Thursday, June 30, 2016

Short Takes: Autistic Adults, Criticizing Banks, and more

Have a great Canada Day! With Canada Day landing on Friday, I’m giving my short takes a day early. Here are my posts for the past two weeks:

Visa Response to Walmart Unconvincing

Misbehaving: The Making of Behavioral Economics

Benchmarking

A Wealth of Common Sense

Here are some short takes and some weekend reading:

Big Cajun Man looks at solutions to the problem of how to keep making financial decisions for an autistic family member who becomes an adult. Hint: the solution is not a power of attorney.

Tom Bradley at Steadyhand observes that few people in the financial industry are in a position to be critical of our banks, but he would like to see the much lower costs that are surely possible due to their massive scale. I’ve long thought that the best hope for lower costs will be a never-ending stream of banking start-ups (such as ING/Tangerine, PC Bank, EQ Bank, etc.). As the big banks buy each start-up, it just encourages more start-ups to give it a try. If enough enter the market, the big banks won’t be able to keep fees sky high by buying them all.

Canadian Couch Potato looks at the trade-offs between holding cheap U.S. ETFs directly versus the convenience of holding a more expensive Canadian ETF that invests in the U.S. ETFs.

Kerry Taylor has a very interesting take on the cost of getting married. She says the average wedding cost in Canada is about $27,000, but you can get married for as little as $427 in Toronto. “Shelling out an additional $26,573 does nothing to get you hitched.” So, don’t blame high costs on getting married. Getting married is cheap; it’s the party you indulge in that’s expensive.

Preet Banerjee interviews Randy Cass, CEO of robo-advisor Nest Wealth, in his latest podcast. Nest Wealth charges its customers a flat monthly fee instead of a percentage of their savings.

My Own Advisor discusses the crossover point where your savings produce enough income to cover your expenses. I think about this quite a bit and I find it difficult to decide how much safety margin to build into my expected expenses. I’ve built in allocations for infrequent purchases like a new roof, car, furnace, and air conditioner. But it’s hard to give up a steady pay cheque when I know there’s a chance I might need more money than I think.

Boomer and Echo looks at the right way to calculate your net worth. I think it depends on what you plan to do with the information.

Tuesday, June 28, 2016

A Wealth of Common Sense

In his book, A Wealth of Common Sense, Ben Carlson explains why the best investment plans use simple strategies with diversification and minimal trading. But his heart seems to be in trading. Maybe this makes his book most useful for those who are currently trading themselves into losses and need to be told to form a strategy that takes their own opinions out of the mix.

The section that best illustrates Carlson’s tendency to think like a trader comes late in the book and is titled “Vetting Your Sources of Financial Advice.” After explaining the problems with most pundits who make extreme stock predictions based on oil prices and other economic indicators, he recommends that you “look for balanced viewpoints that look at both the potential rewards and potential risks.” I’d say that the average investor is crazy to trade frequently in the first place, and no amount of looking for the right talking heads will help. But, if you can’t help yourself, at least take Carlson’s advice on avoiding the worst talking heads.

The bulk of the book contains solid advice. Fifty years ago, individual investors made up more than 90% of stock trading volume, but that has dropped to less than 5% now. It’s important to understand that your neighbour is not your trading competition. “Professional investors now control the markets.”

“In most areas of our lives, trying harder is great advice. But trying harder does not mean doing better in the financial markets. In fact, trying harder is probably one of the easiest ways to achieve below average performance.” Well said. Another good quote: “Stock picking is for home-run hitters who will likely strikeout.”

In paraphrasing Daniel Kahneman, Carlson says “Even smart people need to systematically weed out their irrational impulses, because intelligent does not mean rational.” This can be hard to admit to yourself, but I now see some of my own irrational tendencies.

Carlson has a tendency to overstate things, which can be confusing at times. One example is “there’s no such thing as passive investing.” In reality there are degrees of active/passive investing. It’s only when you decide to think in extremes that you get Carlson’s statement. All he means by this is that even passive investors have to make some decisions, particularly up front.

