Wednesday, January 20, 2021

The Psychology of Money

Morgan Housel is an excellent writer.  No matter the topic, any article of his is a compelling read, as is his book The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness.  It may seem bold to declare the lessons you teach to be “timeless,” but Housel delivers on this promise.  Thoughtful readers will learn about themselves in reading this book.

The format of the book is 20 independent essays, with just a few threads linking them together.  Collectively, though, they provide useful insight into the way we all think about money.

The introduction observes that we’ve collectively “become better farmers, skilled plumbers, and advanced chemists,” but Housel has “seen no compelling evidence” that we’re getting better at handling our money.  He believes this is because “we think about and are taught about money in ways that are too much like physics (with rules and laws) and not enough like psychology (with emotions and nuance).”  I’d like to add another reason.  Finances are a competitive business pitting consumers against sellers and everyone against banks.  Expecting collective improvement is a little like bemoaning the fact that the 50% average win rate of tennis players hasn’t improved in decades.

My favourite essay is “The Seduction of Pessimism.”  Historian Deirdre McCloskey said “For reasons I have never understood, people like to hear that the world is going to hell.”  Housel explains why this is true, despite the fact that “Optimism is the best bet for most people because the world tends to get better for most people most of the time.”

Another good essay is “Wealth is What You Don’t See.”  Flashy spending signals wealth to us, but the only thing we can be sure of when we see an expensive car is that the owner has less money by the amount of the car.  True wealth is the money you haven’t spent.

One essay tries to make the case that it’s better to be reasonable than to be rational.  I was confused at first, but it seems Housel uses a different definition of “rational” than I use.  He gives a number of examples where a seemingly rational choice doesn’t work well because of factors it fails to take into account such as pain, worry, and regret.  However, I think of “rational” as making decisions taking into account all material factors, including the cost of the time spent making the decision.  For example, it is rational to take into account the possibility that investors might lose their nerve and sell at a terrible time.  

A concern I have about the belief that “reasonable” is better than “rational” is that it can be taken too far.  Housel gives some good examples where people’s feelings and tendencies are important to making a decision, but anyone could reject any rational choice asserting that a different choice is reasonable.  For example, “I won’t be able to live with myself unless I pile all my net worth into Tesla stock, so that’s reasonable for me.”  Sometimes it’s better to find a different way to deal with feelings than to put your finances at serious risk.

The essay “Surprise!” makes the case that the world is surprising, and that while a careful study of history may be a good idea, it won’t eliminate future surprise.  Housel says the failure of the Fukushima nuclear reactor (due to it only being able to “withstand the worst past historical earthquake”) was “not a failure of analysis.  It’s a failure of imagination.”  Having spent a career in engineering, I can imagine that it might have been a failure of management as well.  Even if engineers had made the case that a powerful future earthquake was too likely, higher costs and extended timelines might have been intolerable to management.

“The more you want something to be true, the more likely you are to believe a story that overestimates the odds of it being true.”  I often see others believe things just because they want them to be true.  This makes me wonder what I believe just because I want it to be true.

The 20th essay includes an account of how Housel handles his own money.  “Effectively all our net worth is a house, a checking account, and some Vanguard index funds.”  For my own case, all I’d add is that I have a savings account as well.

Unlike most financial books that readers may struggle through, I found this book to be a page turner.  Even when I mildly disagreed with a few parts, it was consistently interesting and made me examine my own thoughts about money.

Monday, January 18, 2021

Master Your Mortgage for Financial Freedom

Many people have heard of the Smith Manoeuvre, which is a way to borrow against the equity in your home to invest and take a tax deduction for the interest on the borrowed money. 

It was originally popularized by Fraser Smith, who passed away in Spetember 2011.  Now his son, Robinson Smith, has written the book Master Your Mortgage for Financial Freedom which covers the Smith Manoeuvre in detail for more modern times.  Smith Jr. explains the Manoeuvre and its subtleties well, but his characterization of its benefits is misleading in places.

The Smith Manoeuvre

In Canada, you can only deduct interest payments on your taxes if you invest the borrowed money in a way that has a reasonable expectation of earning income.  Buying a house does not have the expectation of earning income, so you can’t deduct the interest portion of your mortgage payments.

