Monday, January 26, 2015

Debating What Income Level is Safe in Retirement

How much we can safely spend each month from our savings during retirement can be an emotional subject. People want more income, but they also want to know that they won’t run out of money. The truth on this subject can be very unwelcome. Financial advisors seem to feel this pressure from their clients because advisors often seek ways to argue that higher withdrawal rates are possible. I give a couple of examples here.

Most people whose lifestyles are not fully covered by CPP and OAS payments have not saved enough to cover the difference over a long retirement. Either their lifestyles must become less expensive or they will drain their savings too fast. These people don’t want to hear that their withdrawal rates are unsustainable.

People seek reasons to believe that they can exceed the well-known 4% rule when the reality is that this rule is overly optimistic because it is based on zero investment fees. In truth, a 3% rule is closer to the mark for a long retirement.

Among reasonable people I discuss finances with, one of the most unwelcome observations I make is that the 4% spending rule in retirement is often too aggressive. In a world where so many people would like to quit working but have less saved than they’d need, there is a strong emotional need to believe it’s possible to generate a high income from savings.

Financial planner Wes Moss uses a 5% rule that he justifies by investing in stocks with high dividend yields and then hoping they produce the same capital gains as other stocks with lower dividends. This shouldn’t be very persuasive, but consider it from the point of view of someone who hasn’t saved enough. Suppose you’re retired at 60 and desperately want to spend $5000 per month, but the 4% rule gives you only $3000 per month. Moss says you can have $3750 and I say that only $2250 is safe. I’m pretty sure most people would listen to Moss and push me out the door.

Even David Toyne, Director of Business Development at the very client-friendly firm Steadyhand isn’t immune to the pressure to allow higher income. In an otherwise useful and informative video interview, Toyne said the following at about the 11-minute mark:
“In retirement you can withdraw 4% of your portfolio and that’s a sustainable withdrawal rate—in other words you won’t run out of money—remember that 4% could be 5% if you trim your fee by 1%.” I’m all for cutting fees, but the 4% rule is based on zero fees. Cutting fees might boost your safe withdrawal rate from 3% to 3.5%, but it won’t get you to 5%.

A justification I hear for higher spending levels is that people tend to spend less as they age. This is almost certainly true, but it is largely because people spend less as they see they’re running out of money. A study examining this question produced data supporting this conclusion. People begin to reduce spending, even in their 60s, if their spending is high relative to their savings. But people whose spending is in line with their savings don’t spend less as they age.

I’m not a lone voice on this point. Jeff Brown makes a case for something closer to a 3% rule, and William Bernstein is quoted as saying “Two percent is bullet-proof, 3% is probably safe, 4% is pushing it and, at 5%, you're eating Alpo in your old age.”

Because their clients want to hear they can safely spend more, even some good advisors want to believe that higher withdrawal rates are safe.

Friday, January 23, 2015

Short Takes: Lowering Interest Rates, Closed Stock Markets, and more

Here are my posts for this week:

Alternative Canadian Indexes

The Average Investor

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand called for higher interest rates in Canada. However, Rob Carrick reported that the Bank of Canada just lowered interest rates. Then Tom Bradley followed up with comments on the interest rate decrease concluding that the Bank of Canada is more concerned about the short term than the long term. However this all plays out, the cheap debt party can’t last forever.

Canadian Couch Potato found that it’s not a good idea to trade a Canadian ETF that holds U.S. stocks on a day when the U.S. stock market is closed.

LSM Insurance explains why paying your life insurance premiums yearly instead of monthly can save you a bundle.

The Blunt Bean Counter clarifies which self-employed Ontarians will be eligible for the Ontario Retirement Pension Plan (ORPP).

Big Cajun Man has more trouble taking money out of a TD RESP. Anything that takes multiple visits to a branch to sort out doesn’t sound very pleasant.

My Own Advisor says he’s still discouraged about retirement even though Malcolm Hamilton says “Canadians are unduly and irrationally discouraged about their [retirement] prospects.”

Wednesday, January 21, 2015

The Average Investor

Few of us like to admit we are merely average in some respect. You’ll hear commentators say that anyone who is just an average investor would be better off owning low-cost index funds. Curiously, it is both indexing proponents and detractors who say this. Digging deeper into the meaning of “average investor” gives some insight the value of index investing.

We often hear proponents of active stock-picking or market timing say things like “indexing is fine if you’re just average,” or “why would you want only average returns?” On the other side of this debate, Dave Nadig wrote “you have to accept that you, the investor, are not a special flower. You have to accept that you, the investor, are average.”

I see little hope of convincing overconfident stock pickers and market timers that they are merely average until we define “average investor.” After all, I’ve met many of my neighbours. I’m willing to bet that I can comb through companies’ financial statements better than most of them can. Doesn’t this make me above average?

An important thing to understand about the competition among stock pickers is that the average is dollar-weighted. This means that if you have more money than someone else, you contribute more to the average skill level in the stock market.

