money left?

Caveats and Limitations
  • Low current yields - In line with low interest rates currently on offer from all types of bonds, the real yield or return on RRBs is under 2%. This is as low as such rates have ever been and real interest rates have been trending downwards for a good twenty years as a graph on this post by CanadianFinancialDIY shows. No one expects real rates to rise much, but if one locks in today for the long term, the price has been paid. Higher real yield would mean that the same income stream could be bought for considerably less. As the spreadsheet shows, it costs a hefty $250,000 today to lock in a guaranteed inflation-protected $6,000 annual income stream. Nevertheless, if the purpose is to lock in essential retirement income and one has the cash to fund it and gain the peace of mind, then why would one wait, perhaps for years, in the hope of higher yield? It is a trade-off the investor has to make.
  • Low returns / yields as a matter of course - On top of the current situation, one should expect that highly secure investments will always produce lower returns. Add in the extremely valuable inflation protection, it should be no surprise that yields and returns will always be on the low end. RRBs are not for growth in assets nor for getting rich; they are more about preserving income, wealth and purchasing power.
  • Ladder five year intervals - It would be much easier to plan the cash flows if RRBs existed at more frequent intervals than five years apart.
  • Ordinary long maturity government bonds might have a better payoff - There are equally secure government bonds paying higher interest rates but they are not inflation-adjusted. If inflation is low, below about 2.2% per year, such bonds will give a better return than RRBs. Above that inflation rate, RRBs win. How much you do not want to worry about inflation is a key question with RRBs.
  • Suitable only for registered accounts - Due to tax rules that make the inflation component of the principal subject to annual tax if held outside a registered account even though the inflation payment is only made at maturity with return of the par value, it really only is feasible to hold RRBs within a RRSP, RRIF, TFSA, LRIF or other such tax-deferred account (see the Bank of Canada's About Real Return Bonds).
  • Disposition before maturity may cause capital loss - If real interest rates were to rise, the usual fall in price of bonds in that circumstance would also affect RRBs and a forced sale before maturity, for example on death of a retiree, might result in a capital loss.
It is also possible to buy Canadian RRBs through ETFs or mutual funds. Another post will compare the pros and cons of these methods vs individual direct purchase.

The unique combination of features possessed by RRBs makes them very worthy of consideration in a retiree's portfolio.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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