However, if you have enough equity in your home that a lender is willing to let you borrow more money, you could invest this borrowed money in a non-registered account and deduct the interest on this new loan on your income taxes (as long as you follow CRA’s rules carefully).  A common mistake would be to spend some of the invested money or spend some of the borrowed money.  If you do this, then some of the money you borrowed is no longer borrowed for the purpose of investing to earn income.  So, you would lose some of your tax deduction.

With each mortgage payment, you pay down some of the principal of your mortgage, and assuming the lender was happy with your original mortgage size, you can re-borrow the equity you just paid down for the purpose of investing and deducting any interest on this new loan.  Some lenders offer mortgage products with two parts: the first is a standard mortgage, and the second is a line of credit (LOC) whose limit automatically adjusts so that the amount you still owe on your standard mortgage plus the LOC limit stays constant.  So, after each standard mortgage payment, your LOC limit goes up by the amount of mortgage principal you just paid, and you can re-borrow this amount to invest and deduct LOC interest on your taxes.  This is the Smith Manoeuvre.

Smith describes a number of ways of paying off your mortgage principal faster (that he calls “accelerators”) so that you can borrow against the new principal sooner and boost your tax deductions.

Compared to a Standard Mortgage Plan

Ordinarily, mortgagors pay off their mortgages slowly over many years.  Their risk of losing their home because of financial problems is highest initially when they owe the most.  This risk declines as the mortgage balance declines, and inflation reduces the effective debt size even further.

With the Smith Manoeuvre, the total amount you owe remains constant (declining mortgage balance plus LOC balance) or may even increase as your house value increases and your lender is willing to lend you more money against your house.  So, your risk level as a function of how much you owe doesn’t decline in the same way as it does with the standard mortgage plan.  You could argue that your financial risk does decline somewhat because you’ve got your invested savings to fall back on in hard times, but your risk certainly doesn’t decline as fast as it does with the standard plan.

Leveraged Investing

Smith likes to say that the Smith Manoeuvre isn’t a leveraged investment plan.  He justifies this assertion by saying that you’ve already borrowed to buy your home, and you’re now slowly converting this mortgage that isn’t tax deductible to an LOC debt that is tax deductible.

In fact, the Smith Manoeuvre is a leveraged investing plan.  Under a standard mortgage plan, you would have slowly decreased your leverage and risk over time.  With the Smith Manoeuvre, you maintain your leverage.

Smith Manoeuvre Benefit

To illustrate how you can benefit from the Smith Manoeuvre, Smith assumes that your invested savings will earn 8% per year, after income taxes.  Assuming a 1% annual cost in income taxes on dividends and capital gains, the pretax assumed return is 9% per year.

In one example with a $400,000 mortgage, the Smith Manoeuvre has you coming out ahead roughly $440,000 after 25 years.  But this is misleading because we’re talking about future dollars.  If we assume that we shouldn’t count on more than a 5% real return, then our 9% portfolio return corresponds to 4% inflation.  Discounting the $440,000 to present-day dollars gives about $165,000.

So, the question you must ask yourself is do you want to implement the Smith Manoeuvre to possibly get $165,000 extra dollars if the stock market cooperates and nothing happens in your life for 25 years to mess up this plan?  This type of question always comes up when considering using leverage.  A stock market crash, a housing decline, or losing your job are all potential risks, particularly if they happen in combination.  The Smith Manoeuvre’s risk/reward combination wouldn’t have appealed to me when I was young and buying my first house, but others may differ.

Marketing

The first couple of chapters offer little information about the Smith Manoeuvre.  They are designed to give you the feeling that you’re missing out on tricks that rich people know about, that you’ll retire in poverty, and that you should be outraged by high taxes.  These chapters also contained lots of marketing for Smith’s online calculator ($70 plus $4/month as of this writing), a homeowner course ($300 as of this writing), and training programs for financial professionals to get “certified” on the Smith Manoeuvre and get “territorial exclusivity.”