Most investors think of diversification among stocks as roughly meaning the number of stock you own. However, Carlson seems to mix this definition with a different one: the number of different strategies you use, such as factor tilts toward small caps or value stocks. He observes that trying to follow too many strategies can leave you with an expensive portfolio that isn’t much different from the broad market. For some reason, he calls this “overdiversification.” I’d call this self-imposed closet indexing. The problem is cost, not the degree of diversification.

“Investing really comes down to regret minimization.” I couldn’t make much sense of this one. I certainly don’t want to experience more regret than I have to, but this doesn’t dominate my investment choices. Staying well diversified certainly cuts down on the regret from selling a stock too soon or buying a bad stock. However, I avoid stock picking because I believe I’ll end up with more money by indexing, not to minimize my regret.

“The perfect portfolio or asset allocation does not exist.” My first thought was that among the many asset allocations I could choose, one of them will turn out to make the most money. All Carlson means is that you can’t know in advance which asset class will perform best, so you need to diversify.

“Diversification is worthless without rebalancing.” This is just way overstated. Rebalancing is a great way to control risk, but diversification still has value even if you never rebalance.

“No one has successfully figured out a way to arbitrage long-term thinking.” I’m not sure exactly what Carlson means by this, but investing for the long term is a form or arbitrage. The risk premium is unreasonably large and I exploit it by investing in stocks for the long term. If enough others think the same way, our collective arbitrage will shrink the risk premium.

“Emotional intelligence counts for much more than IQ.” Just as you need both your heart and your lungs, you need some IQ and some control over your emotions. So, on a certain level, there is no point in trying to decide which is more important. But if I had to choose my own mix, I certainly wouldn’t go for all emotional intelligence and no IQ.

“Most investors assume that benchmarking is mainly for measuring performance against the indexes to compare over- or under-performance against the market. But in the advisor-client relationship, the main reason for measuring performance and benchmarking is to improve communication between the parties.” I disagree. Better communication could be a side benefit, but the main purpose of benchmarking is to see how you’re faring against an appropriate mix of indexes.

“The only benchmark that matters is achieving your personal goals, not beating the market.” If the goal is to get people to accept market returns and not risk going for more, I can see why Carlson says this. However, I see too many stock pickers protect their egos by not benchmarking. I recently wrote a post explaining the subtleties of when benchmarking makes sense and when it doesn’t.

Overall, this book can be valuable for overconfident investors to see some the pitfalls they’re likely to encounter using complex strategies that rely on gut feel. If it had been around 15 years ago, it might have helped jolt me sooner out of the delusion that I could be a successful stock picker.

Thursday, June 23, 2016

Benchmarking

Some say that comparing your portfolio’s returns to an appropriate benchmark isn’t important as long as you’re meeting your financial goals. This sounds very reasonable, but whether or not it makes sense depends on the situation.

Situation 1: An investor saves all of her money in GICs. She could be making more over the long term by owning some stocks, but she is saving enough that she is meeting her financial goals. Is this sensible?

With a couple of caveats, I’d say yes. Many investors, particularly GIC investors, don’t think enough about inflation. If you’re about to retire and your GIC portfolio is producing the amount of interest income you’d like to spend, then you could be disappointed in future years as inflation erodes your savings and your income. As long as our hypothetical investor takes into account inflation and possible interest rate changes, she should be fine ignoring the stock market. I prefer to go for the near certainty of an earlier retirement from decades of investing in stocks, but to each her own.

Situation 2: An investor has all his savings in the IG AGF Canadian Balanced Fund, paying total fund fees of 2.89% each year. He prefers not to compare his returns to a blended benchmark of Canadian stocks and bonds because his portfolio seems to be progressing acceptable well.

This investor’s reasoning doesn’t make sense. He is giving away a substantial amount of money each year. If he doesn’t need high returns, he could have a much less risky portfolio that gives more stable returns. With a DIY approach, he might be able to get the same expected returns without any stocks at all. By finding another advisor who chooses funds charging 2% or less each year, he could significantly lower his stock allocation. His current path has him taking equity risk but giving away much of the equity premium. His future returns are expected to be low, but his retirement hopes could still be dashed by a stock market crash. He’d be better off to compare his returns to a benchmark, see the problem, and either go for a less risky portfolio or choose to keep more of the equity premium.

