As in the US, commercial banks in Canada have little to do with the level of interest rates. They are merely outposts of the central bank; in this case, the Bank of Canada (BoC). The bank decides monetary policy, seeking to maintain a delicate balance between economic growth and inflation. Inflation is excessive when there is too much money in circulation, the supply of which the central bank increases by purchasing treasury bonds.
When the BoC increases the stock or supply of money and thus the reserves of the banking system—commonly known as “printing money”—it risks price inflation, a decline in the purchasing power of the monetary unit. After all, the larger the supply of something, the less valuable marginal units of that supply become.
During the lockdown crises of 2020 and 2021, both Canada and the US have enacted near-zero interest rates. The one other time that interest rates were near zero was during the 2008 financial crisis. In both instances, low interest rates have been used to stimulate spending and growth by making it much cheaper to borrow money. As of July 14, 2021, the Bank of Canada is maintaining the interest rate at 0.25% and printing money at the rate of about $2 billion per week, down from $3 billion per week. This printing of money is called quantitative easing.
How Will Shifting Interest Rates Affect Your Retirement Plans?
If the BoC sees indications that inflation may run out of control, it will probably act to increase the interest rate, following the lead of lenders who demand higher interest rates as a result of inflation-induced decline in purchasing power. Canada’s debt-to-GDP ratio has already exceeded one-to-one. The current ratio of 117.8% represents a massive increase in debt over the last several years.
Canadian debt has gone through the roof in the years since the 2008 crisis.
Let’s consider how your retirement plan may be affected by inflation. Let’s say that in 1970, you had CAD$50,000 per year at your disposal to pay for all living expenses. In 2021, you need CAD$348,275 per year to maintain the same quality of life. In other words, over the last 51 years, the buying power of your money has declined substantially. If what you earn on investments fails to outpace the inflation rate, over time your savings will evaporate.
Inflation makes it harder to retire comfortably. Meanwhile, even as your stock portfolio gains net value, in the long run its earning power declines. To understand why this happens, you must understand the relationship between bonds and stocks. Both investment vehicles promise a return on your principal investment.
- Bonds promise interest based on the initial principal investment.
- Stocks promise interest based on the earnings of a company.
When low interest rates prevail, they tend to reduce the earning power of stocks and bonds. For instance, consider the fluctuating yields of Canadian bonds.
If you held the bonds until maturity, they yielded less than 2% over a 10-year or 30-year period.
Low interest rates do give stocks a temporary boost. The problem occurs when the stock price rises faster than the company’s earnings. The relationship being affected here is the price-to-earning (P/E) ratio of stocks; lower interest rates increase the ratio. When the P/E ratio is high, you pay more for every CAD$ the company earns in the future; i.e., you pay more up front to earn less in the future. Although this process is not very noticeable in the short run, it is noticeable in the long run, and it affects your retirement plan.
How Rising Interest Rates Affect Retirement
Whether interest rates are rising or falling, the key to the right investment approach is diversification.
When interest rates rise, fixed-income instruments like bonds drop in value in the secondary market. In the secondary market, the securities being traded are securities that investors already own; in other words, the secondary market is the stock market, with the primary market consisting of stocks as they are first issued by companies. The Toronto Stock Exchange (TSX) is one such secondary market. It is comparable to the NASDAQ and the NYSE in the US.
Bond prices tend to fall in secondary markets when interest rates rise because the bond buyer is not paying for the full price of the asset. Because of the time difference when the bond is issued, buyers demand a discount on the par value of a bond when buying older bonds.
In practice, this means that if your retirement mutual fund has a high percentage of bonds, the prices of the assets in your portfolio will drop somewhat. But the same process will also probably increase the dividends that the bonds pays out as new holdings are added to pay for higher rates. When interest rates are on the rise, it may be a good idea to invest in either cash or short-term bonds.
If the Bank of Canada hikes interest rates, your cash savings will benefit from more generous bank terms—especially if you have cash savings in a guaranteed investment certificate or GIC, so that you can now earn more on every CAD you save.
How Much Should You Save for Retirement?
Deciding how much to save for retirement depends on the age at which you plan to retire. The later it is, the more money you will have saved. How much you should save also depends on how much money you need every year to maintain the quality of life you are accustomed to. Consider your daily expenses, hobbies, travel plans, whether you intend to work part-time after you retire, whether you have family dependents, whether you have debt, etc.
A safe withdrawal rate per annum is 4%. If you have saved CAD$1 million, you will be able to withdraw CAD$40,000 for every year of your retirement.
Then there is the matter of government benefits. Canada has two main benefits for retirees:
- Old Age Security (OAS), the payout of which depends on how long you have lived in Canada.
- The Canada Pension Plan (CPP), the payout of which depends on how long you have contributed to the plan and how much you have contributed. As of October 2020, the average CPP monthly payout was CAD$690.
Given these considerations, how much do you need to save?
