When I Am Sixty Four – Part I


By John Nicola CLU, CHFC, CFP

IN THIS ISSUE: This is the first issue of a 3-part article that will review and analyze the impact of demographics on both our wealth and our health – a notion we refer to as WHEALTH. Here in Part 1, will discuss demographics, their impact on the economy, and what we can achieve in the resulting market.
 

“When I’m 64” was one of the quirkier hits on The Beatles’ 1967 album “Sergeant Pepper’s Lonely Hearts Club Band”. It may surprise you to know that Paul McCartney wrote the song as a 15-year-old, 10 years earlier in honour of his own father.

In one year’s time, Paul McCartney will be 64. Paul – say it ain’t so.

On the other hand, he is the father of a two-year-old and looked pretty good in his 2003 performance in front of 100,000 people in Red Square.

While we are not all destined to become ageing boomer rockers, we certainly are getting older. It can be argued that demographics are the most signifi cant factor in how our fi nancial and health outcomes will unfold. Never in human history has such a signifi cant portion of the world’s population reached old age while extending life expectancy. Today it is estimated that the TFR (Total Fertility Rate) of the world is now 1.8, which is below replacement, and global population will peak much sooner and with fewer people than was expected just 20 years ago.

How could demographics impact our health, fi nances, work and education? In the next three newsletters we will explore some of the possibilities and make suggestions as to how to adapt to this “brave new world”. For some it will prove to be an exciting extension of life as they age full of vitality, good health, and complete fi nancial security. For others it will be a long, slow, and perhaps painful decline. I truly believe that most of us can control or signifi cantly affect which of these outcomes will be ours. The future, in this case, is predictable, so we can offer few excuses for not being prepared. We cannot say we did not see it coming. 

I truly believe that most of us can control or signifi cantly affect which of these outcomes will be ours. The future, in this case, is predictable, so we can offer few excuses for not being prepared. We cannot say we did not see it coming.

Some of the issues and concerns we will review are:

  • There are as many individuals over 60 as there are under age 5 for the fi rst time in recorded history. Within 40 years that 1:1 ratio will become 4:1 as we age while having fewer children.
  • In many developed countries, individuals are spending more time in retirement than working (thanks in no small part to generous public and private pension plans which, in many cases, are underfunded and unsustainable). When “retirement” was introduced as a concept by Otto Von Bismarck in the 19th century, less than 2% of the population survived to age 65 and there were 40 workers for each of them. Today there are 3.3 workers (soon to be 2) per retiree and more than 12% of the population is already over 65.
  • Our savings rates in Canada and the US have dropped to record lows while interest rates on our savings are also at the lowest they have been in 50 years and equity returns have been flat for the last 5 years. This is a tough environment in which to create financial independence.
  • Neither the promises of our current government pension (for virtually the entire OECD) nor our commitments to long-term health care are affordable. We will receive less in pensions and collect them later and, possibly more importantly, we will be responsible fi nancially for more of our own health care.
  • Life expectancy has increased to the point where there is a good chance your children will be grandparents before you die. What does that mean for estate planning? Would you be better off (and feel better) about sharing your estate with family and charitable causes well before your death?
  • And speaking of living too long – how can one develop the best health habits so that our extended lives are vibrant and meaningful as opposed to a long, slow, painful decline? How can we e nsure we do not outlive our capital?

Over the next three newsletters, we would like to review and analyze the impact of demographics on both our wealth and our health. What we call WHEALTH Management.

From everything I have read so far, this is similar to a gripping mystery novel a la The Da Vinci Code – where the hero and heroine are fi ghting against huge odds, but in the end it works out well (although it could be argued that describing demographics as “gripping” is a leap).

In this case, the key will not be in solving the clues as much as it will be in understanding the issues and being very well prepared for them. In this story, good planning will be everything.

