Monday, November 30, 2015

Value of a Public Service Pension

At one time I considered taking a job with the federal government. I had a competing offer in the private sector and set about comparing them based on various factors such as how much I’d enjoy the work, the commute, and total pay. A tricky part was placing a value on a public service pension. The value of a pension is very sensitive to the investment return we assume.

Let’s look at a simple example of a government worker:
– Starts work at age 23 making $40,000 per year
– Works for 35 years
– Retires at age 58 with an indexed pension of 70% of best 5 years average salary
– Pension is reduced by the amount of CPP benefits starting at age 65
– For first 20 years working receives raises of inflation + 4%
– For final 15 years working receives raises of just inflation
– Lives in retirement for 25 years until age 83

With the details in this example, we can calculate what percentage of this worker’s salary would have to be saved from each pay to cover the pension benefits. Of course, the rate of return on investments affects this calculation; the higher the investment returns the less you have to save.

The following chart shows the relationship between investment returns and how much we need to save to cover the pension. Keep in mind that we are talking about a “real” investment return, which means the return after subtracting out inflation.


At one extreme, if we could count on earning returns of 6% above inflation on saved money, we’d only need to set aside a little over 9% of the worker’s salary to cover the pension benefits. At the other extreme, if returns only match inflation, we’d need to set aside a whopping 49% of the worker’s salary!

At an investment return of inflation plus 4%, we’d need to save about 16% of the worker’s salary. This would be fairly reasonable: perhaps the worker could contribute 8% of pay and the government could match that dollar for dollar. Unfortunately, guaranteeing investment returns of 4% over inflation is a lot to ask.

Some commentators think that the expected future returns of stocks will be about 4% over inflation, on average. But this isn’t certain and will come with a lot of volatility. So, we couldn’t invest people’s pension money 100% in stocks. Adding a significant bond allocation drops the average return.

I actually invest my own long-term savings 100% in stocks, but I’m prepared to delay the start of my retirement if stock returns happen to disappoint. If I had taken the government job, I could have planned my retirement date without worrying about when stocks happened to take a slump.

Another thing to consider is that pensions do away with longevity risk. Even if our example worker lives to 110, the pension payments just keep rolling in every month. We have to save more to account for this possibility.

When I was comparing my two job offers, I settled on inflation plus 2% as a reasonable investment return to count on. Based on the chart above, this values the pension at 28% of salary, which is very valuable. In the end I still chose the private sector job, but the pension made the decision a lot closer.

For many people, even inflation plus 2% is not a realistic return expectation for their own savings given that most Canadians pay huge mutual fund fees in the 2-3% range every year. This makes a government pension look even more valuable to the average Canadian.

However, I’m confident in my ability to keep portfolio costs very low, so I think using inflation plus 2% as a safe return expectation made sense for me. Your mileage may vary. Whatever return expectation you think is reasonable, it’s clear that the value of a pension is very sensitive to this assumption. It’s also clear that pensions are very valuable no matter what reasonable returns you expect.

Thursday, November 26, 2015

The Overconfidence Gap

Over the years, the many people I’ve worked with have had both good and bad traits. No doubt they’d think similar things about me. The one trait that I find most tiring is a high overconfidence gap, which I define as the difference between how good you think you are and your actual abilities. Confidence is a useful thing in many contexts, but it can be deadly for your finances.

As a baseball coach, I routinely talk up players’ confidence before sending them to bat. Believing you can hit the ball improves how hard you try and leads to better outcomes. Confidence also leads to more improvement over time. Too much confidence can cause problems, but for the most part confidence is useful in baseball.

I’ve watched the cycle many times. A batter goes to the plate with confidence and either gets a hit or doesn’t. Failing causes a short-term blow to the ego that fades before the next at bat. Confidence helps. Even overconfidence helps within limits.

When it comes to investing, a large overconfidence gap can be very dangerous. You need some confidence to be able to take your money out of a savings account, but too much confidence leads investors to take wild chances on their hunches. I’ve done it myself piling most of my net worth into one stock. But I don’t do this anymore.

The cycle I observe among some high-tech workers is they are very confident in their assessment of some stock. They buy, the stock tanks, and they protect their egos with some explanation of why the bad investment wasn’t their fault. Then they do the same thing over again time after time.

