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 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.
