Thursday, March 31, 2016

Bonds vs. an Annuity in Retirement

To me, the most interesting observation Frederick Vettese makes in his book The Essential Retirement Guide is what to do with the bond allocation of your portfolio at retirement. “It makes sense to liquidate these fixed income investments and buy an annuity.” This seems so logical, but it had never occurred to me before.

The main advantage of an annuity is that it eliminates longevity risk. When the insurance company sets your annuity payments, it can do so based on average lifespans. However, if you invest your money yourself, you have to account for the possibility that you’ll live to be very old. The main disadvantage of an annuity is that its returns are based on long-term bond returns; you can’t get the higher expected returns and inflation protection that stocks provide.

Vettese isn’t the first person to suggest putting part of your nest egg into an annuity. However, what is new to me is the direct comparison to a bond portfolio. To maximize your spending from the fixed income part of your portfolio, it seems like a no-brainer that you should go for the higher payouts of an annuity.

I’ve been thinking about how using an annuity would compare to what I call cushioned retirement investing. The idea of cushioning is to have 5 years’ worth of spending in fixed income and the rest in stocks. Each year you spend from your fixed income investments and replenish them by selling some stocks.

Cushioning protects you if your stocks perform poorly. If this happens, you can cut your yearly spending by a little. This cut creates a fixed income surplus equal to 5 times the cut. At the end of the year, you won’t need to sell as many stocks to replenish your fixed income at a time when stocks are down.

An alternative to cushioning is to just take the amount you planned to put in fixed income at the start of retirement, buy an annuity, and leave the rest in stocks. The stocks will be volatile, but that income volatility will be on top of a solid base of guaranteed income.

I don’t have any good ideas yet for how to quantify the benefits of the annuity plus stocks approach compared to cushioned retirement investing. However, my guess is that the partial elimination of longevity risk might be enough to give the annuity an edge.

Tuesday, March 29, 2016

Should We Plan to Spend Less as We Age in Retirement?

The idea that we’ll naturally want to spend less as we age is very seductive. It means we need less money to retire, can retire younger, and can spend a higher percentage of our savings in the early years of retirement. The latest writer to support this idea is actuary Frederick Vettese in his book The Essential Retirement Guide. This article is not a review of the entire book, but an examination of the chapter “How Spending Decreases with Age.”

All the data confirms that we do spend less as we age. The question at hand is why we spend less. If older retirees spend less because they run out of money, then it doesn’t make sense to bake reduced spending into our retirement plans. However, Vettese concludes that the dominant reason we spend less as we age is a “loss of interest in spending or physical ability to spend.” He uses this to justify “assuming that the retirement income from retirement savings ... does not have to be indexed to inflation.”

This conclusion flies in the face of my personal experience watching elderly members of my extended family suffer from non-indexed pensions being decimated by decades of inflation. But, to Vettese’s credit, he makes decisions based on statistical data and not anecdotes. So, I won’t say any more about my family’s experiences.

Vettese rejects the idea that people spend less because they run out of money by pointing to a study by Axel Borsch-Supan called “Saving and Consumption Patterns of the Elderly, The German Case,” published in the Journal of Population Economics in Bonn, Germany in 1992. I decided to look it up.

This study is based on German savings data from 1978 and 1983. Just about everyone in Germany had a defined-benefit pension, so if Germans increased their saving rate as they aged, this very likely means they voluntarily spend less. And this is exactly what the study found: the saving rate rose from about 3.5% of income at age 65 to about 10% of income for those over 80. However, the rate of spending decline is only about 0.4% per year, far less than the typical inflation rate.

Vettese provides other more recent German data showing that for each year people are older they spend about 1.5% less. However, this data isn’t scaled to income. It’s perfectly plausible that older German retirees have lower incomes than younger retirees. After all, economies grow and incomes rise in real terms. If a pension is based on your final few years of earnings, then young retirees would have larger incomes than old retirees.

Another comprehensive study of U.S. spending discussed by Vettese found that Americans spend about 1.9% less each year after age 66 (which is still less than the long term average inflation rate). The German study only allows us to attribute a small fraction of this decline to voluntarily spending less. The rest of the decline has some other explanation.

