Tuesday, December 31, 2013

Dragged Kicking and Screaming

Well, I’m a twit now. It seems that twitter is taking over blog feeds and blog comments. So, I’m now @MJonMoney on twitter. I take pride in my ability to be clear and concise, but the 140-character limit is a challenge. Here’s hoping that this leads to more useful interaction with my readers.

Feel free to tell me what I’m doing wrong on twitter as I muddle through. My goal is to make my ideas conveniently accessible to people who want to read them without too much shameless self-promotion.

Have a great New Year’s Eve party. Saving tip: to spend less on pills tomorrow, drink less tonight.

Monday, December 30, 2013

Your Unused TFSA and RRSP Contribution Room is Shrinking!

Just in case you need a reason to save more of your hard-earned money instead of buying yet another electronic gadget or pair of shoes, here’s a good one: the TFSA and RRSP contribution room you didn’t use in past years has been shrinking.

Perhaps when you decided you didn’t have enough money to save any in a tax shelter last year you felt safe knowing that you’d be able to use the room in the future. Some magical time will come when you can save enough money to use up past room. But the trouble is that your available room has a leak.

Dollars this year are worth less than dollars last year, and those dollars are worth less than they were the year before. So, let’s stop talking about dollars and start talking about loaves of bread (as a proxy for the cost of living).

Suppose that your $5000 TFSA allotment from 2009 amounted to 2500 loaves of bread. The Consumer Price Index (CPI) in Canada has gone from 113 to 123 since the start of 2009. If you haven’t used this 2009 TFSA room yet, then it is only 2297 loaves of bread now. You’ve lost 203 loaves of TFSA room.

Even though it’s not obvious, contribution room in both TFSAs and RRSPs have a slow leak. If inflation rises in the future, this leak gets bigger. Genuine hardship is a good reason to put off saving, but eating out and buying junk are poor reasons that are costing you money in more ways than one.

Friday, December 27, 2013

Short Takes: Handling Two Estates at Once, and a 2013 Retrospective

During Christmas week I wrote only one post, but I enjoyed writing it:

Which Takes a Bigger Bite from Your TFSA: Income Taxes or Mutual Fund Fees?

There weren’t too many financial posts this week, but here are a couple for some weekend reading:

The Blunt Bean Counter explains how being named an estate executor can leave you handling two estates at once.

My Own Advisor did a 2013 retrospective of his favourite posts each month.

Monday, December 23, 2013

Which Takes a Bigger Bite from Your TFSA: Income Taxes or Mutual Fund Fees?

Getting into the Grinchy side of the Christmas spirit, I thought I’d take a look at how both income taxes and mutual fund fees affect TFSA savings. The effects of these costs will vary considerably from one person to another, so we’ll just look at one particular case.

From stage left, our saver Sally enters. She saves $5000 in her TFSA every year (rising with inflation) starting from age 25 until she retires at age 65. We’ll assume that she makes a return of 4% above inflation each year (before fees). From age 65 to 85, she draws $15,000 per year to live on (in today’s dollars).

For Sally’s tax bite, we’ll look at how much income she had to earn to make the $5000 TFSA contribution. Let’s assume that Sally lives in Ontario and earns between $87,907 and $136,270 so that her marginal tax rate is 43.41%. This means she has to earn $8835 to get $5000 after income taxes. This makes the tax bite on her TFSA contribution $3835 per year.

For the bite of mutual fund fees, let’s assume that Sally is invested in funds with a 2.5% MER. This MER cost will start small in the first year, but will build as her savings build. Here’s how the mutual fund MER bite compares to Sally’s tax bite each year:


By the time Sally is 50, her savings take a bigger hit from mutual fund fees than income taxes. Over the full 60 years, the income tax total (in today’s dollars) is $153,419. But the total mutual fund fees (again in today’s dollars) are a whopping $199,163!

It seems hard to believe that a seemingly tiny 2.5% MER could amount to more than a 43.41% income tax rate. The important difference is that the income taxes apply each year only to the TFSA contribution; each dollar only gets taxed once. With the mutual fund MER, each dollar is hit every year for as long as it stays invested in the mutual funds.

The moral of this story is that when it comes to investing, costs matter.

Friday, December 20, 2013

Short Takes: Rent vs. Buying a Home, Barrier to Index Investing, and more

Solving the technical issues with my blog seems to have re-energized me for writing new posts. I have 3 this week:

Do Stocks Become More or Less Risky Over Time?

The Third Rail

How Mutual Fund Fees Delay Retirement

Here are my short takes and some weekend reading:

Preet Banerjee (video) explains his decision to rent instead of buying a home.

Canadian Couch Potato explains how the slim chance of outperforming the market gets in the way of investors embracing index investing.

Potato asks why do pensions exist if the future is discounted? A good question. I offered possible answers in the comment section.

Boomer and Echo explain the CPP child-rearing dropout provision you may be able to use to increase your CPP benefits. I didn’t know that this dropout could be used by either parent.

Big Cajun Man says you should scan your bills instead of keeping a bunch of paper around. Fortunately, I’m getting a lot of my bills electronically now. But most of my receipts that are relevant for income taxes are still on paper.

The Blunt Bean Counter is trash-talking auditors saying that they are more boring than tax guys in his post explaining financial statement reports.

Million Dollar Journey offers some year-end tax tips for 2013.

My Own Advisor goes through his planned year-end financial planning.

Wednesday, December 18, 2013

How Mutual Fund Fees Delay Retirement

In my never-ending quest to clearly explain the devastating effect of investment fees on your savings, I’ve found another way to look at it. Instead of looking at how much of your money gets consumed by mutual fund fees, let’s look at how they affect your retirement age.

Suppose that Katie is 30 years old and is just starting out saving in her RRSP. She has set up automatic contributions of $1000 per month. She plans to increase this amount each year to keep pace with inflation. Katie wants to know, “if I plan to draw $3000 per month (in today’s dollars) in retirement until I’m 95, when can I retire?”

The answer depends on how her RRSP investments perform. For illustration purposes, let’s assume that her investments beat inflation by 4% per year, before investing fees. Of course, she can’t count on this, and returns vary considerably from one year to the next. But the goal here is to see how fees affect retirement, so we’ll do calculations based on a steady 4% real return.

I whipped up a spreadsheet to work out how her retirement age varies with her investing expenses (including her funds’ Management Expense Ratios (MERs) and other expenses). Here are the results:


So, if Katie manages to keep her expenses down to 0.2% per year (including MERs, commissions, and spreads) using inexpensive index ETFs and trading infrequently, her projected retirement age is 61. If she invests in the Investors Canadian Growth Fund with total fund costs of 3.02% per year, Katie’s projected retirement age is 75. That’s 14 extra years of work to pay the higher fees.

Even if we properly account for Katie’s chosen asset allocation, the variability of investment returns, and the need for more safety after retirement, fund costs will still cause a major shift to a later retirement age.

Costs matter.

Here are a few more of my attempts to explain the importance of fund costs:

MER Drag on Returns in Pictures

MER: Death by a Thousand Cuts 

MERQ as a Better Measure of Fund Costs

MER: the Gift that Keeps on Giving

Tuesday, December 17, 2013

The Third Rail

Canada’s pension system is in trouble and we need to do something about it. This is the main message of the book The Third Rail, written by Jim Leech, CEO of the Ontario Teachers’ Pension Plan, and Jacquie McNish, senior writer with the Globe and Mail. The book is a fairly easy read and is worth a look.

The authors take a detailed look at pension crises in New Brunswick, Rhode Island, and The Netherlands, and describe how the problems were solved. A common theme is that the pension plans were changed to make benefit levels conditional on the returns on pension assets. On one hand this makes a lot of sense. We can’t expect pension backers (taxpayers or companies) to grow benefits faster than they can grow the savings set aside to pay those benefits. On the other hand, if we make cost-of-living increases conditional on pension asset returns, this automatically takes the pressure off pension administrators to manage the funds well. They can award themselves excessive fees or allow companies and governments to take pension contribution holidays, and the automatic reductions in cost-of-living increases will cover up the abuses. If pension benefits are going to be conditional, we need plan administrators to have strong financial incentives to run the plans efficiently and effectively.

Turning to the pension situation in Canada, the authors tell a parable about a farmer whose most productive cow dies. A chance encounter with a magic fish grants the farmer a wish. Does he wish to have his cow back? No, he says “I want my neighbour’s cow to die!” The authors claim that this is “the social dynamic of the pension debate” in Canada. Those who have no pension want to take away others’ pensions. The authors think we should instead try to build a strong pension system for all Canadians.

So the authors accuse Canadians of spitefulness, but I have practical concerns. If we take federal public servant pensions as a model, can we afford to extend such a plan to all Canadians? I think not. According to Statistics Canada, the average federal public servant retires at age 58, and only about 55% of the Canadian population is between 20 and 58 years old. If we eliminate the unemployed and those who cannot work, less than half of Canadians would be working, and this fraction will continue to decline over time. Do we really think we could run our economy including distributing food and other goods and keeping golf courses manicured if less than half of Canadians are working?

