Friday, May 24, 2019

Short Takes: Beliefs and Decision-Making, Fake News, and more

Here are my posts for the past two weeks:

Reader Question about Bucket Investing Plan in Retirement

Should You Withdraw the Commuted Value of Your Defined-Benefit Pension?

The Cost of Longevity Risk

Here are some short takes and some weekend reading:

Annie Duke gives a fascinating talk on how we form beliefs and make decisions. I hope understanding these issues will help me make better decisions in the future. However, the research seems to say I’ll have minimal success.

Julian Matthews explains why we’re susceptible to fake news and what we can do about it.

Robb Engen at Boomer and Echo has made the leap to one-ticket investing using Vanguard’s 100% stocks ETF (VEQT). A huge upside with this approach is its extreme simplicity. The downside for large RRSPs is U.S. foreign withholding taxes. By holding U.S. ETFs directly in my RRSP instead of VEQT, I estimate that I save a little over $500 per year for each $100,000 in my RRSP. To save this money, I have the joy of managing multiple ETFs and doing currency exchanges using Norbert’s Gambit. Whether this extra work is worth it depends on portfolio size.

Nick Maggiulli calls out some instances of financial pornography and explains why it’s not going away any time soon.

Ellen Roseman interviews Preet Banerjee to discuss his 5 simple personal finance rules. I enjoyed his story about how his first media exposure majorly pissed off his then employer. His new venture Money Gaps sounds like an interesting way to drive more solid financial advice to those with modest portfolios. Canadian Couch Potato also interviews Preet to discuss problems in the financial advice industry and what Preet is doing to help fix these problems.

Andrew Hallam points out what he believes is an active Ponzi scheme. The promises of no monthly losses and 30% annual returns are crazy.

Canadian Couch Potato explains what can happen when you trade stocks or ETFs close to their dividend dates. The consequences are generally minor, but sometimes moving your trade date by a day can give a small tax benefit.

Tuesday, May 21, 2019

The Cost of Longevity Risk

One valuable part of CPP, OAS, and defined-benefit pensions is that they keep paying you even if you live a long life. In more technical language, these pensions take care of longevity risk. When you have to manage your own investments, you’re forced to spend conservatively in retirement in case you live long. Here we consider example cases to illustrate the cost of longevity risk.

Shawna is 65 years old and is entitled to a $1000 per month pension, indexed to inflation, for the rest of her life. She is offered the choice of keeping this pension or withdrawing its commuted value to invest in her locked-in retirement account.

To keep this example simple, we’ll assume the pension plan expects Shawna to live 20 more years, and her commuted value is calculated with a discount rate of inflation plus 1.5%. The commuted value of her pension works out to $207,436. We’ll also assume Shawna won’t have to pay any income taxes immediately as she would have to if her commuted value was too much larger.

If Shawna takes the commuted value, she is then hoping to invest her lump sum well enough to all withdrawals of at least $1000 per month, rising with inflation, for the rest of her life. If she just assumes she’ll die at 85, she only needs to generate annual returns of inflation plus 1.5%.

However, Shawna is worried she might live past 85. To be safe, she plans to make the money last for 30 years. The question then is what return does she have to get to produce $1000 per month rising with inflation for 30 years? The answer is inflation plus 4.16%.

Even with an all-stock portfolio, there is significant risk that Shawna’s portfolio won’t produce this return, on average, for 30 years. Taking the commuted value leaves Shawna with a lot more risk than if she just takes the pension.

The situation changes for a younger person. Consider Carla who is 45 and is entitled to a $1000 per month pension, rising with inflation, starting at age 65 for the rest of her life. With the same assumptions as in Shawna’s case, Carla’s commuted value is $154,015.

To make her self-generated pension last for 30 years starting at age 65, Carla needs to generate investment returns of inflation plus 2.52%. This is more realistic than Shawna’s case. Carla is still taking some risk if she takes the commuted value, particularly if she is working with an expensive advisor. But with discipline and low-cost investments, Carla has a reasonable chance of generating more income than she would get with her pension.

It’s easy to get lost in the numbers when trying to decide whether to take a pension or withdraw its commuted value. Any analysis that leaves out longevity risk is flawed.

Wednesday, May 15, 2019

Should You Withdraw the Commuted Value of Your Defined-Benefit Pension?