Running out of money isn’t really a possibility for anyone with a substantial indexed pension, but the many Canadians and Americans who live primarily off their own savings in retirement could easily overspend, run low on money, and be forced to spend less as they age. None of the data Vettese presented rejects this as a possible explanation for much of the spending decline we see in Canada and the U.S.

Any statistics we gather on spending decline as we age is going to mix together data from people with a wide range of reasons for changing their spending over time. Obviously, there are some retirees who spend too much during their first few years, see their mistake, and cut back on spending. I simply don’t find it plausible that the number of retirees who make this mistake is too small to be relevant. I have no data to back up this opinion, but I’ve never seen data that refutes it either.

I’m not claiming that there is no truth to the idea that people voluntarily spend less as they get older. When people get into their eighties they often seem much less willing to travel or go out at all. My claim is that there is no justification for saying that this is the only reason spending declines. In particular, there is no justification for assuming that we will all voluntarily spend less each year by the amount of inflation.

Suppose that for the next 25 years inflation matches its long-term average of about 3% per year. This would mean that costs would more than double over this period. Is it plausible that the typical retiree would choose to spend less than half as much at age 90 as he or she spent at age 65? We’re not talking about just discretionary spending here. The over 50% drop would include food and housing costs like rent or property taxes and home repair. I find the German data that predicts about a 10% voluntary drop in spending to be much more plausible.

Vettese is right when he says that the decline in spending cannot “be quantified with any precision.” The best U.S. figures we have place it at 1.9% per year. The only evidence that this decline comes from retirees simply not feeling like spending comes from German data that places this type of decline at 0.4% per year. The other 1.5% each year could be due to other causes. To assume that voluntary spending will decline at the pace of inflation is far out of line with the available data.

At first I was hesitant to criticize Vettesse’s work because it is good to have a strong voice countering the usual fear-mongering from banks, insurance companies, and financial advisors about a retirement crisis. I welcome reasonable discussions about how much is enough to retire.

For my own retirement planning I’ve assumed that my spending would stay flat in real terms (which means that it rises with inflation). I could be persuaded to plan for a decline of 0.4% per year but no more than that without evidence that it makes sense.

Friday, March 25, 2016

Short Takes: Downside to Going Cashless, Buying Happiness, and more

Here are my posts for the past two weeks:

CPP Forgiveness or Unfairness

Market Timing Using a Spreadsheet

Are You a Stock or a Bond?

Here are some short takes and some weekend reading:

There is an important downside to our trend toward a cashless society.

Contrary to popular belief, this writer says money can buy you happiness if you do it right. I agree that if you spread money out over your entire lifetime, it can make you happier. Sadly, many people seem to blow through large windfalls quickly.

Preet Banerjee interviews Ron Tite to discuss how brands compete for your time. Tite is very funny, so you’ll be entertained while you learn about content marketing.

Boomer and Echo bring us an investing guide for beginners. It can be tricky to put together generic advice that is relevant to a wide range of investors, but this is a good article for beginners.

Frugal Trader updates his journey to financial independence. He includes a detailed accounting of the dividend stream from his stock investments.

The Blunt Bean Counter has an interesting guest post about the laws on parents trying to cut one or more of their children out of their wills.

Canadian Couch Potato takes a run at estimating long-term future investment returns to use for planning purposes.

My Own Advisor explains why you failed at your New Year’s financial resolutions.

Big Cajun Man celebrates 11 years of financial blogging.

Wednesday, March 23, 2016

Are You a Stock or a Bond?

Finance professor Moshe Milevsky has an important central message in his book Are You a Stock or a Bond?: your ability to earn money is an important asset that you must take into account when you decide how to invest your savings and plan for retirement. He calls this ability to earn money your human capital. The message that we should take into account our human capital is an important one, but I’m less impressed with some of the detailed messages in this book.

The basic idea of human capital is for you to look at the risk factors for your income and take them into account in constructing your portfolio. So, an investment banker whose income is “contingent on the vagaries of the stock market” might choose to invest a sizable portion of his savings in fixed income. On the other hand a tenured professor might choose a riskier portfolio.

In Milevsky’s tenured professor example, she has $250,000 and he calculates that she should borrow another $450,000 to invest a total of $700,000 in the stock market. He doesn’t say how he came up with this amount of leverage, but it looks a lot like the results you get when you misapply Modern Portfolio Theory (MPT). Some problems are that returns are not lognormally distributed, they are not uncorrelated over time, and you can’t borrow at the risk-free rate. Even just the interest rate on borrowed funds makes a big difference. MPT’s optimal amount of leverage is extremely sensitive to the borrowing interest rate. My guess is that a sensible amount of leverage for this tenured professor is far below $450,000. However, the main message that she should invest more aggressively than an investment banker makes a lot of sense.