It can be very hard to examine a stock, form a strong opinion, and admit to yourself “it’s just a coin flip whether I’m right or wrong.” It’s staggering that we often think we can do a little work on the side and beat full-time investment professionals at their game.

Even more baffling are the stock-pickers who don’t even read company financial statements. It’s impossible to pick stocks well without examining financial statements and comparing their meaning to the stock’s current price. A quick test I have for those touting a stock is to see if they can quote any of the company’s major financial figures from memory.

Confidence is important in many areas of our lives, but overconfidence can hurt you financially. Mind the overconfidence gap.

Monday, November 23, 2015

How Much Do You Need to Save to Retire?

Just poke around the internet for a while looking for answers to how much money you need to save before you retire and you’ll get answers ranging from next to nothing up to $3 million or more. It looks like some of them must be wrong, but it all comes down to your spending and pensions.

Let’s take an example. A Canadian couple, Mary and Bill, are both 65, have no debts, have no workplace pension, and are about to retire. They both worked enough to get maximum CPP benefits. Together they can expect CPP plus OAS of $3200 per month rising with inflation.

Suppose that $3200 is enough to cover their spending. Then the total savings they need is zero. Nada. Zilch. It can be dangerous to count on being able to work until age 65, to count on maximum CPP benefits, and to assume you can live on $3200 per month, but now that Mary and Bill have made it to 65, they need no savings beyond a modest emergency fund.

What happens if Mary and Bill have a more expensive lifestyle? Let’s say their spending is double their government pensions, $6400 per month after income taxes. Based on a series of assumptions, I work out that they need about $1.1 million in savings. This is hugely different from the first case where they needed no savings.

Let’s take it one step further and see what happens if they want to spend triple their government pensions, or $9600 per month after income taxes. Again, based on several assumptions, I calculate that they need about $2.4 million in savings.

No doubt others would calculate different amounts of savings needed to support the larger spending levels, but the point is that the need for millions of dollars in savings to retire comes from spending more than your pensions.

If you can live on your available inflation-indexed pensions, then you don’t need savings. If you need more money than this, your savings needs climb quickly. How much you need to save is so sensitive to how much you spend that we should never expect consensus among experts on how much you need to save.

Friday, November 20, 2015

Short Takes: Stock Return Expectations, Bond Index Criticisms, and more

Here are my posts for the past two weeks:

Enough Bull

Retirement Spending Stages

Choosing Investments You Understand

Taking My Investment Decisions Out of the Loop

Here are some short takes and some weekend reading:

Jonathan Clements explains why stock investors should expect about 6% return per year and 2% inflation for the next 10 years. A 4% real return sounds just fine to me. I’m not sure why we “need to save like crazy to compensate for the market’s likely modest gains.” However, I’m definitely with him that investors “should make sure they capture as much of those gains as possible, by opting for low-cost market-tracking index funds.”

Canadian Couch Potato explains why certain criticisms of bond indexes are wrong.

Larry Swedroe explains how some funds “juice” their dividends to exploit some investors’ preference for dividends over other types of returns.

Tom Bradley at Steadyhand adds to my list of complaints about index-linked GICs.

Jonathan Chevreau explains that Real-Return bonds aren’t as safe as they appear because it’s difficult to match their maturities to when you’ll need to spend your money.

Dan Hallett has an optimistic view of what will happen when new disclosure rules for financial advisors kick in. I hope he’s right.

Squawkfox uses her foray into gourmet olives to motivate us to track our spending. It can be an eye-opener to see where the money goes.

Big Cajun Man explains the latest step he’s had to take so that CRA will continue to recognize his son’s disability.

Million Dollar Journey says the easiest way to save money is to examine your biggest expenses.

Gail Vaz-Oxlade summarizes what you need to do to be ready to begin investing. Once again I meet all of her criteria except for “If you’re not living on a budget you’re not ready.”

Boomer and Echo helps a reader deal with RRSP over-contributions.

My Own Advisor tests himself on Gail Vaz-Oxlade’s 9 major money mistakes. He definitely gets a passing grade. But, like me, he doesn’t have a budget. I’m always torn talking about this because I see no need to have a budget myself, but I know others who desperately need one but don’t have one.

