Monday, December 12, 2016

How Life Can Mess Up the Best-Laid Financial Plans

I frequently see people whose financial plans rest on a steady income. I’m not just talking about those living hand-to-mouth, never saving a dime. There are also the “spreadsheet planners” who have their financial lives all mapped out. They borrow large sums for a house or to invest, and rely on a steady income to keep up with the interest payments. As long as everything proceeds exactly as they planned, they’ll be multi-millionaires by the time they get close to retirement age.

I’d like to introduce these people to Heather Von St. James. Heather had a great life going but was hit with mesothelioma, a cancer caused by asbestos. Her story about the personal and financial costs she faced is definitely worth a read. (Disclaimer: I have no financial connection to Heather; I just found her story compelling.)

One takeaway from her story is that your income is not fully secure no matter how safe it seems. Heather’s story is a very specific case, but there are many different problems that can lead to long-term or permanent loss of income. In addition to health problems, you could face a situation where the type of work you do is no longer in demand. Workers in their thirties may find it hard to believe what they do could become irrelevant, but over a decade or more, many things are possible.

Heather points out that she was “under the care of my sister, who had taken three weeks off work to care for me while I recovered. All of her expenses came out of her pocket; she never got reimbursed for anything.” So, it’s not just your own health that is a potential concern. Your spouse, child, parent, or sibling could need your help. In Heather’s sister’s case, her loss of income was temporary. But, problems with a child’s health could easily force you to find different work with more flexible hours.

To the extent possible, we need financial plans that take into account the possibility of a reduced income. Taking on a huge debt is risky. You could be forced to sell your house or investments into a bear market.

There are a number of things you can do to reduce your risk. Being Canadian and having access to public health care is a good start. Having long-term disability insurance also helps. But there are still events that these protections won’t cover such as getting laid off and being unable to find new work at the same pay. The best thing to do to protect yourself is to build savings and limit your use of leverage. This means not borrowing based on the full size of your current income.

If you wish to learn more about mesothelioma, follow this link.

29 comments:

  1. The tragic turns life can take are astounding, all anyone can do is ensure they and their loved ones are financial safe if something goes wrong (and that entails reading all the fine print, unfortunately (and then hoping no one changes things)).

    You can end up with a reduced income if you get laid off, or change careers too. The danger you need to address is, right now you might be making your maximum income, can you deal with a drop in income?

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  2. ...or you could be run over by a bus. It's good to plan for things going wrong, but you can't plan for every eventuality. And there is nothing wrong with taking calculated risk - including prudent debt.

    Having lived in a couple of European countries, I found their healthcare systems to be significantly better than Canadian. They use a mixture of both private and public healthcare resulting in a better quality and shorter wait times for everyone.

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    1. @BHCh: The truth is in the numbers. "Prudent debt" is a debt level you can carry on significantly less than your current income. You say "you can't plan for every eventuality," but it is wise to plan for things that have significant probability. Few people early in their careers believe they will ever face a permanent drop in income, but the millions who've been laid off later in their careers know it can happen.

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    2. Right, but is the unemployment insurance really worth it for a skilled/young/single person? I am not at all sure.

      There are a lot of insurance products out there and by the time a young graduate is fully insured he might just benefit from his life insurance as he'll have 100% probability of starvation.

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    3. And with regards to debt - it's all about having a reserve fund or access to LOC to bridge the time until you find something else.

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    4. @BHCh: There is a lot of bad insurance out there. Good long-term disability insurance makes sense. The goal is to get some protection in case a disability leaves you unable to earn an income. This becomes more important when you have a family depending on your income.

      I disagree strongly with your take on debt. Reserve funds and access to an LOC are good things to have, but they do little to help with a permanent drop in income. Younger people with modest incomes who lose their jobs can count on finding something else that pays close to the same income, but older workers with higher incomes often never find work that pays the same as the job they lost. In such a case, if they have debt they can no longer carry, the reserve fund and LOC just delay the inevitable.

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    5. I agree that older people shouldn't carry debt. If anything, they should be lending, eg through bonds. Debt is a good mechanism for young people to borrow from your future self so that you can either educate yourself, take risks and invest and/or afford a better lifestyle when you need it most.

