Thursday, April 2, 2020

Annuities are Great, In Theory

I was listening to Episode 89 of the Rational Reminder podcast, an interesting interview with Wade Pfau who is an expert on retirement income. Much of the discussion was on annuities. This made me reflect on the challenges of using annuities in Canada.

Pfau speaks highly of Moshe Milevsky, and both have done work showing how retirees can use their portfolios more efficiently in retirement if they put some of their money into annuities. Another expert in the same camp is Fred Vettese who advocates buying an annuity with about 30% of your savings.

The math checks out on the work these experts have done to show that you can spend more from your portfolio with less risk of ever running out of money if you use annuities. However, the underlying assumptions need to be examined.

Pfau says investors just don’t like handing a big chunk of their money over to an insurance company, even though buying an annuity is very helpful for dealing with longevity risk. It’s quite true that some people are irrational in this regard.

So, we’ve established that annuities are a great idea in theory. What about practice? The biggest problems with annuities in Canada are inflation and an inefficient market.

I’m not aware of any insurance company in Canada that will sell a CPI-indexed annuity. You can get annuities whose payouts rise by a fixed percentage each year, such as 2%, but they’re not CPI-indexed like CPP or OAS payments.

So, is this lack of inflation protection a big deal? Yes, it is. Several older members of my extended family saw their fixed annuity payments decimated by the high inflation of the 70s and 80s. Nobody knows if or when this will happen again. To ignore the possibility of high inflation over a 30- or 40-year retirement is a big mistake.

Another problem with annuities in Canada is getting prices. It’s possible to find online comparisons of immediate fixed-payout annuities, but I haven’t been able to find payouts for annuities whose payments increase each year. Apparently, for that you have to go talk to a salesperson.

This market inefficiency makes it harder to get a good price and lowers payouts. When retirement income experts do the analysis to determine the optimal amount of your money to put in annuities, they make assumptions about payout levels and inflation. Optimal annuity amounts are quite sensitive to payout levels. They are even more sensitive to treating inflation as a random variable where high inflation is possible.

Protection from longevity risk is important. We need access to OAS- and CPP-like annuities that increase payments by inflation each year. This would certainly reduce initial monthly payments, but would give a more honest view of what an annuity can really pay. At present, annuities are great in theory, but not as good in practice.

Monday, March 30, 2020

How a Retirement Plan Responds to Market Volatility

To illustrate my retirement plan in action, let’s go through an example of how it handles a big stock market drop. My plan certainly isn’t for everyone, but you may find elements of it you like. Hopefully, this post is what reader KT had in mind when asking for a detailed example.

Imagine a hypothetical couple, the Carsons, who are following the same retirement plan my wife and I are following, but they’ve just turned 70, so they’re much further along than we are. Our portfolio is currently split 80/20 between stocks and fixed income, but this will change to 76/24 by the time we’re 70. So the Carsons’ current asset allocation is 76/24.

The Carsons deferred both their CPP and OAS to age 70. In total, they get $4000 per month or $48,000 per year. If this sounds high, then welcome to the power of deferring CPP and OAS. They could be getting a lot more if they both got maximum CPP benefits.

The Carsons have a million dollar portfolio ($760,000 in stocks and $240,000 in fixed income). The fixed income portion represents 5 years of their safe spending level, or $48,000 per year (4.8% of their portfolio). With CPP and OAS, this is a total of $96,000 per year. Like my wife and I, the Carsons actually spend less than this. They saved up more than they needed to give them a cushion before they retired years ago.

Before they retired, the Carsons always spent from the income of the spouse making more money. So their assets and income in retirement are nearly equally split between them. And some of their spending comes from non-registered accounts and TFSAs. So, they each declare a little under $45,000 in income per year. This means their income taxes are quite low.

The Carsons aren’t concerned about being forced to take more than they want out of their RRSPs each year. They’ll just save any excess in their TFSAs or non-registered accounts. It sometimes takes some juggling, but as long as the total amounts across all their accounts add up to their 76/24 asset allocation, all is well.

Each month, the Carsons spend from their fixed-income savings. Whenever their desired fixed-income amount is off by more than 10%, they rebalance. Their current fixed-income target is $240,000. So, if it is ever 10% too high (above $264,000), they buy some stocks. Whenever it is 10% too low (below $216,000), they sell some stocks. When markets are calm, their fixed-income allocation gets too low a couple of times per year, triggering rebalancing.

Unfortunately for the Carsons, their stocks recently dropped 25%. This sudden market crash has many people fearful and trying to decide what to do in response. The Carsons decided to just stick with their plan.

Their stocks are down to $570,000, and with little change in their fixed income savings, their total portfolio is worth $810,000. Their fixed-income allocation should now be 24% of this, or $194,400. So, it is too high by $45,600. This is more than 10% off, so the Carsons rebalance by using $45,600 of their fixed income savings to buy stocks.

