Friday, July 31, 2015

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

Here are my posts for the past two weeks:

So Stocks are Overvalued – Then What?

Your Retirement Income Blueprint

Here are some short takes and some weekend reading:

Jason Zweig calls gold “a pet rock.”

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

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

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

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

Tuesday, July 28, 2015

Your Retirement Income Blueprint

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Wednesday, July 22, 2015

So Stocks are Overvalued – Then What?

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

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

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

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

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

Friday, July 17, 2015

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

Here are my posts for the past two weeks:

Pound Foolish

4% Rule Experiments Using Longevity Statistics

Another Take on Retirement Withdrawal Strategies

Here are some short takes and some weekend reading:

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

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

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

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

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

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

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

Wednesday, July 15, 2015

Another Take on Retirement Withdrawal Strategies

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

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

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

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

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

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

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

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

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

Thursday, July 9, 2015

4% Rule Experiments Using Longevity Statistics

The well-known 4% rule for retirement spending comes from a 1994 paper by financial planner William Bengen called Determining Withdrawal Rates Using Historical Data. Some time ago I repeated his experiments adding in the effect of portfolio fees. This time I include mortality tables so we can see the effect of retiring at different ages instead of using Bengen’s target of a 30-year retirement.

Bengen’s model was to choose a fixed withdrawal rate at the start of retirement and increase the dollar amount by inflation each year regardless of how your portfolio performs. There’s a lot to be said for adjusting your spending based on portfolio returns, but Bengen’s goal was to find a safe withdrawal rate where you wouldn’t have to cut spending. He found that for stock allocations from 50% to 75%, a starting withdrawal rate of 4% (assuming no portfolio costs) was safe for a 30-year retirement.

Here I use mortality statistics from the Society of Actuaries to better model longevity and varying starting retirement ages. Bengen’s 30-year retirement is too short for most 50-year olds and too long for most 80-year olds.

I based the experiments on a century of U.S. stock and bond returns from 1914 to the end of 2013 (using Robert Shiller’s online data). I averaged the results of 100 retirees starting each year during the century. For retirements extending beyond 2013, I wrapped back around to 1914.

There were a number of inputs that went into each simulation:

1. Retirees are single males, single females, or a male-female couple of the same age where I used “joint” statistics.

2. Acceptable probability of running out of money.

3. Age at the start of retirement.

4. Portfolio costs each year.

5. Stock-bond allocation in the retirement portfolio.

The output from each simulation is the starting withdrawal rate that gives the desired probability of running out of money while still alive. In the case of a couple, the withdrawal rate is considered a failure if either person outlives the money. Unless otherwise stated, the default inputs are a 5% chance of running out of money, 60 years old, 0.2% portfolio costs, and a portfolio holding 75% stocks and 25% bonds. I used 0.2% portfolio costs because that is the total of my own portfolio’s expenses (MERs, trading expenses within funds, commissions, spreads, and foreign withholding taxes). Most portfolios have much higher costs than this.

In the first experiment, I examined how the safe withdrawal rate varies with age. As we see from the following chart, when stock allocation is 75% and total portfolio costs are only 0.2% per year, the simple 4% rule is appropriate for 56-year old males, 59-year old females or 63-year old couples.


However, when portfolio costs rise to the more typical 2.5% per year, the following chart show that the ages for a 4% rule rise to 72 for males, 75 for females, and 77 for couples. Keep in mind that these results are based on historical U.S. data and that most experts expect future real returns to be somewhat lower than they were in the U.S for the past century.

Early retirement enthusiasts should make note that the safe withdrawal rate for 50-year olds is about 2.7% for males, 2.6% for females and 2.5% for couples. These rates go up to about 3.7% to 3.8% for rock-bottom portfolio costs of 0.2%. So, for those retiring at 50 or earlier, the 4% rule just doesn’t apply unless you’re prepared to make deep spending cuts as necessary.


In the next experiment, I examined how the withdrawal rate changed with the portfolio’s allocation to stocks. Recall that the default inputs were a 5% chance of running out of money, 60 years old, and 0.2% portfolio costs. As we can see from the following chart, the highest withdrawal rate comes with a portfolio of about 75% stocks and 25% bonds.


It’s just common sense that withdrawal rates must be lower if portfolio costs are higher, but for some reason almost everyone ignores portfolio costs when talking about the 4% rule. It’s possible to be too pessimistic here, though. At first it may seem that 1% portfolio costs would take us from 4% withdrawals to 3% withdrawals, but this isn’t correct. When we’re at risk of running out of money, portfolio costs apply to an ever-shrinking portfolio. This reduces the dollar amount of these costs. As the following chart shows, each 1% of portfolio costs reduces the safe withdrawal rate by about 0.44%.


Some retirees may not be happy with a 5% chance of running out of money. The following chart shows how the withdrawal rate varies as we change the chances of outliving your money. For 60-year old retirees who want a portfolio that would have lasted until age 120 for any starting year in the past century, the safe withdrawal rate is 3.1%. At the other extreme, 60-year old males who can tolerate a 20% chance of running out of money can have a starting withdrawal rate of 5.2%, as long as their portfolio costs are only 0.2% per year. This makes a mockery of common advice from financial advisors to withdraw 5% from portfolios whose total costs are typically above 1.5% per year.


These results can be depressing for the many retirees who don’t have large enough portfolios to generate the income they want. Many otherwise excellent financial advisors seem prone to telling these retirees what they want to hear – that they can withdraw 5% or 6% from their portfolios each year. This is a formula for a few good years of retirement followed by relentless spending cuts for decades.

