moneyFYI
Financial Freedom Is Merely Organized Common Sense
What’s Reinvestment Risk?
One and done seldom applies to investing. You can own good companies and rely on the dividends, but it is seldom forever. When I was young, GE dominated the local business community. I worked there in the summers when I was going to university. They had 6,000 employees. Today fewer. If you don’t count the security people, they have none.
The company was the last of the original Dow Jones companies and left that index years ago. Today they are number 81 in the S&P 500. In November 2021 they announced their intent to split, by product line, into three public companies. If you counted on GE forever, you lose. The day of the giant industrial conglomerate has passed.
Reinvestment risk has always been there
It is not commonly thought through. The problem was most common in the 1980s when interest rates were very high. People would sell their business and take the money to the bank and deposit it at a double digit interest rates. Their lifestyle was set and until the deposit renewed they had enough money. If you rely on 12% and the next renewal is at 7%, something must give. Long bonds would have been better as it turned out but rates had been rising and who want to lock in for 25 years at 12% when you can get 14% for five years at the bank. I had a client who, in 1981, got 22% for five years on a large deposit. The bank must have had a loan already done and just needed matching funds. When it renewed in 1986 he got, in his words, “Less!”
People are short term thinkers. I have heard it said that we live in a 6-year time envelope. We can remember three or four years and can estimate two or three in the future.
That is not something that helps you plan retirement income.
Retirement spending and planning
For a couple both aged 65, the odds are 50-50 one of them will live past 90. You can understand that reinvestment risk is part of their life whether they know it or not. That’s where one and done will hurt them. Relying on what is happening today to be lasting forever is a mistake. It doesn’t work like that.
You could look at the list of companies in the S&P 500. If your grandparents were retiring fifty years ago, how many of the top 10 would they have even known about. Probably one. It won’t be different far in the future for you either. For perspective for we old folks, the last Ed Sullivan Show aired more than 50 years ago – 6 June 1971.
Your plan will require an awareness of change and the need to be aware. You will be forced to deal with inflation. Three percent inflation doubles prices in 24 years. It is not a trivial trick to make more than 3% after taxes and inflation. Take someone in the 30% marginal tax bracket, that where the next dollar of income will cost 30%. If they live in a 3% inflation world, they must invest in interest producing assets that pay 8.6% to have 3% after taxes and inflation. That’s 2.6% for taxes, 3% for inflation and leaving them with 3% that just keeps pace with the cost of living.
The capital will be worth less purchasing power in a year and that’s where the reinvestment risk lives. If you 8.6 percent investment comes due in 5 years, your capital has purchasing power of just 86 cents per $1 originally invested. If rates have fallen by then you may need to consume some of it and there is less spending power than there was before.
Look far ahead.
Four things to notice.
- You can’t get 8.6% on a bank deposit today and you likely can’t get one at that rate in the near future. Use your Tax Free Savings Account (TFSA) to the extent possible. You still cannot get 3% after inflation, but you’ll be closer.
- Inflation is not 3%. It is more like 6%. You need 13% before taxes today to keep 3% after inflation and taxes. Good luck with that plan.
- The stock market doesn’t like inflation over long periods. It may help but it will not be a refuge. The taxation of the income it produces is more attractive though. Capital gains and dividends draw less tax cost. Be careful of the OAS Clawback when income passes $80,000.
- If you can reduce your cost of living by even a few percent by careful planning and shopping, you need less income. Suppose you spend $6,000 per month and could save $500 of it with some trouble. In a 4% investment world with 30% taxes, you would need more than $200,000 of new capital to have the same effect. AND saving cost of living is both tax and inflation proof. Do you know an easier way to add $200,000 after tax, inflation proof dollars to your investment pool.
The bits to take away
The future in the long run is not like the short run pasted together many times. It will be up to you to adjust to what is available and can match your needs.
You should know what those needs are and how they will play out in the future. That’s the meaning of the numbers you find.
You cannot plan what you cannot anticipate. Work on the anticipation part.
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I build strategy and fact-based estate and income plans. The plans identify alternate ways and alternate timing to achieve both spending and estate distribution goals. In the past I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning, have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, Banks – from CIBC to the Business Development Bank.
Be in touch at 705-927-4770 or by email to don@moneyfyi.com
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