Situation 3: A stock picker prefers not to compare his returns to a benchmark. He says the benchmark isn’t relevant in his case.

This investor’s reasoning doesn’t make sense. He needs to know whether there is something wrong with his stock selection process. It’s true that comparing his returns to the wrong benchmark gives no useful information. For example, an investor who chooses Canadian stocks learns little by comparing his returns to the S&P 500. A Canadian dividend investor would do well to compare his returns to that of a Canadian dividend ETF. Consistently underperforming this ETF could be a sign of making poor stock selections. The challenge for each investor is to honestly seek out an appropriate benchmark. It’s always possible to find a benchmark that had a bad year to make personal portfolio returns look better. It’s best to choose the benchmark beforehand and try to make an honest assessment of whether your stock selections are really doing you any good.

It’s true that past returns are no guarantee of future returns. However, we are looking at the gap between our returns and that of a benchmark. When the benchmark is chosen well, this gap has some predictive value. The investor with his money in the expensive balanced fund has past underperformance that is likely to persist into the future. A poor stock picker is likely to remain a poor stock picker, particularly if he isn’t aware that his efforts are losing him money.

For stock pickers who prefer to protect their egos from an objective measure of their real skill level, I have a checklist of best practices.

Tuesday, June 21, 2016

Misbehaving: The Making of Behavioral Economics

Richard Thaler’s book, Misbehaving: The Making of Behavioral Economics, is both a fascinating look at the way humans make economic decisions and an interesting account of the history of this field within economics. Despite being an easy read, this book teaches important lessons.

I had no idea that claiming humans are not completely rational was once controversial in the field of economics. The term used for a person who makes perfectly rational financial decisions is “Econ.” The entire field of economics was built on the notion that we are all Econs. Of course, we aren’t. Economists used to deny that our irrationality had any serious impact on markets, but Thaler devoted his career to showing how our mistakes are an important part of economics.

One interesting finding is that “people who are threatened with big losses and have a chance to break even will be unusually willing to take risks, even if they are normally quite risk averse.” Perhaps this is the source of the common offer of “double or nothing.”

One part of the book was particularly tough on dividend investors. Thaler says that “in a rational world,” preferring dividends to capital gains “makes no sense.” “A retired Econ could buy shares in companies that do not pay dividends, sell off a portion of the stock holdings periodically, and live off those proceeds while paying less in taxes.” He goes on to describe a preference for stocks paying high dividends as “silly.”

Given a chance to take a fair coin flip to win $200 or lose $100, many people who would not do this once say they’d be happy to do it 100 times. Thaler explains why this is irrational, but notes that people think this way anyway.

Other research shows that people become less willing to take on risk if they see frequent losses. Combining this fact with the up-and-down nature of the stock market, we find “that the more often people look at their portfolios, the less willing they are to take on risk, because if you look more often, you will see more losses.”

Thaler explains a number of problems with strong forms of the efficient markets hypothesis, but notes that despite mispricings, “investors who attempt to make money by timing market turns are rarely successful.” This seems to be a common theme in the stock market. We can find anomalies, but it’s hard to profit from them.

The book contains humour as well. In a section analyzing the value of NFL draft picks, Thaler tells the story of the Redskins trading away several picks over multiple years to the Rams to get quarterback RG3. At the beginning of a game between the two teams, “the Ram’s coach sent out all the players they had chosen with the bonus picks to serve as team captains for the coin toss that began the game. The Rams won the game 24-0 and RG3 was sitting on the bench due to poor play.”

Thaler discusses the importance of “nudges,” which are ways to make it easier for people to do the right thing. Translating to the Canadian tax system, he suggests that RRSP contributions would increase if people could direct their tax refunds to their RRSPs and have the contribution count “for the return being filed (for the previous year’s income).”

Another amusing and likely effective nudge is when people need to “leave for higher ground before a storm strikes ... offer those who opt to stay a permanent marker and suggest they use it to write their Social Security number on their body, to aid in the identification of victims after the storm.”