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    6. @BHCh: Borrowing for an education: sensible within limits as long as the money isn't used to fund a "lifestyle".

      Borrowing to take risks: depends on the risks and how much you're borrowing.

      Borrowing to afford a better lifestyle: always dumb.

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    7. Disagree on the last one.

      Makes sense for young professionals with families to take on mortgage so they can bring up kids in a house that is large enough. Otherwise we would only ever have young people squeezing into one room while older people living in huge houses and not being able to get a stable income as nobody would borrow from them.

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    8. @BHCh: On this last point the only thing we disagree on is the definition of "lifestyle spending". If your hypothetical couple gets a mortgage for 2/3 of the maximum amount lenders will give them, then I'm with you. If the borrow right up to the limit the lender will allow, then they're taking on far too much risk.

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    9. Yes, the borrowing should reflect their finances and risk tolerance as opposed to "what the banks will allow". The banks seem to allow some pretty crazy stuff which can easily throw people into bankruptcy if/when the rates go up.

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  3. About debt, I've read academic articles written on it. Every article has found that a modest amount of leverage increases returns. More than a modest amount decreases returns. The assumption is that you can access low cost leverage. A tax deductible margin loan from IB would meet that definition. So one role of debt is growth. And the greatest financial risk is not meeting your goals.

    "Lifecycle Investing" by Ayers and Nalebuff found that leverage improved retirement outcomes. Now I don't advocate 200% leverage or the use of options to obtain leverage (their book advocates both). But is an example the evidence that consistently suppports the responsible use of leverage.

    An underrated feature of debt is that it's one of the few ways you can make money from inflation. The usual inflation hedges (real estate, RRBs, commodities) keep up with inflation, but don't profit from it.

    If principal is fixed on debt, and it usually is, then with inflation, you end up paying less back in real dollars than you paid. Also, if you have fixed interest, the higher the inflation rate the better. Even if your interest rate is floating, you might still come out ahead, if the interest is tax deductible. Assume your marginal tax rate is 45%. Wages usually go up with the inflation rate. But your interest goes up 45% less than your wages. The purpose of the last paragraph is to illustrate that debt can be used to manage risk.

    Debt can be a source of liquidity. Instead of keeping a cash reserve of 6 months spending, on which you're losing money after inflation and taxes, use a LOC or margin loan.

    Debt can be a substitute for bonds. I view bonds as a bridge to tide me over cyclical bear markets. Bonds are an excellent way to manage risk. As their return after interest and taxes is negative for me, I don't view them as as investment. I'm not saying don't have bonds. But once again, using debt for a couple of years to finance consumption can be an attractive alternative to bonds.

    I'm making the case for using debt, instead of the asset classes of cash and bonds. There is no question that there is risk using debt. The only way you can go bankrupt is using debt. Debt can't make a bad portfolio good, but it can make a good portfolio bad. But that must be weighed against the risk of losing purchasing power with bonds and cash.

    I would strongly emphasize that one shouldn't use debt, until one has spent a great deal of time learning about investing including debt. I would also emphasize that the use of debt should be moderate.

    I've gone on a bit of a rant :-). But I would encourage your readers, who are also seasoned investors, to not dismiss the use of debt out of hand. It's perfectly reasonable not to use debt. But it can be helpful if used responsibly.

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    1. @Anonymous: The problem with many analyses is that they look at average outcomes. Average outcomes take a bunch of terrible outcomes and average them in with typical outcomes and wonderful outcomes. But your life will only have one outcome. The question you need to ask yourself is how much risk you want to take that your outcome will be terrible. Unfortunately, what I see too often from the "spreadsheet set" (I'm one of them) is too much focus on typical or average outcomes. Their conclusion of the safe limit on debt ends up too high. Leverage and debt are part of life, but they must be kept to sensible limits. Too many people set limits that are too high.

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    2. ... and there isn't anything that can or should be done about it beyond expressing our views. It's the usual cycle of greed and fear. Responsible adults will continue making mistakes, it's called "life".