Ageing and Investing:


Bernard Baruch lived to age 95, and if the quote above is any indication of his attitude to ageing, then thinking “young” is a factor in longevity. But with long life comes the increased burden of outliving our fi nancial resources.

It is no news to most of us that we are ageing – individually and as a society. And while we may temporarily turn back the waters in the style of King Canute, inexorably the tide comes in.

There has been no society in recorded history that will experience the change in demographics that we will. So in many ways this is uncharted territory. In addition, there are ageing trends occurring now that cannot be sustained. As such, they will change – we may not be sure how, but we can make some educated guesses.

Here are some hard facts:

  • About 12% of North Americans are over age 65 and that will increase to 21% by 2040. At the same time, the 40-64 year old cohort (which makes the highest income and pays the most taxes so that our social programs are affordable) will shrink from 33% to 28%.

Retirement Boomers:

In the next forty years, Canada’s over-65 population will almost double

  • Most health care and public pension funding is spent on older people. According to StatsCan, the wealthiest demographic group in Canada is between ages 55-64 at a median net worth of $155,000 in 1999. For those over 64 it is $126,000. In both cases, these are up between 19% and 56% when compared to 1981 levels. Meanwhile, the net worth of 25-34 year-olds has dropped 35% to a median level of $15,100. These are the people who we hope will fund CPP and OAS for older wealthier Canadians. A very optimistic assumption.
  • Our birth rate has now dropped to 1.5 which is below replacement and also below countries such as the UK, France and the US. In 2004, there were 331,000 births vs. 234,000 deaths for a net gain of 97,000 and this number is reducing rapidly (it was 107,000 in 2003). Only the inclusion of 193,000 immigrants allowed our total population to increase by 1%.

 

Be Fruitful and Multiply (In Fractions)

Population growth has curtailed and we are no longer at replacement levels

  • The Fraser Institute, in its 2004 report on the fi nancial health of Canada, reported that even though our total “offi cial” National and Provincial debt was 70% of GDP at $790 billion, the total present value of all National and Provincial obligations such as health care, OAS, workers compensation, and public pension plans like CPP, is another $1.6 trillion dollars. Every OECD country has such deferred liabilities.
  • Life expectancies are increasing in the developed world while individuals are retiring at younger ages. In 1960, a male worker could be expected to retire for 15 years after 45 years of work. Today, the ratio is about even at 34 years of work and retirement. Much of this comes from generous pension structures that have given current retirees benefi ts that are not properly funded and therefore not sustainable for future generations.

 

All Play and No Work

We are beginning to spend less time in the workforce and more time in retirement

Many pension funds are well-invested and still struggle fi nancially. Consider the Ontario Teachers Plan that has an average net return of 11.4% annually for the last ten years and is still about $19 billion under-funded with total assets of about $84 billion. Why is this? There are several reasons. Firstly, there are now 1.6 working teachers for every retiree vs. 4 in 1990; secondly, the average teacher is retiring at age 56; and lastly, a full pension benefi t of $40,000 annually (indexed) costs about $800,000 to buy today vs. $630,000 in 1999 because of lower interest rates.

Nothing previously mentioned is really news to anyone who has read any number of articles or books on ageing. This might lead one to assume that we are dealing with these issues by saving more for our retirement. In fact, in the OECD the opposite is true. The chart below shows how much savings rates have dropped in many countries even as they age.

Why would reasonably intelligent residents of these countries not save more (the Italians being notable exceptions – but then look what a cappuccino costs there)?

There could be many reasons. One that has been written about more recently from a number of investment specialists and economists (including John Mauldin, Richard Russell and Robert Shiller) involves the wealth effect of the stock market in the late 90’s combined with the housing boom (so far) of the 21st century. These factors may have left people with the feeling that their wealth is increasing fast enough so that they can save less and spend more. Even though equity markets have been basically fl at for fi ve years and interest rates are at 50 year lows, the economy is pretty good globally and the low rates have been a major factor in housing prices.