The only logical conclusion is that if we are going to design a pension system covering all or almost all Canadians, it cannot be as generous as federal public service pensions. We need a system that encourages Canadians to work later in life.

The authors describe a “longevity pension” being considered in Quebec where benefits begin at age 75. This would be in addition to QPP which generally begins around age 65. This kind of proposal makes sense to me. It says, we’ll take care of you after age 75, but if you want to retire earlier, you need to save some money.

Instead of expanding the existing CPP, I like the idea of creating another system that only pays benefits after age 75 and is entirely pre-funded. The idea is that you only get benefits in proportion to the amount you pay in. Young Canadians today could look forward to knowing that they’ll be taken care of after age 75. Until then, they have to work or save enough to live on until they reach 75.

In a discussion of expanding CPP, the authors suggest that “Ottawa could consider speeding up the delivery of enhanced pensions by temporarily bridging the gap to fully fund the new benefits.” Put another way, Ottawa could take some of the increases CPP payroll deductions of young people and give it to current retirees. I’m opposed.

The authors argue that the current system of voluntary pension savings in RRSPs fails in a number of ways. One of their main arguments is that too many people just don’t save. This is very true. And even if you don’t care about the welfare of non-savers, you end up paying for it anyway in the form of more GIS payments. Another strong argument is that “Canadian investors pay average annual management and trailer fees equal to 3.43 per cent of invested assets.” This may not sound like much, but over 40 years, this yearly fee compounds to consume 75% of assets!  (I've now investigated the references that led to the 3.43% figure and it appears to be incorrect. The origin of this figure seems to be from Table 1 of The Ambachtsheer Letter (April 2013), which indicates that the average MER in Canada is 1.93% and Trailer Fees are 1.50% (which sum to 3.43%).  These figures came from "CSA Discussion Paper and Request for Comment 81-407 Mutual Fund Fees," December 13, 2012.  Page 11249 says "At the end of 2011, the asset-weighted average MER of all Canadian mutual funds was 1.93%."  Footnote 10 says "Canadian no-load funds may pay trailing commissions of up to 1.50%."  While 1.50% may be a maximum for trailing commissions, it is far from typical.  Further, trailing commissions are a component of MERs, so it makes no sense to add in the trailing commissions again.  So, the 3.43% figure used by Leech and McNish makes no sense.  Further, it ignores other fees such as front loads and deferred sales charges.  In the end, the conclusion that total fees are very high still holds, but the 3.43% figure should be ignored.)

In contrast, “the typical defined benefit pension fund management expense ratio of 0.4 per cent” consumes only 15% of assets after 40 years. This is obviously far better, but still seems high when we see that Vanguard manages to run funds with much lower expenses. Perhaps pension plan administrators face costs that Vanguard does not.

In summary, I think the authors are right that we need to face our pension problems. They are right when they say that existing defined benefit pensions have sustainability issues. They are also right when they say there is a problem with so few younger Canadians covered by pensions. However, if we are going to have mandatory pension systems (like CPP), the focus should be on large enough benefit amounts to provide a decent standard of living but starting late in life (at least age 75). Attempts to shift money around to give us all great pensions in our late 50s or early 60s are doomed to failure.

Monday, December 16, 2013

Do Stocks Become More or Less Risky Over Time?

A very thoughtful post over at How to Invest Online looked at the opinions of various investment theory heavyweights on the question of whether owning an index of stocks becomes more or less risky the longer you hold them. I want to address the argument that because “the spread of possible ending dollar values get wider, not narrower, with time,” stocks keep getting more risky over time. At its core, this argument is playing a semantic game with the word “risk”.

To explain what I mean, imagine you have the chance to invest in the following hypothetical investment:

1or2 investment: Each month you toss a fair coin. If it comes up tails, you get a return of inflation+1%. If it comes up heads, the return is inflation+2%.

This looks like a fantastic investment. After one year, you’ll beat inflation by between 12.7% and 26.8%. Even the worst-case scenario gives a better return than most of us could possibly hope for. The 1or2 investment is risk-free in the every-day sense of the word “risk”.

If we use the technical definition of “risk” commonly used in finance, we need to look at volatility and standard deviations. Over one month, the standard deviation is about 0.5%. After a year, the standard deviation goes up to 1.7%. At a decade, it’s 5.5%, and after 50 years it’s 12%. The longer you hold the 1or2 investment, the riskier it gets, in a technical sense. It’s clear that the every-day meaning of “risk” is different from the technical meaning used in finance.

Now let’s look at a riskier hypothetical investment:

-2or3 investment: Each month you toss a fair coin. If it comes up tails, you get a return of inflation-2%. If it comes up heads, the return is inflation+3%.

Just as with the 1or2 investment, the -2or3 investment’s standard deviation keeps rising the longer you hold it. However, what if we focus on the probability that the portfolio will lose purchasing power over different holding periods? The following chart shows that the probability of losing purchasing power drops over time.


After 30 years, the probability that the -2or3 investment will lose out to inflation is less than 1 in 5000. So, if you’re trying to decide whether the -2or3 investment gets riskier the longer you hold it, which of the following facts seems more relevant?

1. The standard deviation keeps getting larger the longer you hold the -2or3 investment.

2. The -2or3 investment is expected to beat inflation by 5.8% per year, and the probability that it will lose to inflation over 30 years is less than 1 in 5000.

At this point Boston University professor Zvi Bodie would argue that with real stocks, the odds of losing money increases the longer you hold them. His justification is that option prices rise with the length of the term. However, the Black-Scholes pricing model does not even take into account the expected return of an investment. This means that the Black-Scholes price of using options to insure against losses with the 1or2 investment would rise with time as well, even though there is no risk of loss with this investment.

The bottom line is that if we’re going to talk about whether stocks are risky over the long run, we need to be precise about what we mean by “risky”. The way that most non-specialists would interpret this question, I think the correct answer is that beyond a certain holding period, owning stocks starts becoming less risky.

Friday, December 13, 2013

Short Takes: Impact of Dead Mutual Funds, Online Financial Calculator Problems, and more

In addition to my appeal for help to keep my blog alive, this week I wrote about group RRSPs which generated quite a bit of discussion in the comments section:

Employer Matching in Group RRSPs

Here are my short takes and some weekend reading:

Vanguard has a very interesting report analyzing dead mutual funds. The survivorship bias effect is very clear looking at the chart on page 3 showing the percentage of funds that outperform their benchmarks. This percentage changes dramatically when you take into account dead funds. Thanks to Ken Kivenko (http://www.canadianfundwatch.com/) for pointing me to this report.

Potato finds problems with an online calculator designed to help you decide whether you’re better off renting or buying a home.

Retire Happy Blog reports that Service Canada’s online CPP calculator sometimes produces wildly inaccurate estimates of your future CPP benefits.

Where Does All My Money Go? is offering a nearly half-off deal on pre-orders of Preet’s new book Stop Over-Thinking Your Money!

Big Cajun Man describes a devious tactic used by furnace salespeople that worked on him.

Canadian Couch Potato explains when it’s better to hold a U.S.-listed ETF and when it’s better to hold its Canadian equivalent.

Gail Vaz-Oxlade explains the implications of co-signing a loan for a family member.

My Own Advisor finds out what’s in the Big Cajun Man’s personal investment portfolio.

Million Dollar Journey describes the top renovations for increasing rental income.

Larry MacDonald thinks that there will be a global economic upswing in 2014 that will benefit Canada. I hope he’s right. But just in case, I’ll stick with my investment plan instead of making any bets on my hunches or anyone else’s insights.

Wednesday, December 11, 2013

Employer Matching in Group RRSPs

My employer didn’t get much uptake when it first brought in an insurance company to offer a group RRSP because there was no employer matching. However, this has just changed. The question is how valuable is the employer match balanced against the high MERs on the pooled funds offered in the plan.

My new group RRSP plan is fairly generous: they match half of my contribution up to a maximum of 5% of my base pay. So, if I contribute 10% of my base pay, my employer will kick in another 5%. That’s the good part.

The bad part is that when I poked around in the investment options, the cheapest fees were on an index fund of Canadian stocks. The fees were listed as 1.401% per year (very high for an index fund). However, fee reporting on pooled funds is not the same as with mutual funds. As it happens, this percentage includes both the fund’s fees and the insurance company’s cut, but does not include HST or trading costs. I have no data on trading costs for this fund, but presumably it is very low on an index fund.

Comparing this fund’s fee (plus HST) to the MERs I pay on the ETFs in the rest of my portfolio plus commissions and spread costs, this group RRSP will cost me about 1.43% more per year than my ETF portfolio costs me.

Fortunately, the rules for this group RRSP permit me to transfer the account balance to my self-directed RRSP once per year without any extra charges. So, on average, my money will only sit in the expensive pooled fund for 6 months. The gap between the group RRSP fees and the fees in the rest of my portfolio is only about half of 1.43%, or 0.72%.