The Blunt Bean Counter has a guest expert explaining estate planning for blended families who have a marriage contract and others who don’t have a marriage contract.

Wednesday, November 18, 2015

Taking My Investment Decisions Out of the Loop

All the evidence says that the vast majority of us aren’t good active investors. Our choices tend to be worse than random, and we pay investment costs on top of this. Even index investors can have these problems. Here I explain how I’ve tried to automate my investment decisions as much as possible to take myself out of the loop.

Investors have many worries. Is now a good time to be buying stocks? Should I be selling now? Are there better mutual funds than the ones I own now? Should I shift more money into bonds? Less?

Unfortunately, the evidence shows that most of us make worse than random choices when we try to answer these questions. It’s tough to admit that we can’t beat a coin flip.

My response to this dilemma is to ignore my opinions on the market and invest in indexes. And as long as I’m not trying to beat the market, I maximize my returns with low-cost highly-diversified index ETFs.

But even after making this decision, investment choices can creep back in. For example, when adding new money, which ETF should you buy? I automate this choice using a fixed asset allocation. I have a target percentage of my portfolio for each ETF I own. When I have new savings to invest, I buy those ETFs that are below my target percentage.

Another investment choice that can creep back in relates to rebalancing. If my ETFs have different returns, my portfolio’s percentages can get out of balance too much to fix when I add new money. However, if I use my judgment on when to rebalance, I’m effectively making an active decision. So, I have a method to compute rebalancing thresholds. If my percentages get outside a range computed in my portfolio spreadsheet, then I rebalance.

This leads us to the next subtle form of decision-making. If I bury my head in the sand instead of paying attention to my spreadsheet, I’m effectively overriding the spreadsheet’s decision and substituting my own active decision. This is a common problem because many of us can’t bear the thought of selling an investment that has gone up to buy one that has gone down recently. I deal with this problem by having my spreadsheet send me an email with rebalancing instructions. I get these rarely, but always act on them.

The next area where my own discretion sneaks in is with new money. Over time I accumulate dividends and build savings in the various accounts that make up my portfolio. I have to decide when to invest this cash. In this case, I again let my spreadsheet decide. I have a formula for balancing trading costs against the opportunity cost of sitting on cash. This results in a cash-level threshold for each account. If the spreadsheet tells me the cash level in any account goes over its threshold, it’s time to buy.

I don’t believe the advice to “trust your gut” works well in investing. The evidence says your gut isn’t worth much. No doubt there are other subtle ways that my own decisions worm their way into my portfolio, but I believe I’ve managed to keep myself almost completely out of the loop, just the way I want it.

Monday, November 16, 2015

Choosing Investments You Understand

Some very common advice is to only invest in things you understand. It’s certainly a good idea to avoid investments you don’t understand, but it’s all too easy for a salesperson to give you the illusion of understanding. For this reason, I doubt it helps people much to tell them to choose investments they understand.

Let’s take the example of mutual funds. Suppose a financially naive young couple hear the following pitch:
“A mutual fund is a pool of money invested by expert money managers in stocks and bonds. We have a collection of 5 diversified funds that returned 9% per year over the past 5 years. If you start contributing $500 per month into your RRSP and increase this as your pay increases, then a 9% return will give you over a million dollars in 30 years.”
What’s not to understand about this? Our young couple will feel safe checking off the “make sure you understand the investment” item on their checklist. More experienced investors will know this couple doesn’t really understand, but the couple won’t know this.

Let’s try pitching an even more dubious product, index-linked GICs:
“The stock market has the potential for big gains and GICs provide safety. We’ve found a way to combine them to get the best of both worlds. If stock markets perform well, our index-linked GICs give higher returns than regular GICs, and if the stock markets crash, your principal is 100% guaranteed.”
Again, this explanation gives the illusion of understanding to naive investors. More sophisticated investors know that there is hidden bad news in index-linked GIC interest formulas, but naive investors don’t know this. They have a nice tidy story that feels easy to understand.

The sad truth is that a lot of advice like “invest in what you understand” and “get a good financial advisor” is difficult to follow without more financial savvy than most people have.

Wednesday, November 11, 2015

Retirement Spending Stages

It’s definitely true that most people’s retirement spending declines as they age. Financial Planners tell a story of how this reduction in spending is natural and that you should plan for it in your own retirement. Here I tell a different story that leads to a different conclusion.