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    3. @BHCh: I think it would be perfectly reasonable for CMHC to stop backing mortgages with high debt service ratios. This would effectively stop most people from taking on big mortgages. People would still be free to arrange mortgages with a lender who doesn't lean on CMHC backing, but only a subset of people would do this.

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    4. Agreed. There is no reason for the taxpayer to take on the risk. It distorts the incentives.

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  4. Ayers and Nalebuff did an analysis in the US stock market from 1871-mid 2009. Even the worst case scenario did better with leverage. They then repeated the same analysis in the British stock market (1937-2009) and Japanese stock market (1950-2009). Once again, leverage improved retirement outcome.

    Businesses commonly use debt. Total debt as a percentage of the market value of equity for US nonfarm, nonfinancial firms from 1996 to 2010 had a range of approximately 40-55 percent.

    The following is the median total debt/total debt + equity percent from 2002-2004 of firms with AAA rating (12.4%), AA rating (28.3%), A (37.5%), BBB (42.5%), BB (53.7%), B (75.9%). In 2016, there were only 2 US firms with an AAA rating. 12.4% means a portfolio that is 114% stocks. 28.3% means a portfolio that is 139% stocks.

    Assume you are a company (Jane Q. Public Inc.). It depends on one's personal circumstances, but I think it reasonable for some (certainly not all) people to consider taking on similar debt to AAA rated companies. There are a few individuals who I think could consider taking on similar debt to AA rated companies.

    I have seen an interview with Ray Dalio. Although he didn't present data, he stated that if companies didn't have debt, then stocks would have similar return and volatility as bonds. If you buy stocks, you are buying a levered investment. You are not directly using leverage, but the company is indirectly doing it for you.

    There is unquestionably risk using debt. But there is risk not using debt. Assume that the definition of an investment is a product that will have a positive expected return after expenses, inflation and taxes. In a taxable account with a marginal tax rate of 45%, cash and bonds don't meet that definition. IMO, alternatives to cash and bonds should seriously be considered.

    About using debt for growth, a moderate amount of debt for an experienced investor with a minimum 8 year time horizon and a well diversified portfolio is a reasonable option to consider. The 8 years is the length of a business cycle. Moderate is in the eye of the beholder, but personally, I think that one should be able to withstand a 70% market decline without needing to use a LOC. Debt would also give you an inflation hedge.

    The use of such leverage would increase the probability of a very bad outcome. But that is true if you add bonds to an all cash portfolio. And that is also true if you add stocks to an all cash/bond portfolio. When you buy stocks and bonds, you are getting paid to take risk that you wouldn't if you stayed in cash. The risk of stocks and bonds will show up occasionally, and you will do worse in stocks and bonds than you would in cash. If the risk didn't show up occasionally, you wouldn't get any risk premia, and returns of stocks and bond would be less. What I'm saying is consider taking on an additional moderate amount of risk, if you're well diversified, knowledgeable about personal finance and have a long enough time horizon.

    Remember that this is tax advantaged risk that I'm suggesting you consider. When you pay $5000 in interest, you can get the same tax deduction as you would with putting $5000 in an RRSP.

    Thanks for listening to my second rant :-).



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    1. @Anonymous: The problem with detailed analyses that ignore important details is that they give exactly the wrong results. If you have a bad health event or your job skills lose relevance you could end up suffering a permanent reduction of income. If you can't then carry the interest on your debt, you'll be forced to sell your assets, possibly at fire-sale prices. With this as a possibility with some probability, the analysis changes. The safe level of debt for an individual is lower than the detailed analyses you point to would indicate. This is not a binary decision. It's not a matter of debt or no debt. It's a matter of how much debt is reasonably safe. Many younger people today are taking on too much debt.

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  5. I agree that if you have a bad health event or your job skills lose relevance, you could end up suffering a permanent reduction of income. If you can't meet the interest on your debt, you'll be forced to sell your assets, possibly at fire-sale prices.

    When it comes to using debt, make sure that you have adequate insurance (life insurance (if needed), disability insurance, liability insurance (car, home, umbrella)). Before using debt, consider how secure your human capital is.