Enough with the percentages. Let talk dollars. Suppose my base pay is $100,000. Then my yearly contribution is $10,000, the company’s match is $5000, and the extra cost of 0.72% (on the whole $15,000) amounts to $108. So, the $15,000 contribution in the group RRSP gives me the same result as contributing $15,000 minus $108, or $14,892, to my ETF-based RRSP. To me, the employer match looks like $4892 rather than a full $5000. That’s still a very good deal for me.

But what would things look like if I had to leave the money in for 10 years before pulling it out of the group RRSP? In this case, money would stay in the expensive fund 10 times longer. The result is that the employer match would look like about $4000 per year instead of $5000.

With a more expensive group RRSP held for several decades, the higher fees would build up to the point where they consume the entire company match and more. It seems hard to believe that a small percentage like 2.5% could overwhelm a 50% company match, but it can. The reason is that the 50% is calculated only on the new contributions, but the 2.5% keeps hitting the entire account balance every year. After 30 years, the first month’s contribution has been bled by 2.5% 30 times!

The moral of this story is that free money from your employer is a good thing, but pay attention to fees.

Monday, December 9, 2013

A Reprieve

With some help from my readers, I managed to renew my domain registration. Not to bore you with the details, but there is an amusing bit: the solution involved resetting the password for an account I didn’t know existed from a year-old password reset email I received after first getting my domain.

I always feel bad whenever I blog about blogging. In this case, I was rewarded with several suggestions from readers that added up to a solution. Thanks to the Big Cajun Man, Bet Crooks, Kevin Chmilar, Glenn Cooke, and Neil Jensen for suggestions and offers of help. Thanks also to Tom Bradley, Greg, Tara C, Be*en, Returns Reaper, Trish M., and an anonymous reader for assuring me that I’d be missed. Sorry if I forgot anyone.

Some actual financial content: If I take the number of hours I spent solving this problem, and work out how much I would have been paid for this time at my day job, the resulting sum is the equivalent of 16 months of my blog’s income!

(Not) Going Dark

Update: With the help of some readers, the problem appears to be solved.  Thanks to all!

Writing this blog has been a great journey for me that I’d like to continue. However, I’m caught in the strange situation of being unable to renew my domain registration. It’s only $10 or so, but after sinking about 15 hours of my time over the past month into trying to get Google to take my money, I’ve made no progress. I’ll describe the gory technical details at the end of this post.

It’s not that my blog will disappear entirely, but I would have to go back to the old Blogspot address or try to register some new domain name. Either way I’d be facing losing my current PageRank which would lead to big loss in readership. I’m not sure yet if I’ll want to continue writing with this kind of setback.

Other bloggers have tried hard to get me to leave Google’s Blogger and use WordPress. I have little doubt that WordPress is usually easy to use and has powerful features. However, when I ask bloggers to tell me about any IT problems they’ve had recently and what they had to do to fix these problems, I get answers that make it obvious to me that I would never do what is necessary to keep a WordPress blog going. It’s not that I don’t have the technical background to fix IT problems. The trouble is that while many of my technical friends get a lot of satisfaction from tracking down and solving computer problems, I detest doing this kind of work. I like math and finance, but fixing computer problems ranks somewhere below cleaning toilets for me.

I still have lots of things I’d like to write about. Of particular interest to me is recent work I’ve been doing on the best ways to turn a retirement lump sum into a lifetime of monthly spending. I want to be able to figure out when I think I’ve achieved financial independence.

The threatened cut-off date from Google is Friday, December 13th (fitting, eh?). I will continue trying to resolve this, but if my blog goes dark on the 13th or sometime shortly thereafter, you’ll know why.

The Gory Details

This story began Nov. 13th with an email from Google complaining that the payment for automatically renewing my domain registration for michaeljamesonmoney.com failed. One of the suggested causes was an expired credit card. This made sense because I did get an updated credit card recently. So, I went to https://www.google.com/settings/account, clicked on Dashboard, signed in, found Wallet/Checkout, and updated my credit card details. Problem solved, I thought.

On Dec. 5th I received another email from Google saying that the registration payment failed. I checked my credit card details (they were correct). I then checked with my credit card company to see if they had rejected any charges (they hadn’t). Just in case this is the problem, I’ve entered a different credit card.

I’ve also hunted around in Google’s help areas and in various chat rooms for possible solutions. Many people have had similar problems and have solved them. But the dozen or so remedies I’ve found haven’t worked for me. The main stumbling block is that most solutions involve logging into https://admin.google.com/michaeljamesonmoney.com/, but I always get the following error message:

You are trying to access Google Admin of michaeljamesonmoney.com but you do not have a valid logged in account for it.

I have 3 different Google identities, but I get this error message for all three. I’ve tried on two different computers without success. So, there you have it. If you’ve read this far and have an idea of how I can fix this or how I can talk to an actual human at Google, I’m interested.

Friday, December 6, 2013

Short Takes: Investment Decision-Making, Series D Funds, and more

I wrote about TFSAs this week:

Forgone Consumption

More Confusion Comparing TFSAs to RRSPs

Tax-Free Savings Accounts – How TFSAs Can Make Your Rich

Here are my short takes and some weekend reading:

Carl Richards wrote a piece for the New York Times explaining that data exists to help us make good decisions in sports and investing, but coaches and investors make guesses instead.

Rob Carrick reports that more mutual fund companies are creating Series D funds that have some costs stripped out. This is a step in the right direction, but the MERs are still generally above 1% of your assets every year. Because I pay less than 0.2%, I find this still very high.

Canadian Couch Potato has the most thorough guide I’ve seen yet for saving money on currency conversions using the Norbert gambit. It includes instructions for RBC Direct Investing, BMO InvestorLine, TD Direct Investing, CIBC Investor’s Edge, and Scotia iTrade.

Retire Happy Blog explains why mutual fund distributions are not the same as fund profits.

Big Cajun Man provides a letter template to ask CRA for the child disability benefit retroactively from your disabled child’s birth. It seems simple enough provided you have a legitimate claim and supporting documentation.

The Blunt Bean Counter explains how to decide whether to convert your proprietorship into a corporation. Of particular interest to me was his rule-of-thumb that it doesn’t make sense to form a corporation unless you’ll be leaving at least $50,000 (or maybe even $75,000) per year in the corporation. Apparently, you need to defer part of the income taxes on at least this much money to justify the extra costs of running a corporation.

Gail Vaz-Oxlade shows how to see if you’ve got a lost account being held by the Bank of Canada. It’s pretty easy. Just follow the link and type in your name.

My Own Advisor profiles the investing strategy of a dividend investor. Index investing seems simpler to me.

Million Dollar Journey is getting close to the magic million dollar mark. I assume the name will change to Two-Million Dollar Journey soon.

Thursday, December 5, 2013

Tax-Free Savings Accounts – How TFSAs Can Make You Rich

The book Tax-Fee Savings Accounts – How TFSAs Can Make You Rich, by Gordon Pape, is a very useful guide to TFSAs. Broadly-speaking, the book contains two types of content: 1) easy-to-understand descriptions of the various TFSA rules and 2) advice for how to use a TFSA. The descriptions of the rules are excellent. The advice contains both good and bad parts.

This book is useful for financial novices as well as experts. I won’t discuss the material aimed at novices any further in this review. Instead I’ll discuss parts that I found interesting and parts where I disagreed.

Some Important Fine Points of TFSA Rules

“Never contribute a money-losing security directly to a TFSA. Sell it first, thereby creating a deductible capital loss, and then put the cash from the sale into the plan.” When you deposit stocks directly into a TFSA, the stocks are deemed to have been sold. You would have to pay capital gains taxes on any gains, but capital losses are not allowed.

You can’t “rent” TFSA room. Elaborate schemes using loans designed to allow one person to benefit from another person’s TFSA room are not permitted.

“Every dollar of income from [an RRSP or RRIF] reduces a Guaranteed Income Supplement benefit by 50 cents once the $3500 exemption has been exceeded.” This isn’t about TFSAs, but that $3500 exemption is important to factor into tax planning for low-income Canadians.

“Tax experts warn not to name your spouse/partner as a beneficiary but rather to use the successor holder designation” (except in Quebec). The important difference is whether the spouse gets to move the TFSA contents into his or her own TFSA without using up any of his or her own TFSA room.

Quibbles

My biggest criticism is Pape’s repeated statements showing a misunderstanding of the comparison between RRSPs and TFSAs. (I wrote about this in detail here and here.) No doubt Pape’s words will resonate with some people because over time they come to think of their RRSP assets as entirely their own, even though they received tax breaks in the past. The tax breaks enable people to contribute more money to an RRSP than they could contribute to a TFSA. Pape’s claim that RRSPs do not allow “us to obtain the full benefit of compounding” is simply not true. His advice to a 22-year old to “begin with an RRSP rather than a Tax-Free Savings Account because of the tax deduction” is bad advice if this young person’s income is low enough that the tax deduction is nearly worthless. Many young people are better off starting with a TFSA and waiting for higher income to open an RRSP.