I almost gave up at this point, but the book took a sharp turn and began giving clear, detailed information about the mechanics of employing the Smith Manoeuvre, its various subtleties, and warnings about mistakes that could jeopardize your tax deductions.

I am of two minds about the calculator, courses, and training.  Avoiding mistakes with the Smith Manoeuvre really is complicated enough that people could use some training (or at least some mandatory reading), but I have no idea whether the courses and training offer enough value to justify their cost, and it was annoying to see the constant marketing references throughout the book.

Another Misleading Comparison

Smith introduces two couples to show the power of the Smith Manoeuvre.  The Marshalls have an annual income of $100,000 and decide to use the Smith Manoeuvre.  The Joneses earn a whopping $300,000 per year, but go the conventional route.  In addition to the extra income, the Joneses save $700/month compared to the Marshals’ $500/month, and the Joneses start with $150,000 invested compared to only $50,000 for the Marshalls.

Amazingly, the Marshalls come out ahead in net worth 25 years later despite making $200,000 per year less.  Unmentioned is that the Joneses did almost nothing with their $300,000/year income to help themselves other than saving $200/month more than the Marshalls did.  The presumption is that the Joneses just spent almost all of their large income.  So, this difference in income was hardly factored into the comparison at all.  The Joneses could have made only $90,000 and scrimped more.

Other Observations

In one case study, “even if the Petersens only earned 2% on their investment portfolio, they’d still be better off with The Smith Manoeuvre by over $912,000.”  I can’t see how this is true when the interest rate on their mortgage is 4.5%.  I understand that loan interest is 100% tax deductible, and dividends and capital gains aren’t 100% taxed, but it seems like a stretch to get a meagre 2% investment return to overcome 4.5% loan interest.

Smith advocates getting rid of emergency funds and collapsing RRSPs and TFSAs. He says to use the money to pay down the mortgage to generate more principal to borrow against for investing.  I’m not a fan of going all in on risk and just hoping you never lose your job.

Table 4.5 compares the progress of Darren (who didn’t use the Smith Manoeuvre) and Mark (who did).  Darren ended up having to take out a lump-sum reverse mortgage, but the table of net worth progress fails to account for the remaining amount from the lump sum.

A chart of the 2019 top marginal tax rates in each province has the wrong figure for Ontario.  It lists 46.16%, but the actual figure was 53.53%.

Conclusion

If you’ve already decided you want to implement the Smith Manoeuvre, this book is a valuable resource for understanding the subtleties of implementation.  However, if you’re trying to decide whether to proceed, you need a more objective source of information, or at least additional sources to see all sides.

Friday, January 15, 2021

Short Takes: Behavioural Economics, Renting vs. Buying a Home, and more

I decided to check out the Microsoft software class action settlement.  They say “If you bought PC versions of Microsoft MS-DOS, Windows, Office, Word, Works, and/or Excel between December 23, 1998 and March 11, 2010 (inclusive), you may be eligible for compensation from this settlement.”  There is a link to submit a claim online.  I bought 4 computers during the relevant period, each with Windows and Office.  They assigned a claim value of $13 for Windows and $8 for Office (at least in my case).  So my claim total came to $84.  You have until 2021 Sept. 23 to submit a claim and if you get any money, it won’t be until 2022 sometime.  By then I will have forgotten about it and any money I get will brighten my day.

Here are my posts for the past two weeks:

The Myth of Simple Interest on Loans

Your Money or Your Life

The Total Money Makeover

The Right Way to Calculate Net Worth

Is Delaying CPP “Actuarially Neutral”?

The Sleep-Easy Retirement Guide

Here are some short takes and some weekend reading:

Kerry Taylor interviews Dan Ariely, well known behavioural economist and best-selling author.

The Stress Test Podcast (Episode 6 of Season 2) brings in Preet Banerjee for a sensible discussion of the rent vs. buy decision for your home.

John Robertson takes a first look at Tangerine’s new mutual funds with lower MERs than their old funds.