It is a simple two-step calculation. Subtract the government benefits you expect from your annual expenses, and then divide the result by the 4% annual withdrawal rate. Then you will see how many comfortable retirement years are possible. However, it would be prudent to also take into account the possibility of health problems that require high medical expenditures.
On the other hand, many financial and commercial institutions have discounts for senior citizens, which should help reduce long-term costs.
How to Stay on Track with Your Retirement Plans
Whether you retire at 35 or 65, be careful not to overreact to shifts in interest rates. Take a methodical approach:
Review Your Portfolio
Low-yield bonds are negatively affected by low interest rates, as are traditional savings accounts and GICs. High-yield stock dividends can help compensate for the low return rates of other investments.
Go back to those investment and saving vehicles when interest rates are high; in particular, to bonds that rise with rising interest rates. However, the value of old bonds could drop. So always consider the maturation periods of bonds. The further in the future the maturation periods are, the more sensitive bond prices are to shifts in the interest rate.
Consider Investing in the Stock Market
At the moment, the American market is largely being propped up by the Federal Reserve. Because interest rates have been so low for so long, stocks have reached record levels, making stocks, especially blue chips, an enticing investment. But if monetary policy shifts to higher interest rates, it will become more expensive to take out loans or to pay for goods with credit lines.
Changes in consumer behaviour will tell you which stocks are resilient when interest rates have been hiked. In such a financial environment, people tend to skip discretionary purchases like new cars, new suits, new refrigerators, and new washing machines. But they tend to keep buying nondiscretionary goods and services like utilities and food.
So companies that provide nondiscretionary goods and services and products tend to do best when interest rates are high.
Take Advantage of Better Savings Rates
When interest rates are low, as they are now, you can benefit from them in many long-term ventures. These include buying or renovating a home, refinancing a mortgage, selling real estate in a seller’s market, and buying real estate in a buyer’s market.
When interest rates are high, your cash savings benefit the most.
Bring GICs Into the Picture
Guaranteed investment certificates (GICs) are one of the safest ways to save for retirement. These deposits are guaranteed by the Canadian government. You must deposit cash in a GIC for a fixed period of time. You earn interest on the principal and accumulating interest up to the maturation date.
In a high-interest rate environment, shifting funds from the stock market to a GIC makes sense. But it would be wise to do so for only a short-term period in case interest rates are again reduced.
Use Tax-Advantaged Retirement Vehicles
The Canadian government provides three main types of retirement savings vehicles, each of which offers tax benefits:
- Registered Retirement Savings Plans (RRSPs) enable a deduction on your income tax return depending on the size of your income and of your contributions to RRSP. But when you take money out of the account, it will probably be taxed.
- Tax-Free Savings Accounts (TFSAs) enable you to avoid taxes on the dividend income of various investments. Unfortunately, TFSA imposes a limit on the amount to which this tax exemption can apply, and the limit changes every year. If you exceed the limit, you must pay penalties.
- Registered Disability Savings Plans (RDSPs) are available to Canadian citizens who are eligible for a disability tax credit. Withdrawals from RDSPs are not regarded as income, so they are not tax-deductible. But you can put up to $200,000 in the account during your lifetime.
Stick to Your Long-Term Strategy
To cope with unforeseen changes in interest rates, diversify your portfolio so that it doesn’t need a complete overhaul in and when interest rates change. This means a portfolio with a mix of stocks and bonds. Stock market volatility is a short-term affair; don’t respond to it as if were a long-term one. Hasty decisions result in losses.
Sell your losers and let your runners run. Once you understand which stocks will be affected the most by an interest rate hike, you will realize which stocks to sell in order to put the funds in a GIC instead.
How to Recover From a Setback
During the pandemic, you may have treated retirement savings as an emergency fund and you may have stopped contributing to your retirement savings. To get back to normal, try to resume contributions as soon as possible, starting with 1% of your income and ramping up as quickly as you can to 15% of your income.
Making Your Money Last
The current inflation rate may well exceed the interest rate of any savings , even if there is a hike in the interest rate. With so much money being printed in such a short amount of time, we have entered unchartered territory. The buying power of your cash is likely to steadily erode over time.
Consider investing in the highest-performing blue-chip stocks as a hedge against inflation. For example, the S&P 500 sees an annual rise of 7%, whereas the average inflation rate over the last 100 years has been about 3%.
The corporate landscape has drastically shifted during this time. It has become ultra-centralized, with a few dozen corporations effectively running all human affairs, from logistics and manufacturing to digital content and entertainment. Because many corporations have become “too big to fail,” investing in such companies is likely the safest choice.
Figuring out how interest rates affect your investments is easy once you understand what happens on a fundamental level. Low interest rates make borrowing and credit less expensive. High interest rates make borrowing and spending more expensive. Each component of your retirement investment portfolio is affected differently by changes in the interest rate, and some investments will be more resilient in the wake of such changes than others.