Referring to a table of taxes paid on RRSP withdrawals, the figures “do not make provision for special tax treatment, such as the 50-percent capital gains rate.” I have no idea why capital gains taxes would be relevant to RRSP withdrawal income.

“Avoid speculative stocks and high-volatility mutual funds and exchange-traded funds.” There are so many types of ETFs that they couldn’t possibly be either all good or all bad. Further, Pape recommends certain ETFs at another point in the book.

Another category of concern I have about this book is the active investment advice. The book contains promotions of Pape’s subscription-based investment newsletters. Presumably, the tidbits of advice he gives are a sample of what’s in the newsletters. In one section he profiles a fictional couple who are savvy enough to “generate an average annual return of 15 percent on their money” for 30 years. In an environment of 2% to 3% inflation, this is unrealistic. Other advice to “choose companies that are industry leaders, have a well-established history of surviving even the toughest times, and are trading at the low end of their normal range” is just simplistic. Pape perpetuates the myth that individual investors who work hard can expect to beat the markets by a wide margin over extended periods of time.

Summary

The parts of this book that deal with TFSA rules and strategies are well written and easy to understand. Some parts of the advice offered are excellent as well, but other parts are misleading or just plain wrong.

Wednesday, December 4, 2013

More Confusion Comparing TFSAs to RRSPs

When comparing TFSAs to RRSPs, it’s important to consider only the after-tax portion of your RRSP balance or you’ll be led astray. The concept of forgone consumption is helpful. Here I look at how to compare TFSAs and RRSPs when it comes time to draw from them in retirement.

In the third edition of his book Tax-Free Savings Accounts – How TFSAs Can Make You Rich, Gordon Pape includes a section on questions he has received from readers. Unfortunately, the answer he gives to one of the question leaves much to be desired. Here is a paraphrase of the question:
Q: I expect to run out of non-tax-sheltered investments in about 5 years. When this happens, should I start drawing from my RRSP or TFSA?
Here is Pape’s answer:
A: “Let’s suppose you have a $5000 investment in each plan earning 7 percent annually. Five years from now, that investment will be worth $7012.76. Now you are faced with a withdrawal decision. If you take the money from the RRSP, using a marginal tax rate of 30 percent, you will be assessed $2103.83 on the withdrawal. That will leave you with a net after-tax return of $4908.93. Note that is less that the value of the original $5000 investment, which means that all the income you earned over the five years and more went in taxes. By comparison, a TFSA withdrawal will be worth the full $7012.76 – you keep all the investment income.

“This example does not take into account the benefit of the tax refund you received for the RRSP contribution, but this is in the past. What you are concerned about now is realizing the highest after-tax return from invested money that is already tax-sheltered. Leaving the TFSA intact is the best way to do that.”
It’s hard to decide where to begin with this muddled answer. Pape is saying that if you are comparing equal-sized withdrawals from your RRSP and TFSA, drawing from the RRSP will leave you with more TFSA funds that are more valuable because they won’t be taxed in the future. This is hardly surprising when we compare drawing equal-size amounts from each plan, because drawing from the RRSP will leave you with less money to spend this year due to income taxes. In effect, it is a smaller withdrawal, so it makes sense that you’re left with more money afterward.

Presumably, the reader is making withdrawals because he or she wants a certain amount of money to live on. For someone in a 30% tax bracket, a $7000 withdrawal from a TFSA should be compared to a $10,000 withdrawal from an RRSP. Pape’s comparison is simply irrelevant.

The observation that 5 years of growth in an RRSP doesn’t cover the taxes that will be charged on withdrawals is unhelpful. The original $5000 should be thought of as $3500 for the reader and $1500 for CRA. Viewed this way, both parts grow together and the reader can think of his or her part as growing tax-free.

The real answer to the reader’s question is complex. In some cases it makes sense to draw from both the RRSP and TFSA to keep taxable income steady over the years and avoid getting into a higher tax bracket. For low-income earners, it can make sense to draw the entire RRSP in one or two years (and move it to the TFSA if there is room) so that they can collect the full GIS in future years. For high-income earners trying to avoid OAS clawback is a consideration.

Answering questions like this without adequate details from the questioner is challenging because the answer usually ends up beginning with “it depends ...”. In this case Pape’s answer seems unhelpful no matter the circumstances.

Monday, December 2, 2013

Forgone Consumption

People tie themselves up in knots trying to compare RRSPs to TFSAs. Even well-known author and newsletter publisher Gordon Pape has some difficulty. The idea of forgone consumption helps to simplify things.

It’s important to understand how much you’re really saving when you put money in registered accounts. With TFSAs, the situation is simple. If you deposit $3000, then you’ve saved $3000.

RRSPs are more complex. If you’re in a 40% tax bracket and deposit $5000 in an RRSP, you’ll get $2000 back in taxes. Your forgone consumption is only $3000. RRSPs are easier to understand if you think in terms of only having saved $3000. Think of the other $2000 as belonging to CRA.

Suppose that over 30 years your money grows by a factor of 10. Your TFSA now holds $30,000. In the RRSP, your part has grown to $30,000 and CRA’s part has grown to $20,000. If you withdraw $10,000 from your RRSP and your tax rate is still 40%, you’ll get to keep $6000 from your part and CRA will get $4000 from its part. This shows that if your tax rate stays constant, the part of your RRSPs savings that represents your forgone consumption grows at the same pace as your TFSA savings.

The main consideration that tips the scale in favour of one registered plan or the other is changes in your tax rate. RRSPs look better when your retirement tax rate is lower than it was when you worked. TFSAs look better if your tax rate increases in retirement.

There are other considerations that affect the RRSP to TFSA comparison, such as differences in withholding taxes on U.S. dividends and the Home-Buyer’s Plan, but the main concern is tax rates.

Withholding Taxes on U.S. Dividends

The idea of forgone consumption was explained on page 278 of the 2008 federal budget as well as by Gordon Pape in the third edition of his book Tax-Free Savings Accounts – How TFSAs Can Make You Rich. Unfortunately, Pape fails to use the idea of forgone consumption correctly in recommending whether to hold U.S. dividend-paying stocks in an RRSP or a TFSA.

When you hold U.S. stocks in a non-registered account, the U.S. withholds a 15% tax on dividends. Because of a tax treaty between Canada and the U.S., this withholding tax does not apply to RRSPs. Unfortunately, the U.S. does not recognize TFSAs as retirement savings. Pape explains, “Inside a TFSA, the dividends will be taxed at only a 15 percent rate.”

Pape goes on to say “That actually may be a better deal than holding the U.S. shares in an RRSP or RRIF, and that’s because withdrawals from those plans are taxed at your marginal rate.” This analysis is wrong. When you properly account for forgone consumption, holding the U.S. shares in an RRSP works out better than holding them in a TFSA.

So here’s the scenario: you’ve got savings in both an RRSP and a TFSA and plan to hold some Canadian and U.S. stocks. The question is which account should hold the Canadian stocks and which one should hold the U.S. stocks.

Remember that an RRSP holds not only your forgone consumption but also CRA’s share. Based on a 40% tax rate, if you hold 300 shares of a U.S. company in your TFSA, you could have held 500 shares in your RRSP (300 shares for you and 200 shares for CRA). If the shares pay a $1 per share dividend, the TFSA would grow by US$300 less 15%, or US$255. In the RRSP case, your part grows by US$300, and CRA’s part grows by US$200; you end up with US$45 more in the RRSP case. It may be galling to grow money for CRA, but you’re still better off with U.S. stocks in your RRSP instead of your TFSA.

Contribution Limits

Pape observes that while the 2013 contribution limit for TFSAs is only $5500, “the maximum allowable RRSP contribution for high-income earners in 2013 is $23,820.” This is true enough, but a little misleading. An Ontario earner who is allowed the maximum RRSP contribution is in at least the 43.41% tax bracket. His forgone consumption on a $23,820 RRSP contribution is only $13,480. This is still quite a bit more than the TFSA limit of $5500, but the gap is smaller than it first appears.

Of course, this difference is for high-earners. An Ontarian making $40,000 is in a 20.05% tax bracket and has an RRSP contribution limit of $7200. The forgone consumption on this size of RRSP contribution is $5756, which is not much different from the $5500 TFSA contribution limit. Of course, lower earners need to be wary of having a much higher effective tax rate in retirement than they had while working because of income-tested government benefits like the GIS. Low-income earners are usually better off saving in a TFSA.

Conclusion

The concept of forgone consumption is important for making sensible choices about contributing to RRSPs and TFSAs and for choosing investments within these accounts.