It’s possible to start retirement by spending a little more than the withdrawal rates calculated here if you’re prepared to cut spending as necessary. However, it’s important to be realistic about how deeply you can cut. I’ve watched people fail to cut enough early on and end up with no savings. My own attempt to design a spending strategy in retirement is called Cushioned Retirement Investing. The main idea is to use fixed-income cushioning to reduce how much you have to cut spending if portfolio returns disappoint.

There are many ways for new retirees to justify spending more right away. Who needs to spend a lot when they’re 90? Unfortunately, a 60-year old retiree who spends too much could be cutting back sharply as early as age 65. It’s much better to make a realistic plan and in the happy event that stock markets soar, you can always find ways to spend more.

Monday, July 6, 2015

Pound Foolish

In her book, Pound Foolish, Helaine Olen fulfills her promise of her sub-title Exposing the Dark Side of the Personal Finance Industry. It’s important to approach all big financial decisions carefully, and Olen shows us what awaits the unwary.

Olen takes well-aimed shots at big names such as Jim Cramer and Robert Kiyosaki. She says Suze Orman “has gone from selling subpar pancakes to peddling financial platitudes.” But the book isn’t just a set of amusing quotes. Olen digs into how these people make money and how their words are at odds with their actions.

The author covers the many problems with the financial advice industry. One of the more profitable financial products for advisors to sell is the variable annuity. On the subject of mandating a fiduciary standard, one former branch chief for the SEC said “if you need to act in the customers’ best interest, you can’t sell this crap.”

The most interesting part of the book in my estimation was the detailed reporting on the financial seminar industry. In some cases free meals are used for “scaring and pressuring the mostly elderly audience with half-truths and distortions” to “pressure them into high-commission products.” Other seminars appeal to financial desperation and greed to sell a series of progressively more expensive real estate “courses.”

There are professionally run organizations that offer slickly packaged services to help financial salespeople increase sales through seminars. These services include a designation such as being one of “America’s Top Planners.” In one case, a financial planner got such a designation for his dachshund.

Other seminars are devoted to “teaching” how to trade stocks, options, and currencies for profit. Olen paints a picture of the financially desperate and gullible attending such seminars and paying for more advanced courses.

One criticism I found puzzling was Olen’s portrayal of the book, The Millionaire Next Door, as a how-to guide for getting rich. I saw this book as a search for the rich to try to sell them goods and services. In any case, there are many other examples of books saying we should emulate rich people. This is generally a bad idea because so many people get rich by taking big chances and getting lucky. What we don’t see is the much larger number of people who took big chances and got wiped out.

Olen casts doubt on the conventional wisdom of owning stocks because “During the thirty-year period between 1981 and 2011, in the United States bonds beat stocks by almost a full percentage point.” This is actually a pretty slim margin considering that interest rates were in free fall during that time. The future is always cloudy, but a longer view of history tells us that stocks are expected to beat bonds most of the time.

I have to agree with Olen when it comes to teaching financial literacy: “when it comes to money, the vast majority of us are nuts. Bonkers. Batshit crazy. We are natural born fuckups. We engage in so many self-defeating behaviors it’s impossible to list them all.” “No amount of financial literacy will ever do as much good as straightforward government regulation designed to protect consumers.”

Many efforts to teach financial literacy have been infiltrated by financial organizations that have an interest in having people remain financially illiterate. For many people, financial problems come not from poor spending habits but from low pay and difficulty getting enough paid work hours. But I think there is still value in teaching financial concepts to the masses as long as we pursue regulations at the same time.

Olen says that “the latte is a lie,” meaning that our financial problems don’t come from small indulgences. But this is too simple. There are many factors that go into how people get into financial trouble and small frequent indulgences are one of them. Others are houses and cars. Root causes include poorly-regulated predatory lending by banks, ignorant consumers, and low pay.

I don’t see the point in denying that many people spend foolishly because it is obviously true. What we can say is that the better path to fixing the problem is through regulations rather than trying to change the habits of the masses.

Friday, July 3, 2015

Short Takes: Fee for Service, 100% Mortgage Financing, and more

Here are my posts for the past two weeks:

Guilt-Free Spending Through Planning

I Don’t Want to Go into Debt for This

Here are some short takes and some weekend reading:

Jason Zweig explains why you’re paying too much in financial advisor fees. He says we should be paying fees for service rather than paying a percentage of our assets. Another article from Zweig clearly explains why you should be skeptical of investment strategies that worked in the past.

Canadian Mortgage Trends report that one form of 100% mortgage financing will no longer be available after the end of June, but that combining an unsecured line of credit with a mortgage to get 100% financing will still be possible.

Gail Vaz-Oxlade does a great job of answering many questions from her readers, but I found the last question and answer in this post particularly interesting. It illustrates how banks have more power than some people realize and that some forms of protest are just self-destructive.

John Robertson at Blessed by the Potato reviews the book Wealthing Like Rabbits. He was pleasantly surprised, but did find some problems.

Forbes told Frugal Trader’s story of his Million Dollar Journey.

Boomer and Echo explain how customer loyalty programs have evolved to collect ever more information about us.

Big Cajun Man offers some signs that your debt load is getting out of control.

My Own Advisor explains why he still drives his 15-year old car. Until recently, I was saying the same thing. But then a cluster of needed expensive repairs forced me to get another car.