It’s tempting to laugh at the kinds of mistakes people make and feel confident that we don’t make such mistakes. Of course, this isn’t true. It makes sense to try to make the choices an Econ would make, but we are doomed to fail sometimes. Hopefully, by pointing out the ways we make mistakes, Thaler is helping us make better choices.

Saturday, June 18, 2016

Visa Response to Walmart is Unconvincing

By now most people have heard that Walmart Canada announced it will soon stop accepting Visa credit cards. The reason they cite is that “the fees applied to Visa credit card purchases remain unacceptably high.” Visa now has a public response, but it is not at all convincing.

Visa accuses Walmart of believing “that their cost to accept Visa cards should be much lower than all other merchants – lower than local grocery stores, pharmacies, convenience stores – and yes, charities and schools too.” Walmart’s announcement didn’t include a demand for lower costs than other retailers. All Walmart said was that Visa’s costs were too high for Walmart. Visa could reduce costs for all retailers if they want. This just looks like an attempt by Visa to pit Walmart against other retailers and portray them as greedy. Walmart doesn’t control what Visa charges charities and schools.

Visa accuses Walmart of “unfairly dragging millions of Canadian consumers into the middle of a business disagreement that can and should be resolved between our companies.” This is nonsense. If Walmart is not willing to stop accepting Visa cards under any circumstances, then there is nothing to stop Visa from continuing to increase fees indefinitely. There is clearly a maximum fee level beyond which Walmart is more profitable not accepting Visa cards. It’s Walmart’s responsibility to their shareholders to reject Visa if it makes them more profitable.

The claim that Walmart is “using their size and scale to give themselves an unfair advantage” is amusing. This may be true, but it is also common practice by Visa. Smaller retailers know that when it comes to Visa’s terms, they have to take it or leave it.

It’s common for large businesses to squabble over money. In this case the battle escalated to the point where it became public. These companies are driven by self-interest. The attempt by Visa to stake out a moral high ground is a joke. Neither company’s motives are influenced much by morality. If consumers look at their own self-interest, they will be on Walmart’s side to keep extra costs down.

Friday, June 17, 2016

Short Takes: George Soros’ Short, Cash-Back Scams, and more

Here are my posts for the past two weeks:

A (U.S.) Penny for Your Thoughts

How Not to be Wrong

Building a Tolerance for Debt

“The Foundation of Financial Independence is a Paid-for Home”

Here are some short takes and some weekend reading:

The Reformed Broker has a very sensible take on the news that George Soros is betting against global stocks. No doubt Mr. Soros has high moral character, but if he were acting purely in his own self-interest, he would be best served by leaking this story shortly before buying out his short position and going long.

Robert McLister warns us about a mortgage broker scam where the broker offers cash-back to effectively lower your interest rate but gives too little cash for the claimed reduction in interest rate. This is closely related to cash-back mortgages that I analyzed years ago and created a calculator to compute the effective interest rate for a given amount of cash back.

Larry Swedroe explains why using collar strategies to limit portfolio downside puts a drag on returns.

The Blunt Bean Counter explains the tax implications of divorce when you own both a home and a cottage. Without proper planning, you could end up in a race to see who can use the capital gains exemption for principal residences. The stakes can be quite high.

Boomer and Echo compares Boomer’s family’s spending to that of Mr. Money Mustache, who is known to be very frugal.

Big Cajun Man says you should check on your automatic withdrawals and deposits periodically. He had a case where a bank mysteriously stopped moving his money.

My Own Advisor takes a peek into Kyle Prevost’s portfolio. It’s quite close to mine.

Million Dollar Journey has an update on Frugal Trader’s push to financial independence. As many people have found, being a millionaire doesn’t provide the same lifestyle it once did.

Thursday, June 16, 2016

“The Foundation of Financial Independence is a Paid-for Home”

This article’s title is a frequent quote from journalist Jonathan Chevreau (see here for one among many examples). He is a baby boomer and this advice has worked out spectacularly well for most baby boomers who have followed it. However, today, this advice is likely to lead young people astray.

