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Éric Hallé
Guest Host, Eastern Canada Regional Vice President

David De Pastena
Vice President of Portfolio Solutions

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Éric Hallé: You're listening to On The Money with Dynamic Funds, a podcast series that gives you access to some of the most seasoned portfolio managers in active management, as well as thought leaders in the field of finance.

During our meetings, we ask our guests pertinent questions to get their perspective on the current economic climate, and their advice on how to deal with it.

Welcome to another On The Money podcast. My name is Éric Hallé, Regional Vice-President Eastern Canada for Dynamic Funds, and I host the French version of the series. Today, we're going to explore the challenges investors can face as they approach retirement.

Retirement can be an exciting new chapter in life, but it also comes with its own set of unique financial challenges. With the help of our guest, we'll delve into topics such as managing risk, maximizing retirement income and navigating market fluctuations.

To help us navigate this critical phase of your financial journey, we're joined by Mr. David De Pastena. David has over 20 years' experience advising clients and managing institutional assets. Over the past 9 years, he has focused on working one-on-one with over 500 financial advisors, helping them systematize their investment processes. He also has in-depth knowledge of portfolio composition and specialized investments. Mr. De Pastena holds the following securities: CFA, CFD, CAIA, CIM and FCSI. Hello, David.

David De Pastena: Good morning, Éric.

Éric: It's no secret that the markets have become volatile and dangerous, especially for people living off these assets. Could you remind us why this is a more perilous time than ever for retirees and pre-retirees?

David: Eric, that's a very good question. First of all, we came out of COVID with a rising market that was quite impressive. In 2021, we had phenomenal returns. We look back from 2016 to about 2022, when they started raising interest rates, it was a time when investing was a little easier, even for retirees.

We've reached a different situation perhaps. We're entering a situation where debt levels for countries have never been so high. We're coming to a period in the market's history where volatility has increased significantly, and perhaps this is permanent, where we're going to see more volatility more often.

Statistically, which is perhaps bad news, is that before the next bull market leaves, there are often periods of consolidation when the market rises a little, falls a little, rises a little, falls a little, but we stay in the same range we started with. We saw a similar period from 2000 to 2010, more or less, and possibly this could be the period we're seeing now, before we get the new long-term bull market.

This period, when we see a rise, a fall, a rise, a fall, then what we call a sideways market, is quite dangerous for retirees and pre-retirees. The reason is that if we take someone who's disbursing from their portfolio, so they're making withdrawals, they're taking their capital, and then they're paying for the quality of life, basically. A client who has a million, I use as a round figure, and then he disburses 50,000 a year, but don't forget, the one million at retirement is going to be 950,000. If we have a big correction of 20%, 15%, that portfolio could be worth around 800,000, 850,000. That's going to be a lot. We're reducing our capital a lot.

If we have a retirement portfolio where we're disbursing our assets at the same time as a market that's often volatile, these types of markets, and I don't know how long they'll last, if they continue, can be very dangerous for retirees and pre-retirees. It's going to significantly increase the possibility of running out of money in future years.

Éric: David, you mentioned market conditions that might be easier from 2021 onwards, and often, we can falsely think that investing in the markets becomes easy. The return to reality has been quite steep for many over the past few years.

You mentioned that countries are increasingly indebted, and that greater market volatility is perhaps a new reality. You also alluded to the sideways market, where we're seeing a kind of consolidation of buy and sell positions before the next stock market rally. What can our retirees do in this challenging environment?

David: Éric, there are a number of strategies, and perhaps I can talk a little about them, that inspire me: pension funds. If we step back a little bit to give a history of pension funds for the 40 public companies, at the beginning of the XXIᵉ century and then in the 90s, the trend was that the employer gave us a benefit when we retired. It was common, everyone had a pension fund, then you worked for a long time in the companies.

A couple of things happened. Firstly, these employers around the world took the risk. They took money, which was their money, put it into a pension fund, and invested it.

What's happened is that, with many markets going down, when the pension fund loses money, all things constant under pension fund laws around the world, employers are obliged to put up the difference to make sure there's enough for the annuitants.

The trend over the last 20 years has been for employers to reduce this risk in their pension funds - if there are any left, of course. There are fewer and fewer among large employers. Those that do, what they've done is decided to say: "We're going to manage the risk of this by using a strategy called LDI", which is a cash flow reconciliation. What they're doing is they're going to equalize the liabilities, so the payments to the annuitants, and the assets coming in.

I'm telling you this because it's an interesting way of inspiring us in detail, for investors listening today, perhaps a strategy to consider. I call them paycheque-generating portfolios, but it's the same principle. We create a portfolio that generates income to cover our expenses, just as pension funds do. What happens is that if we have an income-generating portfolio, we never touch our capital. No matter what happens in the market, our income, all things constant, is going to go perpetually.

Éric: David, you mentioned defined-benefit pension funds, which are almost extinct. The risks are really much lower for employers. I think that's understandable in their situation, they don't want to cover a shortfall.

Something you mentioned that caught my attention: generating paycheque-type portfolios. Concretely, if we look into the composition of such a type of portfolio, what are we talking about?