Thursday, January 14, 2021

The Sleep-Easy Retirement Guide

There are many big questions when it comes to retirement and David Aston meets them head on in his thoughtful book The Sleep-Easy Retirement Guide: Answers to the Biggest Financial Questions That Keep You Up at Night.  His style is to discuss the advantages and disadvantages of different courses of action which works very well for the big questions he tackles.

The main audience for this book is “relatively knowledgeable readers” and “the seasoned investor” who need help “answering the more complex and challenging questions.”  The first question sets the tone for the rest of the book: “How can I fit my retirement dreams within my financial reality?”

The Big Questions


In the chapter covering, “How big a nest egg will I need?,” the author does an excellent job making it clear that the safe starting withdrawal rate depends on how old you are when you retire, a fact that too many commentators miss.  For those retiring at 65, he suggests the default starting withdrawal rate is 4%.  But he “recommends reducing the withdrawal rate by 0.1 percentage point per year for retiring between age 60 and 64, and increasing it by 0.1 percentage point per year for retiring between age 66 and 70.”  He goes on to identify other reasons why you might adjust this withdrawal rate up or down.

In answering the question “How much do I need to save each year?,” instead of focusing on a single saving rate, Aston identifies multiple patterns of saving (steady saving, gradual ramp-up, and saving after the mortgage is gone), and shows the savings rate needed for each pattern.  This is just one example of the many ways he recognizes that different people often need different approaches.

When answering the “How long do I need to work?” question, the author gives a detailed example showing how working an extra year or two or three affects your ultimate retirement cash flow.  It’s hard to decide how long to work without such a detailed accounting of how much working longer helps.  One quibble I have is that he didn’t account for the fact that delaying CPP payments causes them to rise with wage inflation rather than CPI inflation even though he points this fact out later: “wages have grown roughly one percentage point faster on average than consumer prices, so chances are that the impact of different indexing factors will grow your CPP entitlement a little faster by deferring it rather than starting it.”

For the “How much should I plan to spend in retirement?” question, Aston gives profiles of several couples and singles along with numerical examples of basic, average, and deluxe retirements.  This gives readers an understanding of what type of retirement they can expect for a given annual spending level.

For the “How much can I draw from my savings each year?” question, the author offers a range of possible answers depending on your risk tolerance and desires in retirement.  One possibility to boost initial spending is to “commit to a real spending decrease of 1% a year every year.”  This idea is backed up by studies showing that this is what the average retiree does.  It’s easy to imagine an elderly version of yourself spending little, but you have to ask yourself if you’d really want to spend less every year, even in your 60s.  These studies average together data from people who choose to spend less as they age with people who are forced to spend less because they’ve overspent early on.

The answers to the question “How do I manage my investments in retirement to make my money last?” include the possibility of buying an annuity.  I particularly like the focus on annuities whose payments rise by 2% each year.  This isn’t a perfect offset to inflation, but it’s far better than fixed annuities (the most common type) that leave you watching your payments drop to half or one-third of their original buying power in your old age.

For the “How can I use the value of my home to help my retirement?” question, the main possibilities are to downsize early or to plan to tap into your home’s value only as a last resort.  However, the claim that “Rental costs usually far exceed owner-specific costs borne by homeowners” requires that we ignore the cost of capital tied up in a paid-for home.  Today’s high housing costs make renting look like the better financial choice.  I prefer to own, but that doesn’t make it better than renting financially.

The chapter on retirement homes, independent living, assisted living, and nursing homes is very informative and thorough.  There is a wide range of options at different price levels that are potentially better than suffering isolation in your home and paying for expensive in-home help.  “While many seniors are intent on staying in their own traditional family home as long as possible, what is often overlooked is that a retirement home can be a home too, after you get accustomed and then attached to your new locale and make friends among fellow residents.”  Aston considers the case for long-term care insurance to be dubious: “needing long-term care isn’t really a low probability event.  … That necessarily means that LTCI premiums are relatively expensive compared to the potential payouts they generate.”  Further, the existence of government supported nursing homes means that “To an extent at least, the government has your back already.”

For the “How can I save my retirement if my finances get off track?” question, Aston splits it into cases where your retirement is far off, it’s almost here, and you’re already retired.  The longer you have until retirement, the more choices you have for getting back on track.  For people making good money and who aren’t sure they have enough saved, “it’s probably a good idea to try to hold on to your career job a bit longer, because once you give it up, it’s usually tricky to find another job with equal earning power.”

