Friday, July 31, 2015

Short Takes: Gold a Pet Rock, Rent vs. Buy, and more

Here are my posts for the past two weeks:

So Stocks are Overvalued – Then What?

Your Retirement Income Blueprint

Here are some short takes and some weekend reading:

Jason Zweig calls gold “a pet rock.”

Mr. Money Mustache brings us some clear thinking on whether to rent or buy your home.

My Own Advisor finds confusion in the advice on how to create retirement income from your portfolio after retirement. There could be a problem with incentives here. By the time you’re 15 or so years into retirement and realize your plan isn’t working, it’s too late for you, and your advisor is probably long retired. You’re essentially relying on advisors’ integrity because they have little economic incentive to make sure your income lasts long enough.

Boomer and Echo find the Financial Planning Standards Council’s projected stock and bond returns to be very low once you factor in the typical fat fees in Canada. After-inflation returns are low enough without giving a big chunk of them away in fees.

Big Cajun Man has amassed a lot of experience with Registered Disability Savings Plans (RDSPs) and the Disability Tax Credit (DTC). Here he shares his experience with working through the system to get benefits.

Tuesday, July 28, 2015

Your Retirement Income Blueprint

Retirement advisor Daryl Diamond says that many financial advisors can help people accumulate wealth during their working years, but when it comes to planning how to create income during retirement, “advisors who are proficient in this area are not all that easy to find.” His book Your Retirement Income Blueprint lays out his “six-step plan to design and build a secure retirement.”

I found this book very helpful in discussing the important issues to consider when creating retirement income. I believe it will help me to better plan my own retirement. However, there were a number of specific areas where I disagree with Diamond. I have already written about the biggest of these, that he advocates withdrawal rates that are too high; I won’t say more about this issue here.

For me, the best part of this book is the discussion of RRSP withdrawal strategies. Common tax advice is to defer taxes as long as possible, which means draining non-registered savings and TFSAs until you’re forced at age 71 to draw from RRSPs and RRIFs. However, my own simulations seemed to show that it can make sense to draw from RRSPs early.

Diamond says “the prolonged deferral of RRSP and other registered money can possibly lead you to a tax trap.” Large RRIF withdrawals can push you into higher tax brackets and even lead to OAS clawbacks. He advocates the idea of “topping up to bracket,” which means drawing RRSP or RRIF income up to the top of your current tax bracket starting after you retire but well before you turn 71.

A common rule of thumb is that you will need 70% of your pre-retirement income during retirement. This rule of thumb has many critics. Diamond’s position is more subtle. He says that while this rule of thumb “may have some application during the accumulation years, it is far better for you to be more specific about your own situation as you approach retirement.” However, he warns that “about half of those who are newly retired find that they end up spending more than they expected in their first two years of retirement.”

On fees, Diamond finds that “too many investors who choose to use an advisor are paying fees but getting little to nothing in exchange.” However, he softens his stance claiming that there are many “mutual funds providing higher, after-fee returns than comparable investments with lower fees.” All academic evidence says that funds with high past returns don’t tend to keep up the high performance. Mutual fund performance chasing of the type Diamond seems to be promoting is a losing game for most investors.

Diamond makes a strong case that most (but not all) people should take CPP early if they have retired early. His reasons include giving your assets more time to grow, but the most compelling reason to me is the survivor’s benefit. When one spouse dies, the other spouse gets a survivor’s benefit. But the total of this benefit and the survivor’s own CPP payments are capped. So, why delay CPP payments to boost the payment amount just to get capped later on?

Unfortunately, in a discussion of annuities, the examples don’t include any indexing. This gives an unrealistic view of annuity payouts. A payment that looks good when you’re 60 won’t look as good at 65 after 5 years of inflation. It will look much worse after a couple of decades of inflation.

A detail about RRSPs and RRIFs that I didn’t know is that if you are still under 71 and have turned your RRSP into a RRIF, “you have the option, should you wish to stop the income from your RRIF, to change it back to an RRSP.”

