Friday, August 22, 2014

Short Takes: Bad Financial Ads, Executive Pay Abuses, and more

Here are my posts for this week:

TFSA Penalties Poised to Rise

Test Driving Financial Rules of Thumb

Here are some short takes and some weekend reading:

Dan Hallett uses his expertise to pick apart the misleading aspects of a few ads for investments. The rule seems to be “if it’s misleading but legal, run it.”

Eric Reguly does a great job of explaining executive pay abuses. Stock options do a terrible job of aligning the interests of shareholders and company executives.

Tom Bradley at Steadyhand is advising retired clients to rebalance by topping up their cash reserves. He says “the general range used by our clients is 12 to 24 months” worth of spending in cash reserves. When I started looking at retirement income strategies, I chose 5 years of spending as a cash buffer. I think the difference is that Steadyhand’s client’s portfolios generally contain a significant allocation to bonds that reduces risk. My strategy was based on the cash buffer being the only safe component; the rest of the portfolio is stocks.

Million Dollar Journey provides a complete set of resources for those considering the Smith Manoeuvre. Take some time to understand the risks well before jumping in. In my opinion, leveraged investing is only appropriate for a small minority of investors.

My Own Advisor gave his take on several financial rules of thumb which prompted me to do the same.

Big Cajun Man found that even Cosmopolitan Magazine had some financial advice he needed to heed.

Wednesday, August 20, 2014

Test Driving Financial Rules of Thumb

Taking a close look at some financial rules of thumb began with a post at Brighter Life and jumped to My Own Advisor. Here I give my take on some very common rules of thumb.

Your retirement income needs to be 70% of your working income.

This is obviously just an average or typical case. You should really look at you spending needs, including saving up for bigger items like replacing a car, windows, furnace, flooring, or roof. My family’s spending is currently about 40% of the combined take-home pay for my wife and me. It makes no sense for us to target a retirement income almost double what we need right now. Retirement needs are driven by your spending, not your income.

Keep an emergency fund equal to six months’ income.

I’m a big believer in liquidity. Access to credit may seem like adequate protection, but lenders may take away access to credit in tough financial times. If you lose your job when the biggest employer in town goes bankrupt, banks may not be in a hurry to lend to you. If you can borrow, the rates may be painful.

Exactly how much you need in emergency savings depends greatly on your flexibility. How much can you reduce spending? Are you able to take a job that you could get quickly but may pay less? Are you able to move to find new work? I tend to have 4 to 5 months of spending in cash. Very flexible people may need less than this and others may need more.

Don’t pay more than 3.5 times your gross annual income for your house.

This seems far too high to me. I’d much sooner rent than spend this much for a house. At current prices, it’s certainly possible to rent a nice house for much less than it would cost to own the house. As long as you’re saving the difference, renting can be much less risky.

Don’t invest more than 5% of your savings in any one stock or bond.

This is sensible for stocks and for bonds that have risk, but makes little sense for Canadian government bonds. I actually violate this rule in my own portfolio. I still have about 10% of my savings in Berkshire Hathaway stock. The large built-up capital gains make me hesitant to sell and pay the taxes.

Accumulate 20 times your gross annual income, then retire.

I don’t see the logic of basing retirement goals on my current income. They should be based on my spending. Using this rule, I get further from retirement every time I get a raise. I can just imagine a worker flying into his boss’s office in a rage: “what’s this raise garbage? My savings were up to 19.5 times my pay. I was going to retire in 6 months. Now I’m down to 18 times. I’ll have to work another 2 years!”

Never touch your retirement savings, except for retirement.

Apart from extreme circumstances, this is a sensible goal.

In retirement, you can sustainably live off of 4% of your starting nest egg, rising with inflation.

There is research that supports this rule of thumb. However, it is based on the assumption that you pay no investment fees. If you’re like most Canadians who own mutual funds and (often unwittingly) pay substantial MERs, the safe withdrawal rate is much lower – more like 3% as I showed when I repeated the research to include the effect of fees.

If your employer matches your contributions to a workplace savings plan, go for it.

This is good advice. One thing to watch out for is that if you are forced to invest in company stock with all or part of the money, you should sell out of that stock and buy something else when possible. There are so many examples of companies going bankrupt and employees losing both their jobs and their savings. Like those employees, you may think that your company can’t go out of business. Those companies went out of business and so can yours.

The percentage of your portfolio in bonds and fixed-income investments should be equal to your age.

This is safe enough, but I find it too simplistic. I prefer to put all savings I won’t need within 5 years into stocks. But this isn’t for everyone. A huge potential risk for all investors is the possibility that they’ll lose their cool during a stock market crash and sell low. The 2008-2009 crash was a good test of your ability to stay invested. If you sold stocks back then, even if you think it was for a smart-sounding reason, you may need to keep your stock allocation lower. Even if you just failed to rebalance from bonds to stocks during the crash, your stock allocation may be higher than you can really handle.

Total home ownership costs shouldn’t exceed 30% of your gross income.

This sounds too high to me. As I wrote above, renting is not a bad option when house prices are high.

Your total debt servicing costs shouldn’t exceed 40% of your income.

Again, this sounds far too high to me.

Don’t plan to retire with debt.


You need to have x times your annual income in life insurance.

This is far too simplistic. As your savings grow, your need for life insurance tends to drop. I have far less life insurance now than I did 15 years ago even though my income is higher now.

If there’s one theme running through my reactions to these rules of thumb, it’s that you should think. This shouldn’t be too hard for my readership, but too many people prefer to be told what to do.