David: I call them paycheque-type portfolios, because they're portfolios that generate income in an organic way. That means that if we invest a million, it's a portfolio that will naturally generate 50,000, 40,000 or 60,000, depending on the amount we choose and the way we create our portfolio.

It's interesting because if we look at the difference between an accumulation portfolio, the 30-40 years before retirement, usually, the target is on return and risk, which are important. In the classic literature, in investment and finance, all those who learned at university, you want to maximize return and reduce risk according to what's called the efficient curve.

It's different for retirees who want to have a portfolio that generates income on a consistent basis, because we don't necessarily want to target the most efficient asset classes, we want to target the most efficient cash flows. We want to take our focus, our target, and then we want to put it on the asset classes, funds, ETFs, equities, that generate income. The focus on income is the most important.

Again, if we generate X percentage of a portfolio, all things constant, if we don't cut that kind of paycheck there, we're going to have it perpetually. There are different ways of creating this kind of portfolio, there are different types of assets. Even some of the big pension funds have this philosophy of looking at-- As I said, they want to reduce the risk of loss, because they want to be sure of paying their annuitants. That's why the balance sheet of a pension fund can be replicated in a certain way with income-generating assets.

Éric: Very interesting, David. You mentioned things like: maximize return, minimize risk, maximize income stream. These are all things that seem very logical, but are you able to give concrete examples of assets that are income-producing?

David: If we look a little bit at pension funds, there are several asset classes that stand out to me. Among others, one of the sub-asset classes that is interesting is real estate. If we look at the owners or shareholders of the large buildings we see in every major city in the world, they are often pension funds. There are several reasons for this.

Firstly, pension funds can predict cash flow in real estate. As we said, what they want to do is, with a high enough probability, they want to forecast liabilities, and then coordinate the two to reduce risk. Because if you have an asset that gives you income, and then you pay that asset to the annuitant, you don't have any risk.

Real estate is quite interesting. There are different types of real estate, of course. There's commercial, residential and industrial. For example, in residential, there are apartments opposite houses, opposite different squares. Real estate is an interesting asset class when you're targeting cash flow, when you're creating portfolios that are supposed to generate income. It happens to be quite an interesting class.

There are different ways of getting into it. You can go on the stock market, obviously. You can be with a manager. We can even buy a building ourselves. Of course, buying a building ourselves involves different risks. This happens to be an asset class where income often rises with inflation. It's very rare for rents to go down, and then often at the same level as inflation. The other very interesting asset class, which is very similar to real estate, is infrastructure.

Why is this? Because infrastructure is a very long-term investment. For example, in Montreal, we have the new train. A major investor in this is a pension fund. And why is that? Because they know that this train will last 20-30-40 years into the future, will have a cash flow that is very stable and very predictable, and will increase over the years. That's an example of infrastructure. If we look even at airports, it's interesting. There are certain mandates that invest in these kinds of businesses.

Infrastructure, then real estate, are asset classes that, all things constant, generate cash flow that rises with inflation, income that is very stable. You can invest in them, receive the cash flow and, of course, spend it with your life. It's a bit like pension funds. Basically, what I'm proposing is to adopt a little of the philosophy of pension funds, and then reduce our risk by having a portfolio that generates income in the types of asset classes I just mentioned.

Éric: Thank you very much, David, for the concrete examples. I think we've all noticed, on a recent trip, the fees that have gone up at the airport or even the number of private or toll roads that are in Quebec, in Ontario. My next question is about stocks. Should retirees continue to hold them?

David: Obviously, the initial answer to that question depends on the individual's level of risk, tolerance and ability to take risk. All things constant, if we're looking at equities. Personally, I think a lot of retirees invest in dividend stocks, but very few people know the difference between different dividend-generating companies.

I'd like to elaborate a little more, to say maybe consider these kinds of companies. I'll elaborate with the two types of companies that pay dividends.

We have one type of company, Company A, for example. They pay out all their profits. They have a fairly high dividend, fairly high income. Sometimes, when profits are too low, they keep that dividend, and then they borrow money to pay that dividend. There are many companies in markets around the world that do this, because they want investors to buy shares for the income. There are pros and cons to this.

The cons are that when things go badly for a company, and we all agree that it's not: "If things go badly for a company", it's: "When things go badly", all companies have difficulties from time to time, depending on the economic cycle, what happens to these companies? They'll borrow to keep that dividend high enough. That's a risk, of course.

The other type of company that pays a dividend is what I call category laws. For them, all things being constant, they'll pass on cost increases to consumers, because consumers like their product, and then they're able to take the increase, and then increase their dividends every year. They pay a little less than the other type of company, type A company, but they increase their dividends. This type of company happens to have an income that corresponds a little more closely to inflation, which rises with inflation.

It's an example of two different types of companies paying different dividends, and then a different way of philosophizing. Obviously, you have to assess which one is more relevant to you. Personally, I think there may be room for the second type of company, or even the first, depending on your stock selection. I'd suggest maybe considering what type of company you're buying in your retirement portfolio, what you're looking for, and then what's the level of risk you want.