Certified Financial Planner Roger Whitney captures the usual story of the three stages of retirement clearly:
“In the ‘go go’ years of retirement, your spending may be at its peak. This is the time for travel, activities, adventures and family.

In the ‘slow go’ years, your spending may slow as you become more settled.

In the ‘no go’ years, you may spend even less as you settle in even more.”
This sounds so logical that it’s easy to accept the advice to spend a lot in your early retirement years. But let’s analyze this a little further.

Let’s call these stages, the 60s, 70s, and 80s. Will you really want to start cutting spending when you’re only 70? It’s true that, on average, people do begin to spend less when they’re this young, but why? I can understand being less adventurous at 85, but why only 70?

Let’s try a completely different story to explain the drop in spending:
In the ‘dumb-dumb’ early years of retirement, people see their big pots of savings and spend too much. Even if they try to stick to a reasonable spending level, they tend to dip into principal for larger items like fixing a roof, replacing a car, or helping an adult child.

In the ‘uh-oh’ years, people realize they’re spending too fast and begin to cut back.

In the ‘oh well’ years, there is little money left and people live on their government benefits and any pension streams they may have.
Obviously, this narrative doesn’t apply to everyone, but it does apply to many, which skews all the spending statistics. If spending less were a common choice, then planning for it would make sense. But if it’s forced on retirees because of overspending, then it makes no sense to bake it into your plans.

The next time someone tells you to be like everyone else and plan for peak spending in early retirement, what you should hear is that most other people spend themselves poor in early retirement, so you should too.

Monday, November 9, 2015

Enough Bull

David Trahair came out with a second edition of his book, Enough Bull, that makes the case for avoiding stocks by investing solely in Guaranteed Investment Certificates (GICs). Unfortunately, just about all of the criticisms I had in reviewing the first edition still apply.

I won’t bother to repeat most of the points from my earlier review. The details Trahair gives about his own investing history show a person who invested more than half of his money in Labour Sponsored Investment Funds (LSIFs) and got burned. He has now retreated into the safety of GICs and recommends you do the same.

The biggest problem with his argument is that he continues to ignore stock dividends. This isn’t just nitpicking. Over 28 years, reinvesting a 2.5% dividend will double your savings. This makes a real difference to how soon you can retire and how much you can spend in retirement.

Trahair looks at the S&P/TSX Composite index in the 25 years starting on 1989 July 31 and finds the price increase (i.e., ignoring dividends) is 5.6% per year. He uses this to justify an assumption that stocks will average only a 5% return per year in the future. “Take off fees and you’ll only get 3%.”

The sad thing is that it is possible to make a reasonable case for GICs, at least for some investors. People pay high mutual fund fees, as Trahair points out. Another point that would bolster his argument is that people tend to underperform their own mutual funds because they tend to jump in and out at bad times. So, for some investors, GICs don’t look too bad. But any reasonable analysis has to include dividends.

As for me, I’ll happily accept the volatility of stocks. My portfolio of the world’s stock indexes costs me less than 0.2% per year, including fund MERs, other fund expenses, trading commissions, bid-ask spreads, and foreign withholding taxes on dividends. The gap between my average return and GIC interest rates has been substantial. Your mileage may vary.

Friday, November 6, 2015

Short Takes: Vanguard Canada ETF Changes, Income Tax Changes, and more

Here are my posts for the past two weeks:

The Consequences of Keeping Bad Employees

Timing Stock Market Peaks

Financial Dictionary

Here are some short takes and some weekend reading:

Canadian Couch Potato explains changes taking place in Vanguard Canada’s ETFs.

Preet Banerjee uses his latest Drawing Conclusions video to explain how Trudeau’s proposed new income tax brackets affect you.

Gail Vaz-Oxlade has an interesting list of 9 Money Mistakes people make. I’ve never come close to the first 8 mistakes, but the last one is about failing to have a budget. I’ve never had a budget in the sense Gail means and my finances have always been great. It’s likely that this only works for my wife and me because we have the right personalities for it, but Gail insists everyone needs a budget. She’s probably right that even among people who insist they don’t need a budget, most of them are wrong, but there seem to be a few of us who really don’t need one.