No. There are some exceptions, but the answer is almost always no. In fact, if a financial advisor is pushing you to pull out the commuted value of your pension, that’s a sign that you’re likely working with a bad advisor.

There is almost no chance that your advisor will choose investments that outperform a pension fund, mainly because the total fees you pay with an advisor are so much higher than the fees charged within a pension fund. Some advisors will tell you that you won’t pay any fees because the mutual funds pay the advisor. Don’t believe this. Mutual funds and advisors get paid out of your savings.

Further, defined-benefit pensions have the advantage of handling longevity risk. Pension funds can afford to pay you based on your expected life span, and they’ll keep paying if you happen to live long. With an advisor managing your money, you need to hold back on your spending in case you live long.

There are some cases where it makes sense to withdraw your pension’s commuted value. Here are a few:

1. Poor health makes you likely to die much younger than average. In this case, taking the commuted value allows you to spend more now or leave a larger legacy.

2. You’re employer’s pension plan is badly underfunded and the company is in financial difficulty. A good example of this was Nortel. The Big Cajun Man was fortunate to get the full commuted value of his Nortel pension before pension payments were cut.

3. You leave an employer long before retirement age, and the pension plan rules make the commuted value more attractive than future pension payments. It’s important to make this determination based on modest return expectations for your portfolio. The fees you’ll pay an advisor severely dampen investment returns over long periods.

I’m sure it’s possible to come up with other narrow exceptions, but you should be very wary of advisors who push hard for you to withdraw the commuted value of a defined-benefit pension. These advisors have strong incentives to increase their assets under management to get more fees. Don’t be swayed by advisors who claim they can generate big investment returns.

Monday, May 13, 2019

Reader Question about Bucket Investing Plan in Retirement

One of this blog’s readers, AT, asks the following question about his retirement bucket investing plan (lightly edited for length):

Loosely following your bucket idea, I put $25,000 in 1, 2, and 3-year GICs. A year came and went and then $25,000 plus change went back into my account. I get CPP, OAS and have activated my RIF and LIF accounts. Does it make sense to have GICs when I have these streams of income which once started, I can't just randomly stop when the market plunges? I'd like to stop them of course and live on a GIC for a year, but if I can't, are GICs any use to me?

In my own portfolio, when stocks plunge, I just rebalance rather than make an active decision to spend only from my fixed-income investments. So, to me, your dilemma just looks like a rebalancing question. If stocks go down, your planned annual spending goes down somewhat, and you end up wanting less in GICs than you have in your non-registered (taxable) account. The remedy is to own a small amount of stock in your non-registered account. One possible way to do this is to take an annual RIF or LIF withdrawal in-kind. Alternatively, you could just use cash from the withdrawals to re-buy stocks.

If you have TFSA room to hold the stocks that no longer fit in your RIF and LIF, then you won’t have any loss of tax-efficiency. If not, it is less tax-efficient to own stocks outside registered accounts, but there is no choice if you want to be holding more stock than your registered accounts can hold. At least if you buy and hold low-cost index funds, you can defer capital gains taxes.

If you’re planning to make more active decisions about whether to spend from stocks or GICs, it’s still possible to use the idea of holding stocks in a TFSA or non-registered account. However, there are so many active retirement spending strategies that it’s hard to say what asset location choices make sense without knowing more about your strategy.

So, GICs can still be of use to you as a buffer against stock market declines, as long as you’re willing to hold some stock outside your RIF and LIF.

Friday, May 10, 2019

Short Takes: Maximizing OAS, Elder Financial Abuse, and more

I wrote one post in the past two weeks:

My “Bucket Strategy” for Retirement Spending

Here are some short takes and some weekend reading:

Ted Rechtshaffen explains how to maximize the amount of OAS you’ll get to keep. This is one of the more sensible articles I’ve read about OAS deferral and clawbacks.

Ellen Roseman interviews elder law specialist Laura Tamblyn Watts about protecting seniors from financial abuse. This is a very difficult area because it’s hard to distinguish between someone who is helping a senior and someone who is stealing money from a senior. If you go too far in protecting against abuse, you make it hard to help as well.

Preet Banerjee interviews David Bach, author of the book The Latte Factor. It’s not just about lattes, but generally the power of small daily amounts of money. I had a laugh at the joke website name, Bonds are for Losers.

Big Cajun Man explains a few things to clueless car flippers.