Friday, November 29, 2013

Short Takes: Identifying Bubbles, Debt to Foreigners, and more

Here are my posts for the week:

Rule of 72 in Reverse for Mutual Funds

Crazy Arguments in Support of Leverage

Now is the Time to Consider Lowering Your Portfolio Risk (Rob Carrick mentioned this post on his Carrick on Money Globe and Mail blog -- thanks, Rob)

Here are my short takes and some weekend reading:

Jeremy Siegel gave a very interesting hour-long lecture (see video here) that includes the great quote “a bubble is an asset class that is going up in price that you don’t own.” Siegel takes a very long-term view of various asset classes and argues that Robert Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio is thrown way off by recent accounting changes that dramatically lower earnings in the last decade compared to decades past. Thanks to Canadian Financial DIY for pointing me to this one.

Big Cajun Man has a nice chart showing that the percentage of Canada’s debt owed to foreigners is lower than the percentage for other nations. However, in just 2 years, Canada’s percentage jumped from 15% to 25% owed to foreigners.

The Blunt Bean Counter has a guest post explaining severance pay laws. It turns out that the terminated employee has an obligation to seek new work to minimize the old employer’s severance costs.

Canadian Couch Potato argues that when leaving expensive mutual funds for low-cost ETFs, it is best to just pay the deferred sales charges (DSCs). He closes with “the best time to implement your portfolio is always now.” This is usually true, but not always. For example, a member of my extended family is currently waiting a month to make a change to avoid a 1.5% DSC. Waiting a year would not have been worth it, but just one extra month of high MERs is far less than the 1.5% DSC.

Million Dollar Journey explains why he finds Qtrade somewhat lacking as a discount brokerage even though many of his readers are vocal about liking Qtrade.

Sandi Martin makes some interesting admissions about her less than perfect financial habits that came from having free banking through her job for many years. I’ve always been wary of employment-related perks. For example, using a work email address for personal email becomes difficult when you change jobs. Similar problems come with joining company sports teams or leaning on other employer freebies. Free stuff is nice, but it’s important not to let your real life get too tangled up with your employer.

My Own Advisor lists some of his favourite financial advice quotes.

Wednesday, November 27, 2013

Now is the Time to Consider Lowering Your Portfolio Risk

During the 2008/2009 stock market crash, it wasn’t too hard to find people telling you to re-evaluate your asset allocation and tolerance for risk. However, that was a terrible time to lower you portfolio risk; now is a much better time to consider this question.

It’s natural for your emotions to tell you to sell stocks after they’ve dropped and to buy more after stock prices rise. To a certain extent it is these emotions that drive stock market swings. However, it’s not too hard to see that this behaviour amounts to selling low and buying high, which is exactly the opposite of what most investors want.

Re-evaluating your asset allocation isn’t necessarily a bad idea, but there are wrong times to do it. The stock market lows of March 2009 were the wrong time to consider selling stocks. Even if you were right in deciding that your stock allocation was too high for your risk tolerance, making a change back then would have caused a permanent loss of capital.

Now would be a great time to consider lowering your stock allocation. Stocks have risen tremendously from their lows four and a half years ago. If you suffered through the stock market crash and doubt that you could handle it again, lowering your stock allocation now would not cause a serious permanent loss of capital.

I’m not saying that investors should sell stocks now. I’m just saying that if you must sell stocks, now is a far better time to do so than 2009 was.

We can flip this argument on its head as well. If you are considering increasing your allocation to stocks, the recent big run-up in stock prices makes now a bad time. 2009 would have been a much better time to decide to buy more stocks.

Most of the time the best thing to do is to stick with a sensible long-term plan. However, if you’re determined to change your allocation, the best time to do it is usually when your emotions are pushing you in the opposite direction.

Tuesday, November 26, 2013

Crazy Arguments in Support of Leverage

I always hesitate to point to work that I think my readers should avoid, but I’ll make an exception here. I was reading an article called Why borrowing to invest (leveraging) is a good idea. I’ve read many reasonable articles that point out the positive side of leverage and expected more of the same here. However, I didn’t get more of the same. (Thanks to Ken Kivenko for pointing me to this article.)

The interesting part of the article begins when the authors take aim at critics of leveraging:
“Critics argue that leveraging increases investment risk and that a rate of return higher than the loan’s interest rate is needed to generate a profit. But neither claim is accurate.”
Okay, this is going to be good. Apparently, leverage doesn’t increase risk and you can profit even if you pay more to borrow than you make on your investments! Let’s start with risk:
“Risk, as far as it pertains to investing, is the odds that you will lose money. By this definition, we have to question how borrowing money can impact risk. After all, whether you invest your own money or that of the bank’s [sic], it’s the performance of your investment that determines profit or loss. Leveraging will impact how much you could potentially lose, but the odds are still based on your investment choices.”
We don’t all agree on a single definition of financial risk, but no sane person ignores the magnitude of potential losses. If an investment goes badly for me, I care a great deal whether I lose $10,000 or $100,000.

Leverage magnifies both gains and losses. This increases financial risk by every reasonable definition I’ve seen.

Let’s move on to how to profit even if your investment returns are less than you pay in interest:
“If investing for a single year, then a return higher than the loan’s interest rate is needed to turn a profit. But most leveraging strategies are designed to be in effect for years, in which case the break-even rate of return drops below the loan’s interest rate.

“The reason is simple. Investment returns compound over time — in other words, gains from one year generate gains in of themselves in the following year. Meanwhile interest on investment loans is fully paid every year and does not accumulate (simple interest). As a result, investment growth outstrips the interest paid over time.”
This reasoning may be hard to follow without an example. Suppose you borrow $100,000 at 4% interest. You pay just the interest of $4000 per year for 25 years. So, you pay a total of $100,000 in interest.

You invest the money and earn a return of 3% per year for those 25 years. After paying off the initial loan, you’re left with $109,378. But you only paid $100,000 in interest. So, you’re ahead $9378. Or at least this is the reasoning of the writers of the article.

I wonder if the authors have heard of inflation or opportunity cost. From your point of view as the investor, you paid $4000 per year for 25 years and ended up with $109,378. This works out to a yearly return of 0.74%. Because this is very likely to be lower than inflation, you actually ended up with less purchasing power than you gave up with the interest payments.

Looking at this from a different angle, suppose you hadn’t used any leverage and had just invested $4000 per year for 25 years earning 3% per year. In the end you’d have $145,837. This is $36,459 more than leveraging produced. It’s hard to see any reasonable way to look at this and conclude that the leverage was beneficial.

Any time someone makes an argument that uses the term “simple interest,” you should be wary. Simple interest does not exist in the real world. All interest compounds. Paying off the interest every year creates the illusion of simple interest if we make the mistake of ignoring the time value of money.

Borrowing money to invest is an advanced investing strategy that should only be done by knowledgeable investors with a high capacity for volatility. Because it makes no sense to borrow to invest in fixed income investments, leverage is for those who can handle more volatility than an all-stock portfolio. If you’re like many Canadians with a balanced portfolio (roughly half stocks and half bonds), you should consider bumping up your percentage of stocks before thinking about leverage.

Investors who work with financial advisors need to be concerned about pitches touting the benefits of leverage. Good advisors would only recommend leverage for the small minority of their clients where it makes sense. The not-so-good advisors will see leverage as a way to collect more fees on a larger amount of money you have invested.

If you’re thinking about using leverage and are dreaming of huge riches, you should ask yourself a sobering question: if stock prices tumble to half their current value and then you lose your job, will you be okay?

Monday, November 25, 2013

Rule of 72 in Reverse for Mutual Funds

Most people have heard of the Rule of 72. It’s a way to estimate how long it takes for your money to double at a given rate of return. Less well known is that this rule can be used to estimate how long it will take for investment fees to consume half your portfolio.

The Rule of 72 says that if multiply your rate of return by the number of years you’ll earn that return and the answer is 72, you’ll roughly double your money. So, if you earn 6% each year, it takes about 72/6=12 years to double your money.

When it comes to fees, the same rule works for finding the number of years it takes for fees to consume half of your money. For example, if you invest in Investors Canadian Growth Fund, the total fund costs each year are 3.02% of invested assets. So, it would take about 72/3.02=23.8 years for half your money to be consumed in costs. This rule just gives an estimate, but it’s pretty close. The actual time is just under 23 years.

Friday, November 22, 2013

Short Takes: Shaking Up Canada’s Mutual Fund Industry, Brokerage Rankings, and more

I gave a warning about misusing TFSAs this week:

Two Common Misconceptions about TFSAs

Here are my short takes and some weekend reading:

Tom Bradley at Steadyhand makes a strong case that the mutual fund industry has lost its chance to create practices that are friendly to investors. He says that regulators need to cause a transition in the industry that is “jolting, expensive and soul searching.”

Million Dollar Journey compares the top Canadian brokerages that offer U.S. Dollar RRSPs. He compares them on fees and on how well they handle currency exchanges between Canadian and U.S. dollars. The Globe and Mail has also come out with its 2013 ranking of online brokerages.

Larry MacDonald explains why tax-loss selling is not as valuable as it appears to be.

Retire Happy Blog does a good job of interpreting the latest SPIVA scorecard comparing active versus passive investing. The 5-year results look quite dismal for active investors.

