The Retirement Crisis: Part 3

The Retirement Crisis: Part 3

From the moment Derek Foster published his first investing guide in 2005, thousands of Canadians have hung on his every word. At just 34, Foster had punched out of his day job as a Radio Shack clerk and telemarketer to become Canada's self-proclaimed "youngest retiree." With a net worth of about $1 million, and time on his hands, he turned to writing. And his books, with titles like Stop Working: Here's How You Can and The Lazy Investor, suggested the path to retirement bliss was alluringly simple. Buy shares in leading companies that pay healthy dividends, he recommended, and hold on to them for the long haul.

Then, in February, eight months into the STOCK MARKET crash that had wiped more than 40 per cent from the value of the TORONTO STOCK EXCHANGE, Foster performed a stunning about-face and sold nearly his entire portfolio of stocks and income trusts. "I held on all last year, but I've been doing lots of research and I don't think we're close to the bottom yet," he told one newspaper in mid-March. "I don't see the market suddenly booming," he told another, the very same week markets launched into the most astonishing mid-RECESSION rally in a century. So what has Foster been doing as markets surged? "I'm reassembling my portfolio," he says. "I tried to get out and get back in cheaper. I'm now replacing some of the exact same names."

If one were looking for lessons from the financial crisis, Foster's U-turn would seem to offer plenty to chew on. Like don't get wedded to any particular investing style. Or if you do, don't panic when things turn rocky. Not that Foster, who just published his fourth book, Stop Working Too: You Still Can!, says any of that applies to him. He insists he didn't get spooked by the crash, and says that bailing out near the bottom of the market, and then buying back in after the rebound didn't cause him any grief, or even lose him any money. "I'm not any further ahead or behind where I would have been," he says, thanks to a side strategy of buying put options, a complicated tool that lets investors bet on falling stock prices. Instead, the number one lesson Foster says he learned from the experience was not to share every investment decision he makes with the public.

For everyone else though, the lesson should be blindingly obvious: don't listen to anyone who tells you they've discovered the path to easy riches and a carefree retirement.

There are as many lessons to be gleaned from the Great Recession as there are smashed retirement dreams. The sudden collapse of the markets took almost everyone by surprise, and spared no one. Yet not everyone suffered to the same degree. In fact, while some investors saw their life savings decimated, others managed to emerge relatively unscathed. What did the second group get right, and the first group do so wrong? In the same way that economists and government officials are raking through the ashes of the old financial system to figure out ways to avoid a repeat of the chaos, investors can learn key lessons by looking back to help them as they save for retirement.

Lesson one might be simply to recognize your own mistakes. "When it comes to personal finances, most people don't spend the time to find out how exposed they are to a shock like this," says David Trahair, a chartered accountant in Toronto and author of Enough Bull: How to Retire Well Without the Stock Market, Mutual Funds, or Even an Investment Advisor. "Unfortunately, a lot of them learned that the hard way."

Long before anyone was talking about collateralized debt obligations or the credit crunch, many investors had already unwittingly loaded up their portfolios with explosives timed to go off at the first sign of trouble. And many had become convinced that the seemingly unstoppable rise in stock prices offered a one-way ticket to the good life. As many boomers moved closer to retirement, and discovered they hadn't saved enough, they piled into investments promising high returns and low risk. Some, like the $32-billion market for asset-backed commercial paper in Canada, blew up in spectacular fashion. Canadians had also piled into income trusts for their hefty cash payouts and perceived stability. But even without the impact of a new federal tax on income trusts, which is set to take effect in 2011, many trust companies ran into trouble. As the recession took hold, they were forced to slash payouts.

Yet it wasn't just products cooked up by the financial engineers on Bay Street that deep-sixed investors, say experts. Over the last year, Adrian Mastracci, a financial adviser at KCM Wealth Management in Vancouver, has seen a steady stream of clients come to him with shredded portfolios. One thing almost all had in common was the lack of a written financial game plan to give any focus to their investments, he says. Some of the walking wounded had their entire portfolios in equities, while others went even further and ploughed all their savings into hot sectors like oil and gas stocks. "Investors often don't realize all the risks they're incurring," he says. "When you're heavily into one sector, you can get creamed." And that's exactly what happened.

What's worse, some Canadian investors borrowed heavily to buy stocks, a practice known as margin investing. At the very peak of the market, in July 2008, investors owed a record $16.3 billion in margin accounts, according to the Investment Industry Regulatory Organization of Canada, the industry's self-appointed overseer. When stock prices went into free fall, banks called the loans. To come up with the necessary cash, many had to sell their investments on the way down, guaranteeing a loss. One of the world's most high-profile margin calls saw Russian oligarch Oleg Deripaska forced to unload his $1.54-billion stake in Magna International. Many retail investors were equally caught up in the downdraft, even if their stories didn't make the headlines.

But the surest way to guarantee steep losses, whatever your portfolio looked like, was to panic. When markets collapsed and it appeared the recession was on the verge of morphing into another GREAT DEPRESSION, headlines screamed blood on the streets and warned of the complete collapse of the financial system. Large numbers of investors dumped their stocks and mutual funds, crystallizing their losses.

