Financial risks to avoid

1. POTENTIAL FINANCIAL RISK AREAS TO AVOID
http://www.retirementplanning.ca/2006/07/29/potential-financial-risk-areas-to-avoid/
There are many risk areas that could affect your financial net worth, cash flow, quality of retirement,
and lifestyle. In many cases, you can eliminate, minimize, or control each of these risk areas by knowing
about them, doing research, and making prudent decisions. Statistically, if you retire at 55 years of age,
you can expect to live to 85 and have 30 years of retirement–almost as long as your working life. Planning to
have enough funds to meet your lifestyle needs is obviously very important. Some of the following potential
risk areas are interrelated, but they are considered separately because they should be specifically identified as
risks. They all have financial implications, directly or indirectly. By obtaining customized financial planning
advice from objective and qualified tax professionals, you should be able to anticipate and neutralize many of
the following risks.
Currency risk
This is a particularly important issue if you are a Snowbird or travel a lot. If the Canadian dollar drops in value
relative to the U.S. dollar, you will obviously notice an increase in the cost of living due to the reduced
purchasing power of your Canadian money when you convert it to U.S. currency. The value of the Canadian
dollar is dependent on many variables, both national and international. If it goes down five per cent, you have
lost five per cent of your purchasing power in the United States.
Inflation risk
This is one of the most serious financial risks to those in retirement. Although both Canada and the United
States currently enjoy very low inflation rates, that can quickly change. As you are probably aware, inflation
eats away at your purchasing power. Inflation at five per cent will reduce your purchasing power by 50 per
cent in less than 15 years. If you have investments that have interest rates or value that changes with the rate of
inflation, or if you have annuities or RRIFs indexed for inflation, then your purchasing power would at least
remain constant. If you have a fixed income, the inflation issue is especially critical.
For example, with Canada Savings Bonds, inflation would erode the purchasing power of the bond as well as
the interest. You also have to look at the real rate of return on your money after tax and inflation is factored in.
If you were earning 3 per cent interest and were taxed at 35 per cent, your net return would be 2 per cent. If
inflation were 3 per cent, you would actually be losing purchasing power with your money, in real terms.
Deflation risk
If there is a severe or prolonged economic downturn or recession, the value of your assets could drop
accordingly.
Interest rate risk
Interest rates in Canada and the United States have been very volatile over the past 15 to 20 years on any type
of interest-sensitive financial investment. In the early 1980s the prime rate was in the double digits, even up to
22 per cent. This was of course attractive for people with interest income from term deposits, mortgages, or
bonds. By the mid-1990s however, rates had plunged to the low single digits, sometimes down to two per cent,
which happened in the last several years. Interest rate risk can cut both ways, however. For example, if you set
your lifestyle needs based on high interest rate returns, your lifestyle will be negatively affected when rates
fall. Or if you lock yourself into a fixed-rate bond when rates are low and then interest rates increase, the value
of the bond investment will go down when you try to sell it. Another example is a locked-in annuity bought at

2. a low interest rate. If rates go up and there is inflation along with it, your purchasing power and lifestyle will
be affected.
Government policy risk
The Canadian and U.S. governments are constantly changing the tax or pension laws, depending on the
political philosophy of the party in power and economic pressures. For example, Old Age Security (OAS)
pension payments are lowered if the recipient’s income exceeds a certain amount. This amount could become
lower and lower over time. The Guaranteed Income Supplement (GIS) could be reduced, or the eligibility
criteria tightened up. Federal and/or provincial income taxes could be increased.
Repayment risk
This type of risk comes in several forms. One form of risk is not being repaid what you are owed when it is
due or when you want your money. For example, if you buy a bond, the issuer’s ability to repay you
determines whether you are going to get your money back. Although bonds issued by municipalities,
corporations, or governments rarely default, several levels of credit risk are normally involved. Agencies such
as Standard & Poor, Moody’s Investors Service, and Dominion Bond Rating Service rate the credit risk of
various bonds, which generally range from “AAA” to “D”. These ratings indicate the repayment risk you are
taking with a particular bond issue.
Insurance companies are also rated by different agencies. Considering that insurance companies go under
from time to time, you don’t want to risk losing money you are expecting from insurance proceeds, cash
surrender value funds, disability insurance payments, or annuities.
If you place money in an institution by means of a term deposit, for example, you want to feel confident that
you will get your money back–principal and interest–if the institution fails.
Another form of repayment risk is receiving your invested money back sooner than you expect or want it. For
example, if you lock into a bond with a 7 per cent yield and the rate falls to two per cent, you will not be able
to replace that bond with a new one at the same yield if the bond issuer redeems or calls the bond earlier than
anticipated. Many corporate bond issuers have this right a certain number of years after the bond was issued.
Most government bonds cannot be called.
Market cycle risk
Many markets, such as the real estate market, stock market and bond market, are cyclical. Depending on
where your investment is at any point in the cycle, it could slowly or rapidly diminish in value. If you wanted
or needed to sell it, you could lose money. Being aware of the market and the direction of the cycle is
obviously important. Generally, the longer you hold an investment, the less the risk. The shorter the term you
intend to keep the investment, the higher the risk that a market correction could impair your investment return.
Economic risk
The economy obviously has an effect on investments such as real estate and stocks. The more buoyant the
economy, the more buoyant the price of real estate and stocks.
Lack-of-diversification risk
The risk here is having all your assets in one specific kind of investment, like real estate or bonds or stocks.
You are not protected if that asset drops in value and you do not have alternative assets to buffer the loss. If
you spread the risk, you lower the risk. To spread the risk, you should not only have different types of assets,
but also have different kinds of investments within each type of asset.
Lack-of-liquidity risk
“Liquidity” is the speed at which you can sell your asset–be it at a fair price, or at all. For example, if you
need to sell your home or stocks and the market has dropped, you could still sell, but it could take much

3. longer and you will get a lower price. Negative publicity about stocks and real estate can have a dramatic
short-term effect on the market, as potential buyers become nervous. Less demand means lower prices.
Taxation risk
This risk affects your lifestyle if increased taxation reduces your anticipated retirement income. This form of
risk could come from higher levels of income tax, the taxing of part or all of your income currently exempt
from taxation (i.e., the Guaranteed Income Supplement), or the taxing of RRSPs or RRIFs in some fashion,
other than when you take the money out. Naturally, all of the above possible initiatives would result in a loud
public outcry. Economic pressure on federal or provincial governments to reduce their respective debts,
however, could result in all areas of personal income being subject to review for additional tax.
Pension risk
This type of risk takes various forms. One form is for federal or provincial governments to reduce the net
amount of pension you receive through Old Age Security (OAS), Canada Pension Plan (CPP), or Guaranteed
Income Supplement (GIS). This could be done through taxation, increased taxation, clawbacks based on your
other income, a reduction in the amount of money, or more restrictive eligibility criteria. As you may know, if
your taxable income is over $53,000, your OAS is “clawed back,” or reduced by the amount of your income
over $53,000. Another form of risk is a pension fund manager who does not invest money wisely–the return
to the pension fund could be much less than what is expected. Or, an employer may not make any profit in a
particular year and therefore decides not to contribute anything to the pension fund. An employer could also
decide to reduce or eliminate some pension plan collateral benefits such as life insurance or health and dental
plan coverage for cost-saving reasons.
After reflecting on the above overview, you can see how foresight, professional advice, and prudent
planning can help to either reduce, or even eliminate financial risks.