Canadian Couch Potato explains the hidden cost of bid-ask spreads when trading. I wrote about this topic myself in the early days of this blog.

Big Cajun Man takes a look at the “4% rule” for drawing an income from your savings in retirement.

My Own Advisor gives us a primer on TFSAs.

Thursday, November 21, 2013

Two Common Misconceptions about TFSAs

The name Tax-Free Savings Account does a good job of making it clear that these accounts produce gains that are tax-free. However, the “savings account” part of the name leads to confusion for some Canadians. Here are two common misconceptions about TFSAs.

Misconception #1: TFSAs are just for holding cash like regular savings accounts.

TFSAs can hold a wide range of investments, including stocks, bonds, and cash just like RRSP accounts. It’s common for banks to offer TFSAs that can only hold cash and GICs, but this is the banks’ restriction, not a TFSA restriction. Most banks offer other TFSAs that do permit holding stocks and other investments. Almost all discount brokerages also offer TFSAs that allow the full range of investments.

Misconception #2: TFSAs can be treated like regular savings accounts with many deposits and withdrawals.

Most people are aware that there are limits on the total amount you can contribute to a TFSA. For those who turned 18 in 2009 or earlier, the lifetime contribution maximum is $25,500 in 2013. A nice difference between TFSAs and RRSPs is that if you make a TFSA withdrawal, you get your contribution room back, but not until the next year.

Let that last bit sink in a little: not until the next year. Suppose you opened a TFSA in 2012 and put in the maximum of $20,000. Then this year you put in another $5500. Later this year you took out $5000 and then put it back. It may not seem like you’ve contributed too much, but CRA disagrees. The $5000 withdrawal will give you extra contribution room in 2014, but for 2013 you’ve contributed $5000 too much and will be charged a 1% penalty each month on the excess.

In many ways TFSAs are much simpler than RRSPs, but there are still some rules that Canadians need to know.

Friday, November 15, 2013

Short Takes: Advisors as Fiduciaries, the Future of Marriage, and more

Here are my posts for the week:

Fight Back

Investment Survey Troubles

Expanded CPP and Debt

Here are my short takes and some weekend reading:

Anita Anand and John Chapman at the University of Toronto Faculty of Law explain in this short article why investment advisors should be fiduciaries. They say that current Canadian laws in this area are “a mess.” Thanks to Ken Kivenko for pointing me to this one.

Scott Adams has a very interesting take on the future of marriage.

Where Does All My Money Go? says you shouldn’t take up a bank’s offer to take a payment holiday.

Canadian Couch Potato shreds claims made by a mutual fund company in their ad.

Big Cajun Man lays out the reasons why some parents are pushed toward sending their kids to a private school.

The Blunt Bean Counter brings us a detailed look at the ins and outs of tax-loss selling.

My Own Advisor calls for clawing back Old Age Security at lower income levels. His reasoning is that it makes no sense for working-class Canadians to subsidize the lifestyles of upper-middle class retirees.

Financial Crooks investigates the fine points of getting trading commissions at RBC lowered from $28.95 to $9.95.

Thursday, November 14, 2013

Expanded CPP and Debt

The push to expand CPP has been strong lately. The idea is that too many Canadians won’t save for their retirements and must be forced to save more money. Setting aside the argument over whether it is a good idea to force Canadians to save more money, I wonder if it is even possible because of debts.

For various reasons, many Canadians simply won’t save for their retirements. Some have good reasons, but most don’t. If we expand CPP, we can force people to save more through increased payroll deductions. Those who already save for their retirements can afford to save a little less because they can expect higher CPP benefits. So, by expanding CPP, we’re mostly affecting those who don’t save now.

But how can we stop people from simply building larger debts as they head into retirement?

When Canadians carry debt into retirement, it’s as though they have pre-spent part of their CPP benefits. If CPP expands, they can borrow even more and pre-spend the increase in CPP benefits.

You might object that people aren’t this calculating. That’s generally true, but lenders are definitely that calculating. Lenders have been wildly successful at marketing debt to Canadians in recent decades. Sadly, many people just keep borrowing until lenders say no. If a borrower has higher CPP benefits coming, then lenders will delay saying no for a little longer allowing borrowers to pre-spend their increase in CPP benefits.

According to Douglas Hoyes, “it is very difficult, if not impossible, for a creditor to garnishee a pension,” but if the debts are backed against seniors’ homes, then the threat of losing one’s home will keep seniors making interest payments out of their expanded CPP benefits.

You might think that I’m offering this line of thought as an argument against expanding CPP, but that’s not where I’m headed. I’m actually a supporter of a modest expansion of CPP as long as the higher benefits go to those who make the higher payroll contributions. What I’m looking for is some sort of solution to the debt problem I described.

If we were to expand CPP, how would we stop Canadians from building up larger debts that eliminate some of the upside of higher CPP benefits?

Wednesday, November 13, 2013

Investment Survey Troubles

In Rob Carrick’s latest roundup of personal finance links on the web he asked his readers to take a short Qualtrics survey to “help build a better investor risk assessment tool.” Unfortunately, the survey has problems that will muddle its results.

The main question on the survey asks which of 4 investments you’d be most comfortable with. Here is the exact wording:
“Investments with higher potential returns typically involve greater risk. The following chart shows four hypothetical investments of $10,000, each with a different potential best and worst outcome at the end of one year. Which investment would you be most comfortable with?”
You are presented with 4 bar graphs giving ranges of possible portfolio returns going from safest to riskiest. Here were the ranges I was presented.

Portfolio A: 0 to $10,900
Portfolio B: -$9600 to $11,200
Portfolio C: -$8900 to $11,800
Portfolio D: -$8400 to $12,400

Just based on the numbers, it’s hard not to choose Portfolio A because its midpoint is more than double the midpoints of the other portfolios. So, even though I tend to be comfortable with volatility, I had to choose the least risky choice in this survey because it offered the highest expected return.

Another problem is that the bar graphs shown were hopelessly out of scale. For example, it shows the downside of Portfolio D as about 4 times bigger than the downside of Portfolio B, even though B actually has the greater potential for loss.

I suspect that the survey results will have some meaning for respondents who look only at the picture and ignore the numbers on it. However, crazy people like me who actually look at numbers will mess up the survey results.

This isn’t the end of the problems, though. When I went to look back at the survey again, I was presented with a different chart. After a few browser reloads, I saw that there appeared to be 5 different charts. Three of these charts had big mismatches between the numbers and the bar graph sizes. The other two were to scale, but still showed the safest investment as having the highest median return.

Overall, I seriously question whether this survey can produce any meaningful results about investor attitudes towards investment volatility.

Tuesday, November 12, 2013

Fight Back

Over her years of using her Toronto Star column to help consumers fight back against unfair company practices, Ellen Roseman has built up wide-ranging consumer skills. Her book Fight Back teaches us what she has learned and goes further with many parts written by experts in different areas. Across 81 short, easy-to-read sections, Roseman covers how to deal with almost every conceivable consumer problem.

The broad categories covered in this book are banks, finances, telecom suppliers, travel, retailers, cars and houses, and the courts. I’ve had troubles in most of these areas, and I find this book very valuable. However, Dave Chilton, who wrote the foreword, shows he is better at singing Roseman’s praises than I am when he starts with “I LOVE ELLEN ROSEMAN’S WRITING.” I agree.

In the rest of this post I’ll discuss specific parts of the book that I found interesting.

Mutual Fund Companies

In the past “many [mutual fund] companies treated investment advisors as their customers, while ignoring the needs of investors. That is no longer true.” I find this surprising. I’d like to hear more from Roseman to understand what she thinks has improved.

Right of Set-Off

“If you keep your operating account with the same bank where your loans are, your funds could be seized by the bank if you get behind on your loan.” This “right of set-off” makes it useful to have “some funds that are beyond the reach of your lending bank.”

Telecom Discounts

Roseman isn’t afraid to describe some tricky tactics to counter those used by internet, cable, and phone companies. These companies have specific deep discount percentages they sometimes offer to keep a customer. “If you know what the discount percentage is, you can pretend you were offered it and you are now calling back to confirm taking it.”

Travel Insurance

“If you make a mistake in any one of your answers [on a health history questionnaire], you will not be able to collect on your insurance ... even if the reason for your claim has nothing to do with the erroneous answer.”

Rental Car Insurance

What car rental companies offer “is not insurance but a collision damage waiver (CDW). This means that the rental company waives its right to collect a high deductible from you if the car is damaged.” I’m not sure I understand this. Does this mean that rental cars are already insured but the deductible is high? If so, I can afford a fairly high deductible as long as the bulk of any very large judgements is covered.

Credit Card Disputes

In my limited experience, credit card companies seem very accommodating when I dispute charges. However, you lose your zero-liability guarantee if you “have reported two or more unauthorized events in the past 12 months.”

Little Black Book of Scams

Roseman recommends reading the little black book of scams. That’s an intriguing title.