With their portfolio going down, the Carsons’ safe spending level dropped to 4.8% of $810,000, or $38,880 per year. Adding in their CPP and OAS, their safe spending level dropped from $96,000 to $86,880 per year. This is a substantial drop. Fortunately, the Carsons weren’t spending their whole $96,000 each year, so the reduction isn’t too painful.

Let’s assume that stocks stay down for a year before starting to rise again. During that year, the Carsons can spend up to $38,880 from their portfolio (plus their CPP and OAS benefits). When their fixed-income allocation drops 10% below its target, they’ll sell some stocks. But remember that they bought $45,600 worth of cheap stocks right after the market crash. During this whole sideways year for the stock market, they won’t have to sell any of the stocks they had before the crash.

Hopefully, this answers a question reader Art had. In an earlier post, I answered Art’s question of what to do about the recent stock market crash. He expected that after a market crash I’d hunker down leaving my stocks alone, spend exclusively from fixed income, and wait for stocks to rebound. When I said I am maintaining my asset allocation, he followed up by asking what role the fixed-income component plays in this case.

One answer is that it reduces my portfolio’s overall volatility. Another answer as suggested by the worked example above is that the rebalancing process automatically halts the selling of stock for a period of time. In this example of a 25% stock price drop, the Carsons don’t touch the stocks they had before the crash for just over a year. In a more severe decline, the stocks remain untouched longer. This protects a portfolio against having to sell stocks after violent price drops.

So, why don’t I just hunker down and not do any stock trading at all until stocks rebound or all the fixed income money is gone? The answer is that I find this to be too much of an all-in bet. It works very well when stocks cooperate and rebound in time. But what if stocks crash again as your fixed-income money runs out? Now you’re in trouble having to sell stocks when they’re very low. I prefer to maintain the moderating effect of having my fixed-income allocation intact.

During the long bull market leading up to the stock crash, the Carsons had to sell stocks frequently to maintain their fixed-income allocation at its target. A big benefit of sticking to your asset allocation is that it has you selling stocks while they’re high and later buying them when they’re low. The benefit of this buying low and selling high partially compensates for the opportunity cost of not being 100% in stocks.

So, even if my approach can’t protect my stocks for a full five-year bear market, it can protect them for a year or so, depending on the severity of the market crash. I’m giving up some protection against a 5-year bear market to perform better in an unusually long-term bear market. Others may make a different choice.

Friday, March 27, 2020

Short Takes: Cash Reserves, Deferred Pensions, and more

Here are my posts for the past two weeks:

It’s Too Late to ‘Re-Evaluate Your Risk Tolerance’

Reader Question: What to do about the Stock Market Crash

Many “Experts” are Wrong about Risk

Here are some short takes and some weekend reading:

I enjoyed this brilliant letter from Warren Buffet’s grandfather explaining the value of maintaining a cash reserve. A great many people today are in need of a cash reserve.

Robb Engen at Boomer and Echo has a big choice to make about whether to take a deferred pension or take it’s commuted value. The deciding factors are how long the pension would be deferred and the current health of the pension plan.

Tom Bradley at Steadyhand says that if you choose to get out of the market, expect some tough choices on when to get back in.

Preet Banerjee explains the Canada Emergency Response Benefit (CERB) in a 3-minute video.

Ben Felix discusses how to handle the recent market crash. Stay calm and think.

Canadian Mortgage Trends describes the big banks’ mortgage referral relief. It’s hard to see how this differs very much from normal operation for banks. I used to get skip-a-payment offers from my bank when I had a mortgage. I don’t know if I could have done it 6 months in a row, so maybe that’s new. This CBC article confirms that interest accrues on the mortgage during the 6 months without making payments. Mortgage deferral will definitely help many people, but it’s not free. Banks will make money from this.

Big Cajun Man has a guest post from his daughter explaining how COVID-19 is affecting her small business.

Joseph Nunes at the C.D. Howe Institute quantifies the power of working longer to save for retirement. With people living longer, it makes sense that we can’t all retire in our late 50s or early 60s. Someone has to provide the goods and services we all need.

Jim Yih at Retire Happy tries to gently steer people away from selling stocks in fear.

The Blunt Bean Counter explains the impact of the coronavirus on small business owners.

Wednesday, March 25, 2020

Many “Experts” are Wrong about Risk

COVID-19 has brought a stock market crash and widespread unemployment, two things that often go hand in hand. None of the specifics of this crisis were predictable, but it was inevitable that the stock market would crash at some point. Now we have a vivid picture of what is wrong with a lot of financial advice.

I frequently argue with bloggers, financial advisors, and others about mortgages, borrowing to invest, and emergency funds. Some so-called experts say it’s fine to max-out your mortgage to invest more in stocks, or borrow to invest, or plan to use a line of credit instead of having an emergency fund.