Another part of the book that makes me uneasy is the positive talk about a number of financial products, such as index-linked notes, variable annuities, guaranteed minimum withdrawal benefits, etc. One section is devoted to methods of finding the right mix of such products in retirement. Milevsky says that many of U.S. versions of these products are good. The ones I’ve looked at in Canada are terrible. In principle, it is possible to design insurance products that change risk characteristics in ways that benefit both the client and insurance company. In practice, from what I’ve seen, such products are used to confuse people into giving away far too much of their hard-earned money.

On the positive side, Milevsky explains the importance of understanding longevity risk. Not knowing how long we will live forces us to be conservative with spending and we’ll likely leave much of our savings unspent unless we’re willing to risk running out of money. The alternative is to pool this risk in the form of a pension or annuity.

Other positives are the discussion of using insurance to protect your human capital, the benefits of diversification, and sequence of returns risk in retirement.

One interesting discussion concerned inflation. Milevsky says that as we age, our personal inflation rates are higher than the official inflation rate. He says “I assume that your required expenses and your personal inflation will increase by 5% to 8% per year.” So, he believes that your spending needs will rise faster than official inflation rates through your retirement. This directly contradicts the many commentators who say that we will all be content to spend less as we age. Personally, I will plan for spending that tracks the official inflation figure.

The title of one chapter is likely to raise some eyebrows: “Debt Can Be Good at All Ages.” Don’t worry, though. He’s not talking about overspending on credit cards or leasing cars. He’s talking about using leverage for investing in income-producing assets. I think he advocates leverage levels that are too high, but modest leverage can be used intelligently.

One particularly funny part of the book is a table of probabilities of a 50/50 event happening multiple times in a row: 50%, 25%, 12.5%, etc. A caption on the table attributes it to some other source. I don’t think it’s necessary to find a source for dividing by 2 a few times.

Another funny part was a discussion of “a stock, mutual fund, or investment that is expected to earn 15% on average, in the long run.” I haven’t heard anyone talk of long-term 15% returns with a straight face since the crazy tech bubble 15 or so years ago.

Despite my criticisms of parts of this book, it makes an important contribution in getting us to think differently about our human capital. I’m glad I read it even if I disagreed with some of the details.

Monday, March 21, 2016

Market Timing Using a Spreadsheet

I’m no market timer, but my investing spreadsheet looks like one. I’ve coded just about all of my investment decisions into one spreadsheet. Whenever I add new savings, the spreadsheet tells me what to buy to bring my portfolio back to its target asset allocation percentages. However, if we look at the rebalancing decisions in isolation, they look like brilliant market timing.

It’s no secret that the Canadian dollar has been extremely volatile compared to the U.S. dollar over the past year. I had no idea this would happen. I didn’t make any predictions. I don’t know what will happen in the future. But my rebalancing spreadsheet looks like it made good predictions.

Before the Canadian dollar began dropping, I was adding new money to U.S. stocks to get my portfolio back to its target percentages. After the Canadian dollar dropped, I was buying Canadian stocks. The recent run-up in the Canadian dollar has me back to buying U.S. stocks. I’ve consistently bought low. How can a simple spreadsheet be so smart?

The answer is that rebalancing looks brilliant whenever the spread between assets grows and then shrinks again. Rebalancing is a loser if the spread between assets just keeps growing. So, as long as the Canadian dollar keeps trading within a given range and Canadian stocks keep up with U.S. stocks over the long run, rebalancing will look a lot like being able to see the future.

Thursday, March 17, 2016

CPP Forgiveness or Unfairness

A friend I’ll call Bill recently began receiving Canada Pension Plan benefits. He was telling me that the return he’s getting on his premiums doesn’t seem all that good. He paid the maximum for almost all of his 43 years of working and the payout is less than he expected. The reasons have to do with inflation and some of CPP’s forgiveness rules.

Bill’s benefits will increase with inflation for the rest of his life. This has to be factored into any computation of his return, but that’s not the only reason his return seems low.