End-of-Lease Charges

Roseman says that her neighbour is on to something when he theorizes about the motives of a particular car company when it leases cars. “The company loses money on artificially inflated residual values” and it uses inflated lease-end charges “to recover the loss.” Given how so many people focus exclusively on the size of monthly payments, it’s easy to see how car companies can be tempted to drive payments lower and make up the difference at the end of the lease.

Friday, November 8, 2013

Short Takes: Analyzing Canadian Stock ETFs, Tax Credits for Disabled Children, and more

This week I fed my interest in poker:

World Series of Poker Main Event Losses

Here are my short takes and some weekend reading:

Canadian Couch Potato uses factor analysis to look for value in Canadian equity ETFs.

Big Cajun Man talks from experience when he explains how to get tax credits for school fees for a disabled child.

My Own Advisor gives a quick, easy-to-understand summary of the things you should know about RRSPs.

The Blunt Bean Counter is giving away copies of Richard Peddie’s book Dream Job.

Tuesday, November 5, 2013

World Series of Poker Main Event Losses

With the main event of the world series of poker wrapping up tonight, I thought I’d throw a wet blanket on the dreams of aspiring poker players by looking at the risk-adjusted payoff of entering this tournament. The results are worse than I expected.

The entry fee to the main event is $10,000. However, the prize payouts average only $9400 per player. Without any risk adjustment the average player is losing $600 by entering the tournament. To an insurance company with billions in assets, this analysis makes sense. But to people of more modest means, a reasonable amount of risk aversion makes the loss much higher.

A sensible level of risk-aversion involves treating gains and losses geometrically. This means that doubling your net worth from $100,000 to $200,000 is as good as it is bad to have it cut in half to $50,000. Based on this model of the utility of money, a person with a $100,000 net worth expects to lose $5918 playing in the main event if his tournament result is just random (equally likely to be first, second, or at any other position). This is a lot worse that just giving away $600.

Here are the results for other levels of net worth:

$1,000,000,000: loss of $610
$100,000,000: loss of $699
$10,000,000: loss of $1360
$1,000,000: loss of $3356
$100,000: loss of $5918
$20,000: loss of $8183

This isn’t the worst of it, though. Most people have higher levels of risk aversion than I used in this model of the utility of money. If we use what is called a “harmonic” model the results look even worse:

$1,000,000,000: loss of $620
$100,000,000: loss of $796
$10,000,000: loss of $1932
$1,000,000: loss of $4405
$100,000: loss of $7038
$20,000: loss of $9144

The lesson here is that you have to be a well above average poker player to have an expectation of coming out ahead playing in the world series main event. Of course, many poker players can convince themselves that they are good enough to win. Only a minority of them can be justified in their confidence.

Friday, November 1, 2013

Short Takes: Rebalancing for Taxes, Bitcoin Taxes, and more

This week I found a problem with a trading account statement and added a new twist to my retirement income strategy:

InvestorLine Computers Charge Me Interest

A Retirement Income Strategy Revisited

Here are my short takes and some weekend reading:

Canadian Couch Potato gives a good example of how to rebalance a portfolio while maintaining assets in tax-efficient accounts.

The Blunt Bean Counter looks at the tax side of Bitcoins.

Glenn Cooke gives a thoughtful review of Potato’s Short Guide to DIY Investing. Glenn makes an interesting pitch for keeping your stock investments in Canadian stocks, but then admits that this is likely just emotional and that including foreign stocks is probably best. Despite his assertion that we need to get emotions out of investing, he illustrates why this can be hard to do.

Larry Swedroe reviews former Federal Reserve vice chair Alan Blinder's new book After the Music Stopped and finds it to be the best he’s read so far on the financial crisis.

Where Does All My Money Go? interviews Rich Cooper who explains some of the ins and outs of a DIY approach to settling your debts for less than you owe when you’re in serious financial trouble.

Financial Crooks reviews Ellen Roseman’s book Fight Back.

My Own Advisor has made some great progress on his 2013 financial goals.

Big Cajun Man thinks that when you’re well behind your retirement savings target, reaching for high-risk investments isn’t the answer.

Million Dollar Journey looks at the advantages and disadvantages of commuting by bicycle. For me the big disadvantage is safety. I used to love cycling but stopped because I always had to travel beside cars for parts of my trip.

Canadian Capitalist updated his explanation of how employee stock purchase plan (ESPP) benefits are taxed.

Wednesday, October 30, 2013

A Retirement Income Strategy Revisited

Last week I made my first stab at designing a retirement income strategy that adapts to portfolio performance. By allowing monthly income to vary we can overcome serious problems with the “4% rule” and rules of thumb about the percentage of bonds in your portfolio. Unfortunately, the monthly changes in income were too erratic. I now have a fix for this problem.

I won’t repeat too much from the original post. I did experiments based on a 60-year old retiring at the start of the year 2000 with $1 million in today’s dollars. I designed a spending plan based on keeping 5 years’ worth of monthly spending in a high-interest savings account (HISA). I used a target life expectancy of 95 and assumed that all savings not in the HISA would be invested in the Canadian stock ETF XIU. (I don’t recommend such a concentration in Canadian stocks for a real portfolio.)

Stocks were extremely volatile from 2000 to 2013 and the goal of this experiment was to design a retirement spending plan that doesn’t have the monthly spending amount vary too much while controlling the risk of overspending and draining savings too early.

The latest feature I’ve added is some filtering on the changes in spending. When the strategy calls for spending to increase from one month to the next, I actually only increase it by 1/40 of the called-for amount. One way to think of this is that it takes roughly 40 months for spending to rise to meet an outperforming portfolio. When the strategy calls for spending to decrease, I only apply 1/20 of the decrease. So, it takes roughly 20 months for spending to drop to reflect an underperforming portfolio. This adds some risk of spending too much while stocks drop sharply, but 20 months’ worth of spending is only one-third of the 5 years’ worth of HISA savings.

So how well does this new filtering smooth out monthly spending? The following chart shows the performance of XIU with reinvested dividends, the unfiltered spending from the previous experiment, and the new filtered spending. All are inflation-adjusted.


Without any filtering, monthly spending reacted immediately to changes in XIU leading to a very bumpy ride. With the filtering, changes are much more gradual but still show good reaction to XIU returns. For example, if XIU had stayed down from 2002 onward instead of roaring up, the filtered spending would have reacted to the new reality in a couple of years.

Overall the addition of the filtering seems to have given us a good compromise between reacting to permanent changes in a portfolio without causing monthly spending to jump around wildly. I’m definitely interested in feedback on this retirement spending strategy. Are there flaws? Are there market events that it would react to badly?

Disclaimer: It would be crazy for anyone to blindly follow my recipe for retirement spending at this point. It needs much more analysis.

Tuesday, October 29, 2013

InvestorLine Computers Charge Me Interest

“INT @21%”

Hmm. That strange line appeared in my InvestorLine RRSP statement. It seemed to be related to my latest Norbert Gambit, which is a way to save money with currency exchanges. All have gone reasonably smoothly until recently when I was hit with a mystery interest charge.

To exchange Canadian dollars for U.S. dollars, I have bought the exchange-traded fund DLR that trades in Canadian dollars and then sold the equivalent ETF DLR.U that trades in U.S. dollars. The idea is simple enough, but a mistake with some accounting generated an interest charge that shouldn’t be there.

To make everything balance out, InvestorLine adds some extra transactions to the Norbert Gambit trades. I did the trades on a Monday. This means that the trades settled three days later on Thursday. So my account statement showed a buy of DLR units and a sell of DLR.U units. To balance things out, InvestorLine added a transfer out of DLR units and a transfer in of DLR.U units. Unfortunately, they accidentally showed these extra transfers as taking place on Wednesday instead of Thursday. Oops.

So, this means InvestorLine computers thought my account was short units of DLR on Wednesday (“short” means I held a negative number of shares). I was charged 21% interest for one day which amounted to over $40. Maybe the rate was so high because I was using an RRSP account where margin isn’t permitted.

InvestorLine quickly agreed to reverse the charge, but if I hadn’t noticed it and called them, I don’t think this would have been fixed. The moral of the story is to check your account statements for unusual activity. This is easy to overlook when you have online account statements.

Friday, October 25, 2013

Short Takes: Why Women Earn Less, Investing in Football Players, and more

I had a couple of popular posts this week judging by the number of comments:

A New Market for Education

A Retirement Income Strategy

Here are my short takes and some weekend reading:

Freakonomics reports on research into why women earn less than men. The finding that women seem less willing to compete for higher pay is consistent with my experience. Among the most competitive business people I know who have questionable morals and are willing to devote far more than 40 hours per week to their careers, the vast majority are men.

The Blunt Bean Counter looks into investing in NFL football player Arian Foster. I suspect that fans will consistently overpay for shares of professional athletes. Owning a slice of a player might feel good but I doubt that it is likely to be a good investment.

Canadian Capitalist answers a reader question about whether it makes sense to maintain an allocation to bonds.