Rather than buy low and sell high, investors did exactly the opposite. Through most of 2007, the last full year of growth and soaring stock prices before the recession, equity funds were the bestselling category of funds, according to the Investment Funds Institute of Canada. During the worst of the crisis, Canadians dumped those very same funds. Between September 2008 and this past April, investors withdrew $7.4 billion more from equity funds than they put in, even though valuations were being cut in half.

Put another way, $1,000 invested at the peak of the market last year fell in value to just $493 in March, but by this week had rebounded to $740 - still a painful loss, but not nearly as bad as it might have been if you'd panicked. "The problem is, humans deal in emotions, and if you had watched your portfolio plummet by half its value, would you have had the guts to not sell?" says Trahair.

Of course, it's easy to say don't panic now. But some investors were also able to stay calm through the crisis because their portfolios, with a healthier balance of stocks, bonds and cash, were far less risky. Trahair thinks many investors should go even further in avoiding risk. In his book, Enough Bull, he argues that GICs, long the black sheep of the financial advisory world, should play a much greater part in many peoples' portfolios. For one thing, GICs and the interest they pay are guaranteed, unlike stocks or mutual funds. Trahair says the financial crisis is also proof positive that most investors can't stomach the wild ups and downs of the stock market.

Critics have been quick to diss the approach, pointing to the record-low rates GICs pay (a one-year GIC offers just 1.2 per cent while a five-year GIC guarantees around 3.25 per cent). But over the long run, GICs have proven not only to be safer than stocks, but also quite fruitful. Over the last half-century, the interest from five-year GICs has averaged 7.3 per cent, compared to six per cent from the S&P TSX. Even more astonishing, between Dec. 31, 1998, and the end of last year, a portfolio of laddered GICs - a strategy in which an investment is staggered over short- and long-term GICs and then rolled over as they mature - generated an average annual return of 3.9 per cent. The S&P TSX, meanwhile, excluding dividends, returned 3.3 per cent. (If dividends are factored in, the TSX returned 5.34, a meager premium considering all the added risk.)

As for today's low interest rates, many economists expect rising inflation will eventually force central banks to raise rates. "Interest rates are at historical lows, they can't get much lower," says Trahair. "The stock market? Who knows, it could go higher, or lower."

It all comes back to the question of risk versus reward, a dynamic completely neglected over the last decade. The problem wasn't just that investors forgot, or even ignored, the art of risk management. The advent of complex financial instruments devised to mitigate uncertainty lulled economists, bankers and investors into believing that risk was no longer a cause for worry. Yet in the end, those very investment products amplified the damage and carried it to every sector of the economy.

So despite what financial planners have promised, you can't have it both ways. The reality is, the safer the investment, the less money you're likely to be able to stash away. And that means many Canadians will have to downsize their retirement expectations if they want to be able to sleep at night and not fear another gut-wrenching crash.

They might start by getting their personal balance sheet in order. Canadians are clearly living beyond their means, and the situation, surprisingly, is getting worse. According to a report earlier this year from the Certified General Accountants Association of Canada, consumer debt reached a record $1.3 trillion last year. Canadian households now owe $1.36 for every dollar of disposable income, up from 97 cents of debt for every dollar of income in 2000.

Scott Hannah, president of the Vancouver-based Credit Counselling Society, which helps consumers who are drowning in debt, says he's seen little evidence households have learned anything from the financial crisis. Nor have they paid much heed to what happened in the U.S., where plunging house prices have left millions of households underwater on their mortgages. He points to the resurgence of the housing market in Canada as a worrying sign. Canadians are once again taking out massive mortgages at record-low rates. When it comes time to refinance, their monthly payments could easily skyrocket.

It's not all that different from what happened in America's subprime housing market. Only instead of low mortgage rates being a product of financial alchemy on the part of lenders, rates are low due to the recession and the massive intervention by central banks. Just last month, Bank of Canada governor Mark Carney warned Canadians not to overextend themselves with large mortgages bought using "exceptionally low" interest rates. Here's why he and others are concerned. The monthly payment on a $250,000 mortgage taken out when five-year mortgage rates were four per cent would jump from $1,319 to nearly $2,000 if rates rose to just eight per cent, where they were earlier this decade.

"People haven't learned that the difference between being financially stable and being in financial chaos is a pretty fine line," says Hannah. "Quite frankly, the average person who hasn't managed their finances effectively would have been better off, in the long term, if our so-called recession hadn't been over so quick. Those lessons that my grandparents learned in the dirty thirties stayed with them for life."

In the absence of learning life lessons, some argue that investors and consumers need more formal education in the ways of money. Governments are beginning to step up on that front. In June, Finance Minister Jim Flaherty launched a task force on financial literacy. Earlier this month Ontario said starting in 2011 it would begin teaching students in Grades 4 through 12 the basics of managing their money.

The crisis has also stirred calls for more regulation and oversight to protect investors. But so long as investors assume markets will always go up and that there are no consequences to living beyond one's means, more red tape will have limited effect.

In the end, will we come away from the financial crisis any smarter? History isn't very encouraging on that front. The line "this time it's different" has been repeated over and over again during the last year, yet the root causes of this crisis - over-leveraging, lax regulations and ignoring risk - have played out before with disastrous consequences.

Perhaps the best lesson to take from the fall is to simply remember that sooner or later, it will happen all over again. Will you be ready?

See also PENSION.

Maclean's November 30, 2009