Diamond’s discussion of TFSAs is somewhat misleading on two points. He says TSFAs have “very flexible ‘in-out’ provisions—any withdrawals restore contribution room.” Those who know about TFSA penalties know that the room isn’t restored until the next calendar year. Freely popping money in and out is a formula for getting a letter from CRA demanding penalties.

“Contributions may be made to a spouse’s TFSA without attribution to the contributor.” This is true. However, if the money is pulled back out of the TFSA and invested in non-registered accounts, the new gains are attributed back to the original TSFA contributor.

“What people pay in management fees on their investments ... is often a minor issue compared to what they needlessly pay in taxes.” This just isn’t true. Both are important issues. However, paying an extra 1% per year in management fees can reduce retirement income by 25% or more. Even an egregious tax error such as failing to split a $60,000 income across both spouses reduces income by about 13%. Clearly, both management fees and taxes matter a great deal.

Diamond explains the problems with variable annuities and Guaranteed Minimum Withdrawal Benefit (GMWB) contracts, but goes too easy on them. A guaranteed minimum payout of 4% may sound reasonable, but it isn’t indexed. He does explain that the very high fees on your capital make it unlikely that payments will increase much, but then says “that does not mean that variable annuities aren’t good.” I’ve never seen a good one. They seem perfectly designed to hide huge fees and exploit people’s lack of understanding of the devastating effects of inflation over decades.

Diamond is positive about monthly income funds because “the capital value of the investments will fluctuate with markets but the number of units or shares remains unchanged.” This sense of not dipping into capital is often just an illusion. Many of these income funds not only don’t increase payments with inflation, but they have had to cut payments. Your account statement makes it look like your capital is intact, but the fund itself has been dipping into your capital to pay you each month.

Diamond believes people often need critical illness insurance and long-term care insurance throughout retirement. He says the “odds are nearly 50%” that you’ll need some form of long-term care. Doesn’t that mean the insurance company will have to charge a hefty premium? By the time you factor in the insurance company’s overhead and profit margin, the premium would have to cost about as much as the care itself. Diamond would have to provide some numbers for this to make any sense to me.

Despite my numerous criticisms of parts of this book, I’m quite happy I read it. I have found it challenging to decide on the best way to handle a portfolio through retirement, and Diamond has provided a good framework for working through the various issues. I recommend this book to those who will have to live in retirement on their own savings.

Wednesday, July 22, 2015

So Stocks are Overvalued – Then What?

Much virtual ink is going into articles on whether stock markets are currently overvalued. Let’s suppose you know for certain that they are 25% overvalued. What should you do?

The natural answer is to sell all stocks. If we knew the markets were going to have a sudden correction soon to erase the 25% overvaluation, the correct next move would be to sell all stocks and short the markets. Of course, we can’t know this.

What if stock markets correct slowly over the next two decades? Suppose that the companies making up the world’s stock markets have business performance that outperforms inflation by 5% per year for the next 20 years. Suppose further that stock prices beat inflation by around 4% per year over that time so that the 25% overvaluation is erased after two decades. Is selling still the right call?

The answer to that question is no. If I knew for certain my stocks would beat inflation by about 4% per year for the next 20 years, I’d be thrilled to hold them.

It’s not enough to have insight into whether stocks are too pricey. To be able to take useful action, you need insight into how prices will come back to “normal.” I have no useful insight into these questions. So, I’ll continue to snooze. I’ll even snooze through the next market crash that is certain to come at some point.

Friday, July 17, 2015

Short Takes: Chinese Stock Interventions, Future of Robo-Advisors, and more

Here are my posts for the past two weeks:

Pound Foolish

4% Rule Experiments Using Longevity Statistics

Another Take on Retirement Withdrawal Strategies

Here are some short takes and some weekend reading:

Jason Zweig puts the Chinese government’s attempts to control their stock market into historical context. A good quote: “The Chinese government regards markets as clay that can be molded. Instead, markets are like water: They always find their own level, no matter who or what tries to control them.”