CPP and OAS


The discussion about how much we can expect from CPP and OAS and when we should start them is better than I’ve seen from many other commentators, but I have some concerns.  Most people have a strong bias towards taking CPP and OAS as soon as possible for mostly emotional reasons.  It’s difficult to give an objective overview of CPP and OAS without playing into this bias.  Some obvious reasons to take CPP and OAS early are if “your health is poor” or “you need the cash flow.”  However, this isn’t the same as being worried you might die young or that you want the cash flow.

Aston says that CPP and OAS are designed to be “actuarially neutral” and that “you won’t usually go too far wrong if you start them any time after you retire and are eligible.”  I already have a post explaining that CPP and OAS don’t look actuarially neutral from the point of view of Canadians who are forced to plan for a long life because they don’t know how long they’ll live.

Another possible problem with delaying CPP and OAS to age 70 that Aston describes is for a couple who spend down their savings in their 60s but one spouse dies near age 70.  This eliminates that spouse’s CPP and OAS and replaces it with a small CPP survivor pension.  This scenario sounds scary and without any means of quantifying the change to cash flow, it’s difficult to tell if you should be concerned.  I crunched the numbers for my own case, and my wife’s standard of living would actually increase if I died at 70, but that only applies to us.  The book would serve its readers better if it contained some example scenarios to show when this problem arises and how severe it is.  Otherwise, it’s just another vague fear driving people to take CPP and OAS early.

The book cites another reason for possibly taking CPP early: “You’ve spent lots of time out of the workforce.”  For technical reasons (related to years with low CPP contributions that you’re allowed to “drop out” from the CPP benefits calculation), if you have several low income years, and you don’t work from age 60 to 65, the boost you get from delaying CPP won’t be as large as it could have been.  This applies to me.  However, I’m still much better off taking CPP at 70.  So, this situation is just a factor to consider rather than a reason on its own for taking CPP early.

The first reason cited for taking CPP later is “You have above-average life expectancy.”  This is true but somewhat misleading.  You don’t need to be healthier than average.  As long as living longer than average is a possibility you can’t ignore in your planning, then you have to stretch out your savings, and delaying CPP and OAS might help improve cash flow.

“Retirement expert and author Fred Vettese says the CPP deferral rates incorporate the assumption of close to a 4% ‘real’ return after adjusting for inflation.”  It’s important to put this into context or else investors who think they can beat a real 4% return will think they’re better off taking CPP early and investing the money.  The 4% real return baked into CPP deferral applies only if you have an average lifespan.  When you consider the possibility of living to 95, the rate jumps to 7% above inflation.  Only overconfident investors believe they are likely to beat inflation by a compound average of 7% per year for the next 30 or more years.

An excellent point: It “doesn’t make sense to consider purchasing an annuity without giving serious consideration first to enhancing your CPP pension by deferring it.  In essence, CPP is a superior form of annuity (indexed for inflation, unlike the kind available for purchase, which is not) that comes with attractive terms for deferral.”

Active Investing

The author is too optimistic about the possibility of hard-working investors outperforming the market with security selection or market timing.  The evidence is clear that in recent decades, stock picking is so competitive that few professional investors have much hope in beating the markets, except by luck.  Individual investors have less hope.

In a discussion of bucket investing (one bucket for cash and another for the rest of your portfolio), if there is a downturn, Aston advises shifting spending to the cash bucket, only “selling long-term assets when prices are favourable,” and possibly “postponing the regular rebalancing of your portfolio.”  This all sounds reasonable enough until you try to implement it and realize you’re forced to make frequent judgment calls about what constitutes a downturn.  I prefer a purely mechanical strategy where my judgment isn’t involved.

One of the investing strategies suggested is choosing dividend stocks for income.  We’re to “look for profitable, well-managed, blue-chip companies with sound balance sheets.  The proportion of profits paid out in dividends (known as the ‘payout ratio’) should be within reasonable limits for that industry.  The companies should have strong competitive positions in stable industries that are growing.”  The vast majority of investors who work at this diligently will just make random selections based on past results that look good.