In much of Canada, house prices have become—pardon the technical term—stupid. My first mortgage was less than one-and-a-half times my family’s yearly gross income. Even cheaper fully-detached homes on nice lots were available at the time. Today I see families getting mortgages for four to five times their gross incomes. The multiple on their take-home pay is even higher. This creates enormous multi-decade financial burdens at a time when secure long-term employment is becoming scarcer.

Getting back to baby boomers, buying a home had many advantages. One such advantage was that in the period shortly after buying a home, mortgage payments forced a family to control spending and save indirectly by increasing home equity. Then as inflation eroded the value of the owed payments, the pressure eased off. Falling interest rates caused mortgage payments to drop even further.

However, today’s home buyers can expect a different experience. Rather than creating a sensible level of forced savings, many families have mortgage payments that are a huge burden eating up a big chunk of their take-home pay. Low inflation takes away the hope that future mortgage payments will be more affordable. There is very little room for interest rates to decrease and they may increase. Even a modest interest rate increase will drive up mortgage payments significantly.

Baby boomers enjoyed huge increases in the values of their homes. In most cases, these increases exceeded inflation by a wide margin. Today’s home buyers can’t expect the same outcome. For house prices to increase by as much in the coming decades as they did in the past few decades, there would have to be a flood of rich people to pay the astronomical prices. It’s possible that house prices will manage to increase with inflation, but another possibility is a substantial drop in prices at some point.

Young people face too much marketing and parental advice to take on huge financial commitments such as expensive houses and cars. A much safer path is to pay as you go by renting and buying modest used cars. The trick with this path is to save a significant fraction of your income along the way. I usually recommend 20% of take-home pay.

The purpose of such saving isn’t just a very far off thing like retirement. Maybe you’ll decide to buy a house when you can better afford it. Or maybe you’ll go back to school. Or maybe you’ll need a cash buffer while you change careers. If this doesn’t motivate you, then just think about the reality of working for several years and having nothing to show for it. You should have some savings in return for the work you put in.

A big benefit that baby boomers got from owning their own homes was ending up with a paid-for home 20 to 30 years later. Those who rent are certainly at risk of having nothing to show for their years of working if they don’t save any money. However, home ownership has its risks as well. Many people today have over-extended themselves and are destined to repeatedly re-expand their mortgages or lose their homes entirely. This risk would become much worse with job loss or if interest rates rise.

Baby boomers who bought homes when they were starting out did well, but this strategy is much less likely to work out well today. Now it’s definitely a bad idea to borrow as much as a bank is willing to lend you for a house. You’re likely better off taking a lower risk path that includes renting a home and saving some of your income as a foundation for financial independence.

Tuesday, June 14, 2016

Building a Tolerance for Debt

The first time I got a mortgage, the feeling of being in debt occupied my mind and kept me off balance for quite a while. I felt I should cut back on spending as a response to this feeling of financial “emergency.” Eventually, I got used to it, as do others. The trouble comes when you get used to more serious debt problems.

When discussing credit cards, I usually tell people that having a balance on credit cards you can’t pay off each month is a hair-on-fire emergency that should trigger immediate cuts to discretionary spending. No more eating out, movies, or other unnecessary spending until the credit cards are paid off. However, it’s not possible to stay in a panic state for a long time. It’s very easy to get used to being in debt.

Many people who lose their jobs or have some other financial calamities find themselves not only with credit card debt, but also in debt to hydro, the gas company, the phone company, and many other creditors. As they dig themselves out of debt, just owing on credit cards feels like a relief.

It’s harder to persuade most people with credit card debt to cut back on eating out and other discretionary spending if they’ve experienced much worse debt problems in the past. They’ve built up a tolerance to the panic feeling of debt trouble. I’ve met some people whose response to debt trouble is to become more sensitive to even small amounts of debt, but there are more people who become relaxed about debt.

One of the less obvious negatives about going through big debt trouble is that it can leave you relaxed about having smaller debt trouble.

Monday, June 13, 2016

How Not to be Wrong

Jordan Ellenberg’s ambitiously-titled book How Not to be Wrong does a good job of teaching many broadly applicable ways of avoiding mistakes. It contains surprisingly little of what we’d recognize as math considering its subtitle The Power of Mathematical Thinking. Ellenberg explains that mathematical thinking often looks a lot like common sense. While this book isn’t specifically about personal finance or investing, it does teach lessons that are useful for our financial lives.