The problem, of course, is one cannot eat one’s home (Hansel and Gretel notwithstanding) during one’s retirement. To assume the boomer generation can all downsize their homes to a younger generation (that has less income and net worth) for a tidy profi t would suggest we are all wearing rose-coloured glasses.

A Penny Saved…

Savings rates have virtually plummeted over the past decade and a half

We have spent all of this time focusing on problems and crises. What about solutions and opportunities? On the following page is a partial list based on what we are investing in now (or are considering) and what else might be worth a look. But first, what are some of the outcomes we might see as we go forward?

  • Retirement ages will stop dropping and eventually increase towards our mid 70’s.
  • We will have to fund an ever increasing percentage of our health care costs privately, and both health and fi nancial benefi ts will go to those who get preventative health care.
  • While OECD savings rates are low, overall global savings rates are high (China, India and much of the developing world are, in effect, continued on financing our spending). That is combined with the huge growth in the effective global labour force that has occurred since the end of the Cold War in 1989 and the inclusion of China as a productive trading nation. Together, these could keep a lid on interest rates for far longer than we might imagine today. In other words, a low interest, low inflation (or deflationary) environment.
  • Birth rates are unlikely to increase, and that would mean higher levels of immigration to Canada just to maintain our population.
  • Savings rates have to rise if people want the investment capital they will need to retire comfortably. This will reduce spending which could also exacerbate the potential for deflation. It is interesting to note that in the OECD, the countries with the highest savings rates have the lowest growth. This makes sense, since they are deferring gratification today for consumption later on. All the high savings countries have older median populations than Canada, Australia and the US.

So what looks good from an investment point of view? We have focused on cash flow for many years as the key component to a good investment. To that we must add diversification, because as Betty Davis said, “Fasten your seatbelts – it’s going to be a bumpy night (ride)”.

  • Safe bonds may do better than one might expect given debt levels. It might be better to buy inflation-linked bonds just in case spending trumps global savings.
  • Common shares with high dividend yields that have a good growth pattern. The dividend yield of both the S&P 500 and TSX is about 1.8%, and since about 70% of your long-term total returns from equities come from dividends, this is not a good place to start. You can find a solid group of companies that have better yields and good growth in dividend payouts as well.
  • In some cases, it will make sense to take a hedging strategy and write options on common shares already owned. This will limit upside potential if stock prices rise, but increase current income when combined with dividends. This is a proven approach in markets where overall price appreciation is hard to come by (as we feel is the case today).
  • Annuities can provide significantly higher after-tax returns than bonds with similar investment risk. They also can solve the problem of outliving one’s capital since payments usually continue for your life or that of you and your spouse. While they are not liquid, they can be leveraged if needed and can form an attractive base for a truly balanced portfolio. For younger investors, buying annuities on healthy parents can also work well.
  • While we have reasons to be concerned about housing, we do feel that investment grade commercial real estate has a place in most portfolios. The key is that the net income yield (cap rate) needs to be ideally 2%+ more than the borrowing rates for mortgages. Today, commercial 5-year mortgages are about 5%, so the cap rate should be 7% or higher. Many other factors apply and REIT’s are also another way to participate in this market (although many of them are getting expensive when compared to their underlying real estate).
  • Income trusts have been very good investments for our clients for the last 6 years. Is it too late now to invest in them? Any asset class that appreciates as much as this much (although from very depressed levels in some cases) is likely to see corrections at some point. However, if one chooses quality trusts with low payout ratios (that is, their distributions are significantly less than their cash flows) in areas that are likely to at least keep pace with inflation, then price fluctuations would simply be an opportunity to increase one’s position.

Overall, ageing will create many difficult issues and choices for both governments and individuals. Because we tend to act slowly, it is likely that this crisis will get worse before it gets better. The best defence is, arguably, to be well informed, have a savings rate of ideally 15% or more and be well diversified in a cash flow generating portfolio.

Then when you’re 64, you can be like Paul and have a two-year-old.