A “moderately knowledgeable investor” “can adopt a … do-it-yourself approach to create a portfolio using individual stocks, bonds and GICs.”  I disagree that this path makes sense for a moderately knowledgeable investor.  Even most professional investors fare poorly.

“I believe the key to superior investment selection for many active brokers is to make effective use of a top-notch research department by closely following their recommendations on specific stocks and other investments suitable for specific types of clients.”  I don’t believe this is likely to give good results.

A good advisor “should be able to provide a comparison for you of the historical performance of the investments they use or recommend against a market benchmark.”  This is too easy for an advisor to game by shopping for benchmarks with weak results.

Conclusion

This book tackles head on most of the questions we have about preparing for retirement.  It covers a wide range of possible solutions to these big challenges.  Knowledgeable readers won’t get prescriptions for exactly what to do and won’t agree with everything they read, but they will learn useful ways to think about the problems and new ideas for solving them.

Tuesday, January 12, 2021

Is Delaying CPP “Actuarially Neutral”?

You can start your Canada Pension Plan (CPP) payment any time from age 60 to 70.  The longer you wait, the bigger the monthly payments.  We often hear that CPP is designed to be actuarially neutral, which means that you expect to get the same total amount from the system no matter when you start taking payments.  However, the truth of this statement changes depending on whose point of view we consider.

In his thoughtful book The Sleep-Easy Retirement Guide, David Aston writes that CPP is “designed to be ‘actuarially neutral’” and “you won’t usually go too far wrong if you start [payments] any time after you retire and are eligible.”  This isn’t true for most of us.

If we look at this from the point of view of the CPP system itself, it’s true that they care little whether you start payments early or late.  As long as their guess is right about how long the average person will live, they know how much they’ll pay out.  To be even one year off in their average longevity estimate would be considered a large error.

Next, let’s look at this from the point of view of people who are wealthy enough that they’ll never spend all their money.  Then timing CPP becomes a game of trying to maximize the estate they leave for their heirs.  For a wealthy person of average health, CPP timing doesn’t make much difference averaged across all possible lifespans.

But what about the vast majority of us who do need to be worried about running out of money in retirement?  Suppose Mary is in her 50s, has average health, and her life expectancy is about 82.  For planning purposes, Mary might decide that a reasonable range for how old she’ll get is somewhere between 70 and 95.

What should Mary do with this information?  She could decide she’s worried about dying young and make sure she spends all her savings by the time she’s 70.  This has the obvious disadvantage of leaving her eating cat food in her 70s and beyond.

Mary could go the other way and stretch out her savings until she’s 95.  This has the disadvantage that if she doesn’t make it to 95, she won’t get to spend some of her money.

Which is the more serious problem?  I’m much more worried about running out of money than leaving some money unspent.  While some people might choose to spend a little extra when they’re young enough to enjoy it, I’m guessing that most people would choose to stretch out their savings in case of a long life rather than spend it all quickly so they leave no money behind.

So, how does this thinking carry over to when we should start CPP?  If Mary has to plan for a long life to age 95, she’ll get a lot more out of CPP if she starts her payments when she’s 70 instead of starting them earlier.  The total amount of money Mary will have available to spend between now and when she’s 95 is greater if she delays the start of CPP to age 70.    Even the modest CPP payment penalty that can arise if Mary makes no CPP contributions between age 60 and 65 doesn’t change this conclusion.

Doesn’t this mean Mary will have to suffer between now and when she turns 70?  Not as long as Mary has enough savings to spend in place of the CPP payments she won’t get in her 60s.  Even though Mary is in her 50s today, as long as she has enough savings to bridge the gap through her 60s, the decision to start CPP at 70 allows her to spend more starting today.

From the typical Canadian’s point of view, the rules for increasing CPP payments when you start taking them later don’t look actuarially neutral.  We are forced to plan for the possibility of a long life, and this makes delaying CPP to age 70 look profitable for those who are healthy and have enough savings to get through their 60s.