Kerry Taylor (a.k.a. Squawkfox) has some fun and practical ideas for introducing money concepts to young kids. One of the points made in the article is that a lot of financial lessons need to come from parents instead of leaving it to schools. I agree.

Potato reports that he encountered some door-to-door salespeople pushing investments in condo construction. Anyone considering investing with a door-knocker might consider the merits of running with scissors first.

Big Cajun Man says you pay too much for your telecom needs.

Boomer and Echo defends the two ETF investment solution based on Vanguard Canada’s exchange-traded funds VCN and VXC. With the possible addition of some fixed income, this seems like a very good portfolio for anyone who’d rather not deal with currency exchange.

Andrew Hallam writes about how John Bogle’s son manages an actively-managed fund while Bogle senior advocates index investing. A rarity for Hallam, this article doesn’t require clicking on multiple links to “read the rest of the article.”

My Own Advisor takes a look at what the Liberal’s government’s promised policies mean for him.

Tuesday, November 3, 2015

Financial Dictionary

It took me a great deal of life experience to get my far from complete understanding of the financial world. Here is my attempt to capture in as few words as possible the right way to think about some financial terms.

Bank: An entity that aims to take you for about 3% of everything you own or owe each year.

Bonds: Payday loans to governments.

Car: The most expensive part of your self-image.

Commute: The most underestimated cost of both time and money.

Debt: A crushing burden that weighs down your life and dreams.

Expenses: Anything a salesperson calls an “investment”.

Government: An entity that transfers your tax money to its employees.

Inflation: An invisible force that slowly makes your retirement income worthless.

Insurance: Something sold using the illusion that it will prevent bad things from happening.

Insurance Company: An entity that pays small claims and denies large ones.

Investment Industry: All entities whose income comes solely from dipping into your savings.

Longevity Risk: Cat food.

Lottery Tickets: A common retirement plan whose success rate increases when combined with smoking.

Organization: An entity whose main function is to pay its administrators.

Payday Loans: The last lap in swirling down the financial toilet.

Smoking: A means of combating longevity risk.

Stocks: An overconfidence tax when bought. A fear tax when sold. A wealth generator when held in great variety for a long time.

Monday, November 2, 2015

Timing Stock Market Peaks

Active stock pickers like I was for many years often feel regret when they fail to sell a stock at its peak. We almost always leave money on the table. However, expecting to hit the peak just isn’t reasonable. As a case study, I look at the one stock that made me the most money. Despite my fantastic luck, I was still nowhere near selling at the peak.

The stock market bubble in the late 1990s was a crazy time when even the dumbest investors felt like geniuses because just about everything they bought went up in a hurry. During that time I bet crazily on one stock and won. My portfolio return for 1999 was almost 200%!

Every way I look at the numbers, I conclude that I was just plain lucky. I left a huge percentage of my net worth in one stock and it happened to pay off. But even so, I often think back to what could have been if I had held onto all of it and sold at the absolute peak.

Instead of selling at the stock’s peak, I sold it off in blocks primarily between mid-1998 and mid-2000. It turns out that my total profits were only 22% of what they could have been if I was clairvoyant and had sold at the peak. That certainly doesn’t sound lucky, but I assure you that in this case it was lucky. For a stock with a huge run up and spectacular fall, selling it all at the top is nearly impossible.

What about mechanical selling strategies? What if I had set some maximum percentage of my net worth to put in this one stock? The idea is that each day I could have calculated how much of my net worth was in this stock and sold some if necessary to get below a target percentage. I decided to crunch some numbers to see what would have happened.

I calculated the profits for different net worth percentage thresholds. The profits are expressed as a percentage of the gains from selling at the absolute peak price.


We see that there is a huge gap between the peak and any of the selling patterns I examined. As shown in the chart, my actual share sales netted me about 22% of the peak amount. If I had set a maximum for this stock at about 50% of my net worth, I would have made 18% of the peak. (Putting 50% of your net worth in one stock is insane, but I actually had a much higher percentage in this stock for a while.)

None of the thresholds for a mechanical strategy would even have netted me as much as my actual sales. This speaks to just how lucky I was.

Whether it’s trading in one stock or market timing the entire stock market, expecting to sell at a peak price is just unrealistic. I’m a much more relaxed and realistic investor now that I’m an indexer.