    I'm not questioning that the use of debt increases risk. But debt can increase the size of your portfolio. And the larger a portfolio you have, the more secure you are. To take an extreme example, if Warren Buffett loses 99.9% of his portfolio, he is still very rich.

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    1. @Anonymous: We seem to be finding some common ground. It's true that wealthy people have less to worry about. But if they don't need the money, why take big risks? When it comes to portfolio leverage, Buffett has said it should be limited to 25%. He also says "Never risk what you have and need for what you don’t have and don’t need."

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  6. Someone did a portfolio analysis on Buffett, and his portfolio leverage is 60%. But to be able to withstand a 70% market decline, 125% stocks is probably as far as you should go.

    IB offers margin loans starting at 2%. Assume one's marginal tax rate is 45% and the interest on the loan is tax deductible. As long as your aftertax return is greater than 1.1%, you'll come out ahead with margin. If you invest in stocks, and especially Canadian stocks, it is possible that your pretax return could be less than 2%, and you'd still come out ahead with leverage.

    About needs, unless someone has a good pension, they need retirement savings. The risk of leverage must be balanced against the risk of not meeting your goals, such as having enough $ for retirement.

    Enough ranting. Have a good day.

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    1. @Anonymous: I've seen such analyses of Buffett's portfolio, but they don't all come up with the same leverage percentage. In any case, it doesn't matter much because individuals can't get the same loan terms Buffett gets. I agree that 25% should be an upper limit on portfolio leverage. However, it gets trickier when you have a mortgage at the same time. One reasonable test is to make sure you can carry the total interest on a reduced salary.

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  7. It looks like one of my posts disappeared. Was it too controversial :-)?

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    1. @Anonymous: For some reason, Google marked it as spam. I found it and rescued it.

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  8. Michael, excellent post. This is a great advice for Canadians.

    As someone who was well paid but working in a dying industry I found myself unemployed in my mid 40's. Fortunately I was able to reinvent myself and invest in my own business that was later sold. During these last 10 years of my career I made significantly less money however, and retired at age 55. Our saving grace was debt that was eliminated in my mid 30's, a habit of living on less than we earned, a spouse with a good job, and strong savings to back us up. A big change in income can happen to anyone, but some may not be so fortunate, willing or able to deal with the consequences.

    Being debt free with money gave me options and made a stressful time MUCH easier to deal with. For many folks I can't see living up to your means max, and relying on a LOC or small emergency fund as safe plans.

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    1. @RBull: It sounds like you were well-prepared for your permanent drop in income. After writing this article, I started thinking about the experiences of some of my friends. Of the 3 friends I've seen recently, 2 have had permanent drops in income, and the third lived through a long low-income period while changing careers (but now earns more). All were well-served by not living right up to their means during good times.

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    2. Thanks Michael. We are fortunate things turned out as well as they did. We're also both fortunate to have grown up with parents were frugal and had generally good financial habits. This probably rubbed off on us, although we have siblings where it didn't.
      I think your scenario with potential health or career issues is becoming more common.

      It also seems to me the problem may be made worse by these low rates and a society more willing to accept big debt as a norm during working years and even into retirement. This makes them much less prepared to for drops in income, or rising debt costs.

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  9. I should have added I was one with all the spreadsheets built with continued higher incomes to grow savings. Plans that didn't materialize nearly to expectations. My forced career change had a huge impact on our planned assets, but we still ended up with "enough" to retire a little earlier and have decent lifestyle. I'm pretty sure many people out there are much more stretched on the way they live and the outcome would not have been as positive, with a similar job/health financial crisis. We are now very thankful for building a decent financial foundation starting early in our adult lives. It could not have happened with big debt and long term obligations.

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    1. @RBull: I think your experience with a forced career change is more common than many realize. Fortunately for you, you didn't have too much debt to dig out of with a lower income.

      I should point out that I have nothing against using spreadsheets -- after all, I use them a lot myself. But too often people treat some spreadsheet inputs, like income and investment returns, as smooth and certain. The uncertainty in these inputs makes a huge difference in deciding on a safe amount of leverage.

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