Canadian Couch Potato has some concrete advice for ETF investors who are looking to do some tax-loss selling.

Larry Swedroe explains how bond dealers hide their cut in the yields they offer.

Big Cajun Man asks when you got your first credit card and discusses how attitudes toward credit cards have changed over generations.

Where Does All My Money Go? interviews a legal expert about what happens to digital assets when you die.

Million Dollar Journey gives an answer to the question of how much money you have to save for early retirement. I think the assumptions used are a little optimistic, but I’m still mulling over what I think is the best answer.

Sandi Martin writes an open letter to the big banks inviting them to blow her mind. I wouldn’t count on banks making any of the suggested changes. To predict business behaviour, it’s better to think of businesses as profit-seeking machines capable of little else instead of thinking of them as collections of people with feelings. However, just reading her letter was cathartic for me.

My Own Advisor bemoans the constant barrage of financial product promotions. It’s easier to make a living convincing people to give you their money than it is to build a better mousetrap.

Gail Vaz-Oxlade tries to knock some financial sense into people who desperately need it. Every so often Gail answers some letters in her blog, and I found this crop of questions and answers particularly entertaining. A couple of quotes: “you and your partner don’t have the good sense God gave a goose” and “make sure you don’t get pregnant.”

Wednesday, October 23, 2013

A Retirement Income Strategy

I find most rule-of-thumb strategies for drawing retirement income from savings very unsatisfying. We have things like the “4% rule” and using your age as a percentage for your bond allocation, but such one-size-fits-all rules can’t possibly fit everyone. Here I introduce my own candidate strategy for generating retirement income.

Troubles with the 4% Rule

The 4% rule says that when you start retirement you can calculate 4% of your initial savings and spend this much each year rising with inflation. So, if you have $1 million saved, you spend $40,000 in the first year and increase this amount by inflation every year.

Of course, the main problem with this rule is the possibility of running out of money. If your investments perform poorly in the first few years, you just keep spending based on your initial savings even though your savings will start to dwindle quickly.

A second problem is that everyone uses the same percentage regardless of how they invest their money. Suppose two investors, April and Ben, have exactly the same asset allocation. But April is a do-it-yourself investor who pays 0.2% in ETF fees each year, and Ben pay 3% fees each year on his mutual funds. Obviously, Ben’s spending has to be 2.8% lower than April’s. If April can only spend 4%, then Ben can only spend 1.2%.

Yet another problem is the inconsistency of treating two investors differently when they have exactly the same portfolio size. Suppose that Cheryl and Dan are both 70 years old, have been retired for 5 years, and both have $1 million in savings. However, Cheryl’s portfolio began 5 years ago with $1.1 million and Dan’s has stayed steady at $1 million. The 4% rule will have Cheryl spending 10% more than Dan because she started with the larger portfolio. But this makes no sense given that they are in the same position now. You could even argue that Cheryl should spend less than Dan because her portfolio returns are weaker than Dan’s and, being a woman, she is likely to live longer.

Troubles with using your age as a bond percentage

People have different risk tolerances. Some of these differences are rational and some irrational. A tenured professor might reasonably have more appetite for stock risk than a middle manager in a high-tech company. A retired 55-year old might reasonably have less appetite for risk than a 55-year old who plans to work for another 10 years. On the irrational side, some people simply can’t sleep at night with any of their money in risky investments no matter what a rational analysis might conclude. Given these differences, how can we have a one-size-fits-all bond allocation rule make sense?

Income variability

Any strategy that keeps income completely stable (like the 4% rule) is going to either have a risk of running out of money or have such a big margin of safety that income will be very low. So, we need a strategy that adapts monthly spending based on portfolio performance. The goal is to find a way to keep spending as steady as possible without undue risk of running out of money.

I’m sure that financial advisors will tell me that many of their clients simply could not tolerate a reduction in their monthly spending. While this may be true, I would rather slowly reduce my spending than just run off the edge of a cliff when the money runs out. So, even if many people can’t adjust their lifestyles until all the money is gone, I’m more interested in a strategy that makes sense. That said, I still think controlling the volatility of cash flow is an important goal.

My proposed retirement income strategy

So here’s the idea. After retirement, we maintain 5 years of spending in a high-interest savings account (HISA). The rest gets invested the same way it was before retiring. In my case, that’s 100% low-cost stock index ETFs. The tricky bit is calculating the appropriate monthly spending amount. And because this amount will vary somewhat, the 5 years’ worth of savings in the HISA will vary somewhat. This means that there will be rebalancing between the HISA and the investment portfolio.

To calculate monthly spending, we need to make a series of assumptions. We choose a spending level so that if our return assumptions are exactly correct, we will run out of money at a chosen life expectancy. If returns are higher than expected then spending will go up the next month, and if returns are lower than expected then spending drops. As we will see in an experiment, monthly spending based on this rule turns out to be more stable than portfolio returns.

Here are some of the assumptions that I used in an experiment:

Portfolio return: inflation + 3%

This may seem conservative for an all-stock portfolio, but if we choose this to be too high then retirement spending will drop over time. I think it makes sense to choose this percentage to be lower than historical returns, but how much lower depends on how accepting you would be of reduced monthly income. Another thing to consider is that this percentage should be lower for investors who choose to include investments in bonds, real estate, or any other asset classes that historically have had lower returns than stocks.

HISA return: inflation +0%

I’m assuming here that the high-interest savings account interest will just match inflation.

Years of spending money to keep in the HISA: 5

I don’t have any particular justification for using 5 years other than it seems like long enough to stay sheltered from some wild swings in the stock market.

Life expectancy: 95

This is conservative, but hey, who wants to run out of money early. It probably would make sense to increase this life expectancy age is we get closer to it. Perhaps the remaining life expectancy should never go below 15 years.

Using these assumptions, I did an experiment based on a 60-year old retiring at the start of the year 2000 with $1 million in today’s dollars. (All of the dollar amounts in the experiment are adjusted for inflation.) The portfolio holdings other than the money in the HISA are invested 100% in the Canadian stock ETF XIU. I don’t recommend such a high concentration in Canadian stocks, but the goal here is to see how portfolio volatility affects monthly retirement income.

A few other details were that I assumed stock trades cost a $10 commission, a one-cent per share loss due to spreads on each XIU trade, and we only make stock trades when the amount of cash in the HISA is more than 5% from its target value.

Here are the steps that get performed at the start of each month.

1. Take the total portfolio value and calculate the monthly spending amount (rising with inflation) so that we would run out of money exactly at age 95. Transfer this amount to a chequing account from the HISA or form the investment account if there is cash there, possibly from dividends. (If any readers are interested the details on how to calculate the monthly spending amount, I’ll answer questions about it in the comments section for this post.)

2. Calculate the amount that needs to be in the HISA to support 5 years of this monthly spending.

3. If the actual HISA balance is low by more than 5% of its target value then sell enough stock (or other investments) to bring the HISA up to target. Selling stock periodically is inevitable as we spend down our savings.

4. If the actual HISA balance is high by more than 5% of its target value then transfer the excess from the HISA and buy stock (or other investments). This can happen when stocks drop sharply.

Experimental results

The following chart shows how monthly spending, adjusted for inflation, varied from the year 2000 to the present. Also shown on the chart is the value of XIU with reinvested dividends adjusted for inflation. The starting dollar amount of XIU was chosen to best contrast XIU price with monthly retirement spending in the chart.


While the XIU investment value varied over a range of 98% of its starting level, monthly spending varied over a range of 56% of its starting level. So, monthly retirement spending is less volatile than stock prices, but perhaps still too volatile.

At this point you may ask why monthly spending has to be so volatile. After all, if the stock market drops, it will probably come back eventually. This may or may not be true, but the model I used always assumes that whatever the current stock market level, this is the base from which steady 3% above inflation gains will be made. So, in this sense, we assume any big drop in stock prices is permanent and spending must go down. Factoring in some amount of stock price reversion of the mean in the model may be a path to improving my strategy, or it may just increase the risk of running out of money.

To try to reduce monthly spending volatility, I did a second experiment where we hold 10 years’ worth of spending in the HISA. Here are the results:


This time the monthly spending is steadier; it varies over a range of only 45% of its starting value. The trade-off is that monthly spending is generally about 10% lower in this case because more of the retiree’s portfolio is locked up in the low-return HISA instead of in XIU. Despite XIU’s volatility, it did give a positive return above inflation from the year 2000 to the present.

Limitations of this analysis

I haven’t dealt with taxes or the complication of a portfolio split across a number of different types of accounts, like RRSPs, RRIFs, TFSAs, and taxable accounts. I haven’t factored in CPP benefits or old age security. As well, I’ve only experimented with one time period for stocks. However, I did choose a very volatile period that included two significant bear markets for stocks, so at last we have a test of severe conditions.

Overall I consider this to be just a starting point for my thinking on how I’ll handle my own portfolio when I choose to retire. To be clear, I think it would be crazy for anyone to blindly follow my recipe for retirement spending. I’m very interested in ideas for improving it.