If Bill hadn’t worked for 7 years he wouldn’t have made any CPP contributions during that time, but he would still be getting the same CPP benefits today. This is because when we calculate CPP benefits we get to drop out the 17% of months where we earned the least. If Bill had been the primary caregiver of his children when they were under 7 years old, he could have dropped out another 7 years as well.

On the surface, this seems very generous. You get to raise kids and have a few bad earning years and you still get the same pension. However, there’s a flip side. To give more money to some, you have to give less to others. People like Bill get lower returns on their contributions because they have little use for the dropout periods.

Some may suggest that maybe the dropouts give some people more without punishing anyone else. This isn’t possible. We can’t summon value out of thin air. If CPP is self-sustaining, then whatever extra we give to some people must be taken from others. The only alternative is that CPP isn’t self-sustaining and has to draw from tax revenues, which we all pay for. No matter how you slice it, the dropouts take money from those who don’t use them.

Don’t mistake this explanation as a condemnation of how CPP works. It may well be sensible public policy to have these dropout periods. But the inevitable side effect is that Bill’s rate of return on his contributions is lower than the return seen by those who use the dropouts.

Friday, March 11, 2016

Short Takes: Dwindling Gold Reserves, Real Estate Market Not Normal, and more

Here are my posts for the past two weeks:

Examining Six Reasons to Downgrade Retirement Saving

The Economics of Fixing a Furnace

Here are some short takes and some weekend reading:

Canada has sold of most of its gold reserves in favour of financial assets. This makes a lot of sense to me. Gold has little inherent value compared to its current price. I’d rather put my bet on owning a small slice of all businesses.

Tom Bradley at Steadyhand cautions that the Vancouver and Toronto real estate markets are not normal.

Big Cajun Man has a funny way of illustrating hidden ways you may be wasting money.

Boomer and Echo ask whether zero down mortgages are a last gasp from a housing bubble ready to pop.

Preet Banerjee starts up his podcast again with an interview with WealthSimple CEO Michael Katchen.

The Blunt Bean Counter explains what’s going on with CRA “compliance letters” that will be sent to about 30,000 people this year.

My Own Advisor interviews Andrew Hallam, the millionaire teacher.

Tuesday, March 8, 2016

The Economics of Fixing a Furnace

I don’t bother to insure against costs I can handle, such as fixing a furnace. However, a recent experience has me re-examining the motives of furnace service companies.

For the first time in about 6 years my furnace stopped working. The house was getting cold fast and I wasn’t inclined to be cost-sensitive. I was prepared to pay double to get it fixed Sunday evening instead of waiting until Monday morning. It’s no fun to get hit with costs at unpredictable times, but at least I had saved plenty of money over the years by not buying a service contract.

Back when I decided not to pay for a furnace service contract, I had reasons. The main reason was that insurance is expected to cost more than just paying as you go. The second was that I figured furnace repair companies would be more responsive to a paying customer who created profits instead of service contract customers who just create costs when they have furnace problems.

My wife picked a furnace repair company and called. She was asked “you don’t have a contract?” and told “we’re really busy.” Apparently all their workers were out doing yearly furnace cleanings. It was clear that taking our money was an inconvenience. She got off the line without a promise that they’d send someone.

This definitely challenged my thinking that the profit motive would have repair people rushing out to my home. Maybe regular furnace cleaning and inspection is a lot more profitable than actually fixing furnaces. Or maybe the working level person who handles the scheduling is paid by the hour and doesn’t care if the business is profitable. Whatever the reason, I thought maybe getting my furnace fixed will be harder than I thought.

At that point, the furnace actually started working again for a half hour or so before quitting again. It was then that we thought of checking the warranty. It turned out it was still under warranty, and we got it fixed for free that night. That’s a happy ending this time, but I still wonder about the motives of the company that didn’t want our money.

I’ve had similar experiences with my pool. It’s tough to find people to do repairs at any price. They all want to do pool openings and closings that pay them well and require little skill. For years I paid a company to do the openings and closings just because they would also do repairs as necessary. When they started dragging their feet on repairs, I dropped them and did the openings and closings myself.

I still have no intention of paying for a furnace service contract, but I have a new challenge. I need to see if there are businesses that actually focus on doing furnace repairs instead of just doing inspections and cleanings. I have a similar need for a pool repair company.