Imagine what it’s like to have huge mortgage payments without a paycheque coming in. Sadly, many people don’t have to imagine. Those who use leverage to invest in stocks are looking at 45-60% losses or more, and they don’t know if it’s going to get worse. In these circumstances, an emergency fund helps a lot more than piling up more debt on a line of credit.

The problem with most thinking on these subjects is that people imagine normal circumstances. You don’t need an emergency fund when things are going smoothly. Borrowing heavily for a house or stocks works wonderfully when the economy and stock markets are running well.

Many experts do elaborate calculations to prove that you’ll end up with more money if you keep a big mortgage, use leverage, and fail to keep some cash in a savings account. During normal times, these strategies do give an advantage. It’s times like now when the cost of being unprepared is so high that it overwhelms this advantage. When you’re forced to sell at huge losses to get money to live on, these losses are permanent.

Does this mean we should all push to eliminate all debt and ignore investing? Absolutely not. Balance is key. When people ask whether they should pay down the mortgage or add to retirement savings, the correct answer is usually to do some of each. Few people are cut out for leveraging their investments, and all of us could use some cash in a savings account just in case.

It does no good to blame people who have been seriously harmed financially by this crisis. But the truth is there are steps each of us can take to be better prepared. It’s too late to prepare for this crisis, but there will be another crisis, and it will come during good times when we least expect it. Limit your debts to amounts you can handle during bad times, not just good times.

Monday, March 23, 2020

Reader Question: What to do about the Stock Market Crash

Art asks the following (lightly-edited) question about what to do with his portfolio now that the stock market has crashed.

Like everybody, I guess, I've lost a lot of money. Life goes on and I'm surprised at my risk tolerance. I have no desire to sell low (I grew up on the game Stock Ticker).

But I do get monthly RIF and LIF payments. As I can't stop payment, due to current conditions (and assuming that things will get better), I'm thinking of switching from month to month to an annual withdrawal which would leave me having losses only on paper. That makes sense to me as I can live without my RIF and LIF for now. I set up some GICs and they will keep me floating for a couple of years.

My second idea is, if I stay month to month, is to sell bonds (in my case ZAG) as they have suffered less damage than the stocks. I'm using Couch Potato 50-25-25, XAW/VCN/ZAG. Along with that, I would start a new RRSP as things are certainly a bargain right now and plough back whatever I get month to month and as above, and live off my GICs.

This is WHY we have GICs, right?

If you can let me know what you think, I would appreciate it.

Let’s start with the important stuff: I played Stock Ticker as a kid too. I don’t know if it had any effect on my risk tolerance, but who knows what drives these things. It’s good that you’re not panicking, Art.

As for the rest of your questions, my choice has been to continue with my plan unchanged through this market crash. But it’s important to look at exactly what it means to stick with my plan, because parts of it look similar to your thoughts.

My plan involves maintaining an asset allocation currently at about 80/20 between stocks and fixed income (cash, GICs, and short-term Canadian government bonds). The stock market crash has thrown this balance way off, so I’m selling bonds to buy more stocks to restore my balance.

Now that your stocks have tanked, your allocation to ZAG and GICs is high. So it makes sense to either shift some bonds or GICs to stocks, or live off bonds and GICs until you’re back to your desired asset allocation.

You could decide to go further and just live off your fixed income longer than it takes to restore your target allocations. This would effectively increase your stock allocation percentage higher than it was before the crash. This would be an active choice, but not one I’d make myself.

As for what to do with cash flowing from your RIF and LIF that you don’t currently need to live on, keep in mind that the government is letting you reduce RIF payments by 25% this year. If you’ll still have more cash than you need, then it makes sense to invest the excess in a way that’s consistent with your overall portfolio’s target allocations. Whether you invest this extra money within an RRSP, a TFSA, or a non-registered account depends on whether you have TFSA room, RRSP room, and a high enough income to justify making an RRSP contribution.

Whether you should change your withdrawal frequency from monthly to yearly comes down to convenience for me. I prefer yearly because it’s less work and I don’t have tight cash flow. Your idea is to delay selling stocks right now, which is an active decision that I wouldn’t bother to make, but is mostly harmless.

The question about why we have GICs depends on your philosophy. There are certainly many people whose plans involve shifting all spending to GICs after a market crash while waiting for stock prices to recover. This is obviously an active decision based on when you declare a stock drop to be large enough to call it a crash. As you have probably guessed, Art, I prefer a mechanical strategy without any hard switches from one mode of handling a portfolio to another.

So you’ll have to decide whether you want to follow your gut or just follow a mechanical plan that can be coded into a spreadsheet. One benefit of the mechanical strategy is that it eliminates hand-wringing about what to do next.