The book begins with one of the best answers I’ve seen to the question posed by many frustrated math students: “When am I going to use this?” I can’t do justice to the answer in just a few words, but I’ll give it a try. Just as you never see a professional soccer player “zigzagging between traffic cones” in the middle of a game, you may not spend much time doing algebra or calculus in your daily life. But the soccer player’s drills make him a better player, and math training helps you “understand the world in a deeper, sounder, and more meaningful way.”

Ellenberg follows up this explanation with an interesting story from World War II about examining returning planes for bullet holes to see where they need more armour. The correct answer comes from the observation that the bullet holes in the planes that don’t come back tell the true story of where to put the armour.

The rest of the book covers many ways that people get things wrong, such as false linearity. If current trends continue, we can project which year everyone will be obese. Another linearity error is believing that if some medicine is good for you, then more medicine must be better.

One amusing mistake of inference concerns scientific research. If you run enough experiments, you’ll eventually get a positive result by coincidence. A scientific paper demonstrating this problem “proved” to an accepted statistical standard that dead fish can read people’s minds.

I was pleased to see a section discussing whether “hot shooters” exist in basketball. Fans believe it happens but many researchers have crunched the numbers and found no evidence of hot shooting. One effect I’ve noticed as a fan has been confirmed by researchers studying the statistics: “players who had just made a shot were more likely to take a more difficult shot on their next attempt.”

Much of the more mathematical parts of the book are in the footnotes. Some of the humour is in the footnotes as well. “The natural logarithm [base e=2.718... as opposed to base 10] is the one you always use if you’re a mathematician or if you have e fingers.”

An interesting result concerned mean reversion and Scared Straight programs that “took juvenile offenders on tours of state prisons, where inmates warned them about the horrors that awaited them on the inside.” Of course, authorities selected the juveniles who had the worst records for this program and it seemed to work. However, any time you pick the worst samples there is some reversion to the mean where the worst ones become less bad over time. Once this was taken into account, “researchers found that the program actually increased antisocial behavior” among the juveniles.

In the end, Ellenberg is trying to add more tools for us to apply with our common sense, such as “more of a good thing is not always better,” “improbable things happen a lot,” and that you should make decisions “not just on the most likely future, but on the cloud of all possible futures.” These are valuable lessons in investing and in the rest of our lives.

Thursday, June 9, 2016

A (U.S.) Penny for Your Thoughts

Now that Canadians have had a few years of life without the penny, we’ve more or less figured out that none of the terrible predictions came true. But the U.S. has penny proponents who are sure that eliminating the penny will bring big trouble. I think their tactics are all wrong, though.

One penny advocacy group wastes their time trying to refute obvious facts such as that the penny is essentially worthless, and that eliminating pennies will save time at checkout and will save the government some money. You can see the attempted refutations here.

This approach of trying to make nonsense arguments sound reasonable is a bad strategy. I think they need to hit people with on a more emotional level. Here’s one idea from another successful lobby:

The government wants to come into your house and take all your pennies!

Nobody wants the authorities trampling flowers and rooting through their underwear drawers. And just think of the increased cost of having to play Rummoli with nickels.

All prices will have to be 5 times more once the penny is gone!

This is a way better grabber than some conspiracy theory of retailers fixing prices so they get the benefit from rounding to the nearest nickel.

It would probably be too offensive to use something like “First they came for the Socialists’ pennies …,” but when your position makes no sense, sometimes desperate moves are all you have.

The truth obviously won’t do. Saying “I’m old and I don’t like it when things change” or “I like collecting pennies more than I like talking to people” won’t change opinions.

Maybe Canada and the U.S. are in a race. Which will happen first: the U.S. eliminates the penny or Canada gets rid of both nickels and dimes? My money is on the U.S., but the current presidential race makes it hard to imagine a time when U.S. politics stops being dysfunctional.