Dan Hallett brings us a thoughtful critique of robo-advisors and a look at their future.

Canadian Couch Potato beats up on Tony Robbins’ All-Season Portfolio. Okay, “beats up” is a little strong. He says it’s not really much different from a balanced portfolio. Canadian Couch Potato also has a new white paper discussing how to calculate your portfolio’s return.

Preet Banerjee explains credit card balance protection insurance in his latest Drawing Conclusions video. He sets out to answer whether you should get such insurance. The answer for me personally is an emphatic NO.

Big Cajun Man digs into some Bank of Canada data to see whether Canadians are borrowing to invest or to consume.

Boomer and Echo say that Aeroplan rewards aren’t all that rewarding.

My Own Advisor uses an article by Paul Merriman as an opportunity to revisit his decision not to own bonds.

Wednesday, July 15, 2015

Another Take on Retirement Withdrawal Strategies

I’ve long argued that we need to account for inflation with our retirement income plans. Many disagree arguing that we spend less as we get older. Retirement income planner, Daryl Diamond, argues that both extremes are wrong in his book Your Retirement Income Blueprint. He plans for retirement income purchasing power to drop by 25% at age 75.

I don’t see much sense in arguments that we can plan retirement spending based on constant dollars. Even at 2% inflation, why should we expect a retiree to want to spend 10% less only 5 years into retirement? An elderly couple in my extended family have seen inflation triple prices since they retired. They are struggling with trying to live on only one-third of their former consumption.

Daryl Diamond says “retirement income projections that do not adjust at all for inflation or that are fully indexed through retirement are both in error.” He indexes spending plans up to age 75, then drops spending by 25%, and resumes indexing thereafter.

I’m not convinced that most retirees will want to spend 25% less when they reach age 75, but at least this is a more sensible strategy than ignoring inflation entirely. Unfortunately, this 25% drop is self-fulfilling if it gets planned in. Retirees on Diamond’s plan will have to reduce spending whether they want to or not. Otherwise they risk running out of money.

Diamond’s preference is to start with a 5% withdrawal rate rising with inflation with the one-time 25% reduction at age 75. He says this “has proven to be quite resilient in the face of negative markets over the last 25 years.” He goes on to show some 22-year scenarios (riddled with small calculation errors) based on real market returns starting in 1992.

How can experience over 25 years give much insight into whether retirees will run out of money over 30+ years of retirement? Diamond says “I know this example does not go back and review a hundred years of data.” Unfortunately, it doesn’t even cover a full retirement for a typical 60-year old couple.

For some reason, none of Diamond’s scenarios include the 25% spending reduction at age 75. So, they are testing a 5% withdrawal rate indexed to inflation with no reduction. As an experiment, I reordered the returns in one scenario to begin in 2008 and after 2013 wrap back to 1992. At an indexed 5% withdrawal rate, the retiree ran out of money in the 23rd year.

Diamond has not persuaded me change my conclusions from recent withdrawal rate experiments. Anyone retiring at 60 or 65 who pays typical investment fees is taking a chance even withdrawing initially at 4%. As for the 25% spending reduction at age 75, it may make sense to let each retiree decide whether to include this as long as the question is framed in a way they can truly understand.

This whole business of withdrawal rates reminds me of times when my boss wanted me to collect information to make some important decision. In reality, my boss knew which choice he wanted and this was really an exercise in justifying that choice no matter the truth. With withdrawal rates, retirees play the role of my boss, and advisors play my role. Retirees want as much retirement income as they can get. Advisors have to justify higher withdrawal rates somehow or risk losing clients. After all, will you pick the advisor who says you can spend $5000 per month or the one saying $3000 per month? Fortunately for advisors and unfortunately for their clients, the result of over-consumption won’t be obvious for many years.