If I have a $100,000 portfolio, then someone with $200,000 contributes twice as much to the average as I do, and someone with $50,000 contributes only half as much. This may offend our sense of democracy, but it is the reality of competition among stock pickers.

What about a mutual fund controlling $10 billion? They count as much as 100,000 people with $100,000 each to the average of all stock pickers. When your neighbour hands his money over to a mutual fund, his stock-picking skill no longer counts in the average; his money just makes the fund’s managers count for slightly more in the average.

When your other neighbour sticks to index investing, he has taken himself out of the average as well. People only count in the average skill level of stock pickers to the extent that they are actually picking their own stocks.

So, your competition isn’t really your neighbours. As an active investor, you’re really competing against an army of professional investor dollars and a lesser number of individual investor dollars. To a first approximation, the average investor is a professional money manager.

You don’t have to admit that you’re merely an average investor among your friends and acquaintances to embrace index investing. You just have to admit that you’re not better than investment professionals. And even if you are better than the pros, you have to be better by enough to make up for the higher costs of active investing.

Monday, January 19, 2015

Alternative Canadian Indexes

A reader, J.H., asked the following thoughtful question about non-market-weighted indexes in Canada (edited for length):
“I wonder if it’s wise to not buy a Canadian Index ETF because these funds are so over-weighted in financials and energy equity (as high as 65% in November in some indexes).

“I note a more equally-weighted fund, ZLB has beaten the index since its inception, and is doing better than the Canadian index during these unsettled times. It's designed to defend against volatility, but its composition of generally equal-weighted stocks also offers more diversity than a Canadian Index ETF. Index funds seem to be better investments when they have greater diversification, like those mirroring the US market. At least that's the hunch of this investor who is still learning the ropes.

“If ZLB is not for some, they could try a strategy of setting up their own Canadian portfolio of equally-weighted stocks.”
A great virtue of market weighted indexes is that when a stock’s price changes, it remains market-weighted. No trading is needed to rebalance as stock prices fluctuate. However, with equal market weighting or anything other than market-weighting, price changes put the allocation out of balance and ETFs must make trades to get back into balance.

This means that market-weighted indexes will tend to offer the lowest cost way to invest. Any other weighting method must outperform a market-weighted index by enough to cover the extra trading costs (and in taxable accounts income tax costs).

These higher costs may not be large, but I’ve cast my lot on the assumption that ETFs based on alternative weighting methods will not give better results after costs than market-weighted ETFs. I don’t know for certain whether I’m right or wrong about this, but that’s the choice I’ve made.

As for the concern about the concentration of financials and energy in Canadian stocks, I deal with this by only having 30% of my stock investments in Canada. The rest are in the U.S. and international index ETFs.

I can’t resist commenting on “during these unsettled times.” The present is always unsettled, and the future is unknown. The past seems more settled because we know the outcomes and they can’t change. The human tendency of hindsight bias makes us believe we knew the past would unfold as it did even though the truth is we didn’t know what was going to happen.

It’s true that over short periods of time some non-market-weighted indexes have outperformed market indexes. I’ve decided to bet this won’t persist. The bigger the gap in total costs between a non-market-weighted ETF and a market-weighted ETF, the more skeptical I am that the outperformance will persist. Others may see things differently.

Friday, January 16, 2015

Short Takes: Switching to Index Investing, Capital Gains on Investment Real Estate, and more

Here are my posts for this week:

Crashing a 2014 stock-picking contest

When would you offer more than the asking price?

Here are some short takes and some weekend reading:

Robb Engen at Boomer and Echo gives a thoughtful discussion of his 2014 portfolio return and his decision to switch to simple ETF-based index investing.

Preet Banerjee explains how your capital gains on investment real estate can be much less than simply the sale price minus the purchase price.

Canadian Couch Potato has made some extensive changes to his model portfolios.  I like the changes.  Hes sticking to the major asset classes instead of including REITs and other assets.  Simplicity is important.  Its amazing how complicated things can get as you try to manage several types of accounts in a single portfolio.  For the ETF-based portfolios, hes focusing on Vanguard's ETFs.  This makes sense to me because they're a great company.

Canadian Portfolio Manager analyzes 4 actively-managed funds that appear to offer market-beating returns, but after accounting for value tilts and small-cap tilts the shine comes off. I’m of two minds about these factor regressions. On one hand they show that outperformance is often just overweighting in value and small-cap stocks. On the other hand, what if a fund manager had the skill to know whether such stocks would outperform over a given period of time? Factor regression will deny the existence of such skill by definition. Taken to the extreme, if we add enough factors so that every stock is in its own category, then buy-and-hold outperformance is impossible by definition. All that said, I think 3-factor regressions are likely a useful way to examine outperformance.

Big Cajun Man pays homage to the humble Mason jar as a versatile source of frugality.

My Own Advisor is musing about transitioning out of the work force. Sounds like someone who doesn’t feel like going to work today. That probably applies to many of us.