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Retirement savings

October 12, 2016

Saving for retirement when interest rates are low

Low interest rates make it easier to pay down debt. But they also make it harder to save for long-term goals like retirement.

It wasn’t a surprise to hear on Sept. 7 that the Bank of Canada was holding its target for the overnight rate at a paltry 0.5%. Global economic growth sputtered in the first half of the year. Here at home, the Consumer Price Index rose just 1.3% in the 12 months to July, well below the central bank’s 2% inflation target.

For Canadians frustrated by an interest rate environment engineered to stimulate growth rather than encourage long-term financial planning, there’s no end in sight.

A bit of background first.

Central banks set the overnight rate to manage inflation. It’s also applied to loans made between financial institutions to make sure they have enough cash on hand in the unlikely event that a large number of customers withdraw their funds all at once. These short-term (often 1-day) loans are made on what’s called the interbank lending market. The interest rates applied to consumer loans are also based on the overnight rate.

What’s more important to retirement savings is how all this plays out in the bond market.

When investors believe the overnight rate is too low, which can trigger inflation, they demand higher interest rates from governments and companies borrowing money via the bond market. That makes sense. If the cost of living will be more expensive in the future, then you want to charge bond issuers more in exchange for the loan you’re extending them.

If bond investors don’t anticipate inflation – either because the overnight rate is appropriate or maybe a bit too high – then they’re willing to buy long-term debt at lower interest rates. This is pretty much where we’ve been since before the turn of the century.

While low interest rates are often linked to the 2008-2009 financial crisis, they’ve been a fact of life since long before that time. Interest rates fell steadily through the 1990s and 2000s as inflation fears wound down. It’s been about 25 years since a 10-year government of Canada bond offered investors a double-digit rate.

By the time of the financial crisis, the Bank of Canada’s decision to make a series of further cuts to its overnight rate turned an already remarkable interest rate environment into a real-time economics history lesson.

What do we do if rates stay low?

In a perfect world, low interest rates encourage borrowing by both consumers and business leaders who in turn re-invest those funds into the economy. This is all meant to trigger growth, and move the economy back toward the central bank’s inflation target.

But there are unintended consequences.

For example, fixed income investments (bonds, Guaranteed Investment Certificates, etc.) play an important role in retirement planning. Financial advisors often recommend that their clients hold a percentage allocation that’s roughly equal to their age. As you get closer to retirement, you increase your fixed income holdings. The idea is that you want the reduced volatility that these important investments provide because you have less time to make up for short-term losses.

But as fixed income rates remain in the doldrums, that’s a tough rule to stick by. Meanwhile, the price of other asset classes – stocks and real estate principally – can rise sharply because investors have fewer options to turn to.

Another example: Too many Canadians are borrowing more than they can afford. The average household debt-to-disposable income ratio across the country sits at an alarming 168%. That’s not good for anyone, no matter how cheap the carrying costs.

I think household debt is going to emerge as a significant roadblock to middle-class Canadians’ retirement plans in the coming years. As this extended period of low interest rates persists, we could see thousands of investors who have saved and invested diligently, but who can’t afford to retire because they’re too deep in debt.

Here are 5 recommendations:

  1. Save more. Figure out what you can afford to save each month and have that amount automatically moved from your paycheque to your retirement savings account.
  2. Spend less. Obviously.
  3. Borrow less. Avoid carrying a credit card balance. And if you find yourself with more debt than you can afford to pay off at the end of the month, prioritize repaying those amounts borrowed at the highest interest rate first.
  4. Take advantage of workplace savings plans. They offer lower investment fees than retail mutual funds, and in many cases employers match a percentage of your monthly contribution. If you’re fortunate enough to benefit from an employer match, make sure you take full advantage.
  5. Talk to a financial advisor. This is a uniquely difficult time to prepare for your financial future. Don’t discount the value of a professional opinion.

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