Friday, June 3, 2016

Short Takes: Predicting Doom, Loving Lower Stock Prices, and more

Here are my posts for the past two weeks:

Dangers of Using the Rich as Role Models

Pensionize Your Nest Egg

Here are some short takes and some weekend reading:

Larry Swedroe explains why the Shiller cyclically adjusted price-to-earnings ratio (called CAPE 10) is not a good indicator of whether stocks are over- or under-valued. Other commentators use the CAPE 10 to predict imminent doom in the stock market.

Tom Bradley explains why we need to overcome our emotional reactions and learn to love market sell-offs. It’s amazing how our instinctive reactions to falling stock prices can be so incredibly wrong.

Preet Banerjee explains what he would tell his younger self about how to start off investing (video).

Dan Hallett points out how some fund advertisers are misleading investors with returns from F-series funds.

Boomer and Echo explain what’s behind car dealership offers to buy back your 3- to 5-year old car.

Canadian Couch Potato explains why he removed real-return bonds from his model portfolios.

My Own Advisor takes a run at comparing his investment returns to that of a benchmark. This is an important part of finding out whether a stock-picker’s hard work is producing any value.

Big Cajun Man says that people with some experience at failing to manage their own money well can help financial planners identify where their clients will run into trouble trying to follow a plan.

Wednesday, June 1, 2016

Pensionize Your Nest Egg

There are two central messages of the book Pensionize Your Nest Egg, by Moshe Milevsky and Alexandra Macqueen. The first is that having assets saved for retirement is not the same as having a pension. The second is that you can turn assets into a pension with the right insurance products. Both are true, but I have serious reservations about the variable annuities the authors recommend.

To a first approximation, the authors say that if there is a nontrivial chance that you’ll run out of money in retirement, then you don’t have a pension. Any attempt to manage your asset allocation through bucketing or other means can leave you vulnerable to the risks of living long, inflation, getting poor investment returns, or having poorer returns early in retirement that deplete your nest egg. The authors do a good job of explaining each of these risks.

The offered remedies for all of these problems are various types of annuities sold by insurance companies. The authors offer a process for determining how to split your nest egg across stocks, bonds, simple annuities, variable annuities, and various types of guaranteed income riders with these annuities. They call this “pensionizing” your nest egg.

There is no reason, in principle, why this can’t be great advice. Having an insurance company average out longevity risk across many retirees can benefit everyone. The problem I’ve seen is the sky high fees embedded in the complex annuity products I’ve examined. In one case, the guaranteed income looked good with the possibility of income increases if stocks performed well. But the rules for when these income increases would kick in combined with huge yearly fees made it very likely that few if any increases would occur. This would leave the retiree with income eroding with inflation each year.

The authors assert that “converting some of your initial nest egg into a stream of lifetime income by pensionizing it increases the amount you can spend at all ages, regardless of the exact cost of the pension annuity.” This is clearly false if the fees baked into annuities are too high. I can only assume the authors imagine the fees to be limited to reasonable levels.

The authors do compare the costs of annuities to the costs of other types of investments. However, the annual percentages given will mislead many readers. They say that the total annual fee of the typical Canadian mutual fund is 1.84%/year, and that variable annuities with lifetime income guarantees have annual fees in the 3-5% range.

This isn’t a fair comparison because some of the variable annuity fee exists to cover the cost of the income guarantee. Even ignoring this fact, to most people, the cost difference doesn’t look huge. However, suppose that the average dollar of your nest egg stays invested through 15 years of retirement. If we convert these annual costs to 15-year costs, the mutual fund costs 24%, and the variable annuity costs 37-54%! Even seemingly small increments in fees make a big difference.

The book’s table of costs also lists the fees for exchange-traded funds (ETFs). Strangely, though, it lists these fees as starting at 0.5%/year in Canada and the U.S. It’s not difficult at all to find index ETFs charging less than 0.1% per year.

Many commentators advocate a retirement strategy of owning more bonds and fewer stocks as you age and placing some fraction of your nest egg in a simple annuity when you reach 75-80 years old. As long as the stocks and bonds are invested in low-cost ETFs, I’m skeptical that the authors’ pensionizing strategy is superior. I’d have to see the numbers to be convinced otherwise.