Monday, August 18, 2014

TFSA Penalties Poised to Rise

While the number of people mistakenly over-contributing to their TFSAs has been declining each year, the size of individual penalties is likely to grow. This is a consequence of a common type of mistake and growing TFSA balances.

To illustrate the problem, consider our hypothetical hero Joe who dutifully fills up his TFSA every January. Like many Canadians, Joe doesn’t realize that his TFSA can be more than just a savings account collecting modest interest. It’s now January 2020, and after filling up his TFSA yet again he now has $75,000 saved.

Then Joe sees an ad at another bank offering TFSA rates a half percent higher than he’s getting now. That would pay him an extra $375 per year. He decides to take action and withdraws the whole $75,000 and deposits it into a TFSA at the new bank.

Unfortunately, Joe does not do a “qualifying transfer,” which is when the TFSA contents are transferred directly from one TFSA to another without Joe ever handling the money. He just does the transfer himself. “What’s the difference?” you might ask. Qualifying transfers don’t count as a withdrawal and a contribution, but doing it yourself does count as a withdrawal and a contribution.

Those who are familiar with basic TFSA rules will realize that Joe has now made an over-contribution of $75,000. He will be penalized 1% or $750 each month, for a total penalty of $9000 for the year. The catch is that while Joe is allowed to withdraw his money, he’s not allowed to put it back again until the next calendar year (2021).

If Joe had made the same mistake back in 2009 when his balance was only $5000, his penalties for the year would only have been $600 instead of $9000. Anger over the size of TFSA penalties is bad enough right now. Without changes to either the TFSA contribution rules or to the way contributions are tracked to prevent mistakes, anger will grow along with the rising penalties.

Friday, August 15, 2014

Short Takes: Financial Happiness Secrets, Advice on Moving Out, and more

Here are my posts for this week:

Why Market Timing Fails

Loan Pushers

Too Big to Fail

Here are some short takes and some weekend reading:

David Chilton (the Wealthy Barber) explains in this video clip the secret to a happy financial life. Saving isn’t just about making a better future; it’s about making life simpler and better right now. His remarks at the end about math knowledge are interesting. I’ve definitely noticed that people with strong math skills tend to earn more money than the general population. Whether they’re better at handling and investing that money is another question.

Gail Vaz-Oxlade has some very good advice for young people preparing to move out of their parents’ homes for the first time.

Canadian Couch Potato shows how to reduce transaction costs and optimize asset location by treating all family investment accounts as a single big portfolio.

Doug Runchey explains how working past age 60 affects CPP benefits in a number of example cases.

Dan Hallett takes a look at a market-linked GIC that seems good on the surface but wilts under Hallett’s scrutiny.

Big Cajun Man uses some examples to explain the TFSA over-contribution rules. Unfortunately, I think the “Savings Account” part of the TFSA name will continue to make people think they can treat it like a regular savings account.

My Own Advisor has added a new personal finance goal for the year. He’s trying to save up $4000 for home improvements. My wife and I have a system for home improvements. We do things that need doing immediately, such as replacing a furnace or appliance that isn’t working, replacing leaking windows, or fixing a leaking roof. For more cosmetic things, we just disagree on the details endlessly and never spend the money.

Thursday, August 14, 2014

Too Big to Fail

I wouldn’t have thought it possible to turn an account of the 2008 financial crisis into a story as compelling as a novel, but Andrew Ross Sorkin did it with his book Too Big to Fail. Sorkin gives an inside account of the actions of Wall Street executives and government officials that captures their panic, greed, loyalty, and in some cases patriotism.

One theme in the early part of the book is the power play that exists at the top of large corporations. In one example, an executive forcing another out of a company is just a routine “disposal of a potential rival.” In another example, one executive is pushed out but not a second because the second “appeared nonthreatening.” This is a peculiar world where competence is valued, but too much competence is threatening.

Another theme is executives making themselves rich at the expense of their own firms. Even when the market for Collateralized Debt Obligations (CDOs) “was perceptibly unraveling,” Merrill Lynch kept churning them out. “If they were worried, however, Merrill’s top executives didn’t show it, for they had a powerful incentive to stay the course. Huge bonuses were triggered by the $700 million in fees generated by creating and trading CDOs, despite the fact that not all of them were sold. (Accounting rules allowed banks to treat a securitization as a sale under certain conditions.)” So, executives made bonuses on CDOs that were causing Merrill to lose money.

A surprising part of this story to me was the degree to which discussions were conducted in face-to-face meetings. The participants spent a lot of time traveling to hastily called meetings. In one case, some Morgan Stanley executives stuck in traffic “found a break in the street divider and inched the car onto the bike lane, speeding down it.”

When Lehman Brothers finally went bankrupt, “the staff wasn’t just devastated, they were angry.” They erected a wall of shame that included photos of the CEO and president “with the caption ‘Dumb and Dumber.’”

An interesting characterization of the changes on Wall Street: In 1927, business was “defined by personal relationships and implicit trust, not leverage and ever more complicated financial engineering.” This world was “obliterated over the past decade as firms sought to go public and began using shareholder money to place what proved to be dangerously risky bets.”

Have the lessons of the financial crisis led to positive changes? “Goldman, like so many of the nation’s largest financial institutions, remains too big to fail.” Unless “regulations are changed radically—to include such measures as stricter limits on leverage at large financial institutions, curbs on pay structures that encourage irresponsible risks, and a crackdown on rumormongers and the manipulation of stock and derivatives markets—there will continue to be firms that are too big to fail.”

It’s unlikely that someone with no interest at all in the financial crisis would like this book, but the inside account of the players and their motivations certainly helps to make it an interesting read for those who have some interest in the crisis.