Wednesday, March 2, 2016

Examining Six Reasons to Downgrade Retirement Saving

Rob Carrick upset many personal finance experts when he said there are six reasons to downgrade retirement savings as a financial priority. There is a thread of truth in each one, but I fear that readers who are overspending will latch onto one or more of them to justify continuing down their high-spending paths.

Before getting into Carrick’s list, I’d like to discuss the phrase “retirement saving.” It’s hard for young people to think about retirement. It’s too far off. I’ve found it more effective to explain the importance of building net worth. Having more money gives you choices in life. Ultimately, having a substantial net worth will give you a pleasant retirement, but even during your working life, having more money smooths out life’s tough breaks.

I’ve found that focusing on net worth resonates better with young people than talking about retirement saving. But there is another advantage as well. Too many people think they’re saving for their retirement when they simultaneously grow their lines of credit and contribute to an RRSP. If your new savings don’t exceed your debt growth, then you’re not really saving.

That said, let’s dig into Carrick’s six reasons to postpone retirement saving.

1. You’re saving for a first house in an expensive city

Saving to buy a house builds net worth. So, as long as you don’t build debts at the same time, I would say that this is a form of retirement saving in a sense. Having a larger down payment should ultimately lead to paying off the mortgage sooner and building larger RRSP and TFSA savings.

I’m not a fan of overpaying for a house in today’s market where house prices are often very large multiples of people’s income. But as long as you pay a reasonable price for a house, building a down payment is a good idea even if you don’t build explicit retirement savings at the same time.

2. You’re part of a maxed-out young family

If you’re part of a maxed out young family with house payments, car payments, and all the rest, then you’ve probably taken on too much debt. Maybe better choices would be a cheaper car, less eating out, a smaller home, or renting a place to live. But once you’ve dug the hole, it’s sensible to focus on increasing net worth. Paying off debt is as good as (or better than) setting aside retirement savings.

However, this approach can be a slippery slope to more bad choices. Paying off one car that’s too expensive just to buy another too expensive car is just living hand-to-mouth. With a proper focus on net worth, debts will melt away, and you can start building traditional retirement savings.

3. You have credit card debt

Having credit card debt is almost always a sign of poor choices. Maybe you’ve got a sad story of bad luck that drove you into debt. That’s usually a sign that you had no emergency savings and had no margin between your income and your lifestyle spending.

But once you’ve got credit card debt, you should see this as a hair-on-fire emergency. Not only should retirement savings stop, but all unnecessary spending should stop. Stop eating out, cancel cable, and stop all other spending that isn’t absolutely necessary until the credit card debt is paid off.

This is another slippery slope case. It’s no use to pay off credit cards and then go back to the same dumb habits. Focus on growing net worth.

4. You have student debt

Getting an education is the best investment I ever made. But even in the case of student debt, we may have lingering bad choices from the past. When experts call student debt “good debt,” some students take this to mean that they can spend freely and all the debt will be good. This is nonsense. Get a great education and borrow as little as possible.

Paying off your student debt grows your net worth as well or better than making an RRSP contribution, depending on your circumstances. Once the debt is gone, keep focusing on net worth and you will naturally start contributing to an RRSP, TFSA, or both.

5. Your line-of-credit debt has become permanent

This is often a sign that you’re indirectly using a line of credit to make RRSP contributions. Maybe it doesn’t look this way, but if you make an RRSP contribution from your pay cheque and have to dip into your line of credit before your next pay cheque, then you’re effectively contributing to the RRSP from the line of credit.

To increase your net worth, you’ll have to actually reduce your lifestyle spending. This will allow you to pay down the line of credit, contribute to retirement savings, or both.

6. You have no financial cushion

As Carrick says, build an emergency fund so you don’t have to go into debt for unexpected expenses. The other part of having an emergency fund is that if you’re forced to use it, you need to cut back on lifestyle spending to replenish it.


In the end, I agree with Carrick that there are many situations where it makes sense to stop making RRSP or TFSA contributions as retirement savings. However, those who miss his detailed messages might use his article as an excuse to overspend. It’s important not to turn a temporary suspension of retirement savings into a permanent choice. Better still, avoid getting into a financial bind in the first place. Build your net worth consistently, whether it is by paying down debt or adding to savings. Control your lifestyle spending so that your net worth keeps rising.