You are sitting pretty. You have managed to salt away not quite a fortune,
but enough to get by on. Dreams of early retirement dance in your head. Then
your banker phones. The GICs and term deposits that you invested in during the
early 1990s are coming due. He offers you the going rate, less than 3%! Your
capital is intact but it earns next to nothing. To badly paraphrase Porgy and
Bess: "I've got plenty of money, but it earns next to nothing for me!"
To properly understand the concept of income risk, one has to consider the
effect of the movement of interest rates on an investment portfolio. Let's say
we have salted away $1,000,000 in bank GICs after winning the Olympic lottery in
1981. We quit our job and decide to write books on the romantic habits of
earthworms. Being conservative, we decide to only spend the income generated by
our investments.
At this time interest rates were nearly 20% in Canada. That meant our tidy
nest egg earned almost $200,000 a year. While we were out in the garden,
studiously observing the heat being generated by our slimy charges, we were
generating far more income than the average family. As central bankers around
the world fought the good fight against inflation, interested rates dropped
until 1986. In 1986, inflation had dropped to single digits and interest rates
had followed. Taking time out from our research, we would have found that our
GICs were rolling over at less than 10%. This meant our interest income had
dropped to less than $100,000 a year, a 50% decline in income. Poking our head
up from the dirt in 1991 when the GICs came due again, we would have found a
similar picture, leaving our income nearly the same.
The big shock comes in 1996. The interest rate on 5 year GICs is presently
around 5%, giving us a $50,000 income. At this point, if we don't want to dip
into our capital, we clearly have to consider getting a real job and leave our
beloved worms to their own devices.
Something has clearly crept up on us and caught us in our unawares. We've
been the victim of "income risk", which has executed a sneak attack on
our investments. Income risk is one of the least understood and most poorly
communicated risks in the financial world. Everyone seems to know that inflation
is an ugly enemy which results in major shifts in wealth and income flows. Not
many understand that disinflation does exactly the opposite thing, leading to
hugely underestimated shifts in income and living standards for the
unsuspecting.
How does one protect oneself from this lurking menace? That is a good
question, and very hard to do after the fact. Beforehand, however, one must
match there income needs to a proper maturity debt portfolio. If we wanted to
lock in or "fix" our income, we should have invested in a longer term "fixed
income" instrument or bond. Let's say we knew this when we won the lottery
and began our study of romantic worms. Being sharp, we would have bought the
longest-term bond we could have found in 1981, which was then about 25 years.
This would have locked in our $200,000 income stream until well after the year
2000. Of course, in 1981, with rampaging inflation paramount in everyone's mind
this would have been a gutsy thing to do. By 1986, however, it would have been a
reasonable thing to do, sparing us the latest income ravages of the latest bout
of declining interest rates.
What does one do now, however, with low rates and few income boosting
investments available? "Stretch for yield" and "buy equities"
seems to be the favourite advice of many financial experts. Patience is an
investment virtue. If you need income stability, forget market vagaries and
outlook. Find a good quality, longer-term bond that matches your need and invest
"for the long term". Don't "stretch for yield". Avoid
speculative securities which might only pay their stated coupon for a few
payments before defaulting.
Equities, as an investment in the rising cash flows of good companies, are
always a fine choice. Beware the hype, however. Stocks not only go up, they also
go down. Experts of all stripes are floating theories based on demographics,
spirographs and sunspot activities to explain why "it is really different
this time." Stocks are not just bundles of risk and return and blips on a
graph that always moves up. The dividend yield on stocks, the actual cash payout
from holding stocks, is below 3% in both Canada and the United States. Our
unanimous experts are counting on very large price increases to support their
rosy projections (and pay for their next Porsche). If your cash income need is
over 3%, there is a fairly good chance that you will need to dip into your
capital at a point when the market is down. With an equity portfolio, your acid
test will be whether you will be able to keep yourself from throwing in the
towel and selling, as Sir John Templeton calls it, "at the point of maximum
pessimism." This is when you are probably down 30% and the experts cannot
see any light at the end of the tunnel. How likely is a 30% drop? Investment
history shows that this is not that remote a risk.
Just when everyone has recognized the pitfalls of floating rate investments
and the income deprivation caused by plummeting interest rates, caution should
be your watchword. The experts who were unanimously agreed on the great dangers
of inflation cannot now conceive of its return. Easy money has made fools of
those bearish on financial assets of any sort. The last time the financial
experts mocked those stupid enough to invest in low yielding treasury bills,
early 1994, we had an unexpected tightening of monetary policy and horrendous
meltdowns in the value of all but the shortest-term financial assets.
"When cash is trash, prepare for the smash."
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