Eric: Thank you, David. If I had to summarize, I would say that not all dividends are created equally and it's very important to do your homework. If we look at the situation in 2022, which is a rather special situation, with bonds and equities down significantly, how can a retiree diversify his or her sources of income in such a context? Perhaps you could elaborate with a few examples.

David: I think from this time, I'm going to come back to pension funds, and then I'm going to come back from my experiences with institutional investors. If we look at institutional investors, they've realized that traditional asset classes, for example, bonds and equities, are fine, but if we want something that reacts differently, we need to consider another asset clause called alternatives.

When I talk about alternatives, it's an umbrella that's pretty broad. Basically, an alternative is an investment that reacts differently to the market than equities and fixed income. They react differently, so it could be that when the market goes down, these businesses go up, or when the market goes down, they go down less. I'd like to clarify one thing: I'm talking about alternatives, and I'm suggesting that retirees switch to alternative income.

Obviously, this will come from an alternative asset class, but perhaps to diversify our income. Often, the world is going to have income from traditional asset classes, fixed income that give a coupon, interest income or dividend companies that give dividends or capital gain, but perhaps to look at alternatives that give income that is different. Maybe classified differently, that reacts differently, that you don't have the risk of there being cuts or there being rate hikes and then rate cuts.

I think these days, especially with the year we had last year, we really need to consider having alternatives in our portfolios, especially when we've seen equities and fixed income go down at the same time. We need something that's, let's use yoga a little bit, yin and yang a little bit different. It's important to have that, it's going to decrease our volatility. Plus, we can have income that's uncorrelated, that's very different from other businesses.

It's a bit like having different sources of income that aren't connected. For example, some people have a property, then a T4, then an employer. Obviously, they're not correlated. We try to do the same thing in our portfolios as we do in real life. We want to have diversified income.

An interesting asset class to consider, with less volatility, are alternatives that use bonds, but with no interest rate risk. That could be interesting. We're still invested in bond species, but in a different way. These kinds of mandates are able to generate a coupon, an income, without having a risk correlated to rising or falling rates, or being volatile because central banks are raising or lowering interest rates.

In general, investors should be looking at alternatives or even option strategies. That's interesting these days. It generates income, sometimes in a tax-efficient way, which can be favorable, and then quite high for retirees. According to all the research we've seen, if someone is approaching disbursement rates of more than 4-5-6%, we're not going to have the choice sometimes of looking at these alternative asset classes to increase our potential income.

If we look at dividends, they're not that high, and then interest rates, even though they've gone up a lot, aren't that high for someone who needs more than 6%, for example. There's an important consideration, and I think people should consider alternatives in their retirement portfolios. It's not just for early retirees or people in accumulation. It can be even more important for retirees, because it can sometimes reduce volatility too.

Éric: David, you've given us a lot of options. You talked about strategies, even alternative strategies. What should investors look for to make sure they're holding the most appropriate income-producing assets for them?

David: Eric, I'll sum it up with three things that we always want to use as a kind of check, regardless of whether we're investing ourselves or with an advisor. I think you should always check the consistency of a distribution, regardless of the product: stock, ETF or fund. Does the product itself distribute income at the frequency you want? That's consistency first.

The second important issue, and perhaps the most important in my opinion, is sustainability. I'll give you an example: can this investment continue to pay out, the income, the dividend, no matter how it's paid out, in perpetuity?

Let me give you an example. I talked about companies increasing their debt levels to pay a dividend, but that's not sustainable, it's not sustainable over time. Basically, it's very dangerous to borrow, borrow, borrow. For example, it's like spending more, putting the difference on your credit card, then increasing your credit card. Eventually, you run out of credit. That's a pretty dangerous situation.

Durability. Is the product capable over time, perpetually, with the best way we can do it, obviously, there's nothing that's 100% for life, with a pretty high probability, is this investment going to continue to pay what it's supposed to pay?

I talked about consistency, sustainability, and then the third issue, especially for Canadians, where the marginal tax rate is quite high, taxation is important. Which means, is the investment best for, say, non-registered accounts? Often, if we look, I'll give an example, a fixed-income investment is taxed, all things constant, at the highest marginal tax rate level. We have to look at what we call our net, then our gross in terms of our tax.

You can't just evaluate investments on constancy, on sustainability. Especially for people in non-registered accounts, you have to be very careful about the type of income you receive. Obviously, interest income is taxed much more than capital gains. That's important to consider too, because if we have too much income-- Example, we can lose our old age security, because at a certain amount, the government says: "You've earned too much, you're rich, all things constant, you have to give back your monthly old age security payment."

It's important to consider these three things: constancy, sustainability, and then the taxation of what we receive as income in our investments, to create what I call portfolios that generate paycheques.

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Éric: For our listeners, three things to remember: consistency, sustainability and taxation. David, thank you for your time and opinions today.

David: Thank you very much, Eric, for the invitation.

Eric: As evidenced by our motto, invest in good advice, we encourage investors to team up with a qualified advisor. Thanks for joining us, have a great day and see you next time.

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You've just heard another On The Money podcast from Dynamic Funds. To find out more about Dynamic and its full range of funds, contact your financial advisor or visit our website at dynamic.ca.

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