Thursday, July 11, 2019

Estimating the Value of 0% Financing

I recently helped a family member buy a new car. She was paying cash for the car, so we had to estimate the value of the 0% financing offered to figure out a sensible price to pay for the car.

The key factors that matter for estimating the value of low financing interest rates are duration and interest rate reduction. For example, suppose financing is offered for 4 years at a rate that is 4% below a competitive interest rate. This is a total of 4x4%=16%. However, if the car will be paid off over 4 years, the average balance owing will be close to half the price of the car. So, the value of the financing is about 8%.

For this example, you can reduce the car’s MSRP by 8% as a starting point for a cash sale negotiation. This is equivalent to paying the full MSRP and taking the financing. From there you can negotiate down from the adjusted MSRP.

It was interesting to talk to multiple dealerships and take this approach. A couple just pretended they didn’t know what I was talking about. They played it initially like they never heard of financing having a cash value. The place we eventually bought the car from immediately applied a cash-back figure that represented the value of low-interest financing.

A complicating factor was that I made a mistake initially with valuing the financing. I forgot about the average balance owing being only half the price of the car. So, I initially thought the financing was twice as valuable as it really was.

In the end, the price we got appeared to be better than indicated by the somewhat confusing report we downloaded from unhaggle. It’s always hard to know if you got a good or bad deal on a car, and I’m always left feeling uneasy for a while.

I don’t have much advice for most aspects of buying a car, but there are three things I’m confident about. One is how to value low-interest financing, the second is that it’s best to buy from Phil Edmonston’s Lemon-Aid guide recommended vehicle list, and the third is that it’s best to avoid debt and pay cash for cars.

Friday, July 5, 2019

Short Takes: Paying in Home Currency, Rent vs. Own, and more

Here are my posts for the past two weeks:

Switch: How to Change Things When Change is Hard

How Fast Will Your Portfolio Shrink in Retirement?

Here are some short takes and some weekend reading:

Preet Banerjee explains why you should never accept a foreign merchant’s offer to let you pay in your home currency.

Benjamin Felix compares renting to owning a home in terms of unrecoverable costs.

Big Cajun Man can probably hear the circus music after completing another round with CRA. They’ve accepted both halves of his documentation, but not both at the same time.

Tuesday, July 2, 2019

How Fast Will Your Portfolio Shrink in Retirement?

Once you’re halfway through retirement, you’d expect about half your savings to be gone, right? This turns out this is very wrong when we don’t adjust for inflation. The return your portfolio generates causes your savings to hold steady for a while and then fall off a cliff.

I read the following quote in the second edition of Victory Lap Retirement:

“A recent Employee Benefit Research Institute study found that people in the U.S. who retired with more than $500,000 in savings still had, on average, 88 percent of it left eighteen years after retirement.”

Frederick Vettese provided further detail. This 88% figure is the median rather than the average.

This statistic was used as proof that retirees aren’t spending enough. After all, if you planned on a 35-year retirement, half the money should be gone after 18 years, right? Not even close. Below is a chart of portfolio size based on the following assumptions.

- annual portfolio return of 2% above inflation
- annual withdrawals of 4% of the starting portfolio size, rising with inflation each year
- inflation of 2.12% (the average U.S. inflation from 2001 to 2018)

So, to be on track for a 35-year retirement, your remaining portfolio 18 years into retirement should be 83% of your starting portfolio size. This is a far cry from an intuitive guess that about half the money should be left.

Still, the earlier quote said the average retiree who started with at least half a million dollars had 88% of their money left 18 years into retirement. Further, thanks to a reader named Dave who found the original EBRI study online, we know that the 88% figure is inflation-adjusted.

Here is an inflation-adjusted version of the chart above:

So, 18 years into retirement in this scenario, you’d have 57% of your money left after adjusting for inflation. But the median U.S. retiree who started retirement with at least half a million dollars has 88% of the money left after adjusting for inflation. This is so high it would seem that retirees are severely underspending in retirement.

However, we have to look at the definition of retirement used in the study:

Definition of Retirement: A primary worker is identified for each household. For couples, the spouse with higher Social Security earnings is the assigned primary worker as he/she has higher average lifetime earnings. Self-reported retirement (month and year) for the primary worker in 2014 (latest survey) is used as the retirement (month and year) for the household.

So, even if the lower income spouse still works, the couple is retired. Also, because retirement is “self-reported,” we need to consider post-retirement working income. Most people who leave an office job, but make some money part-time doing a different type of work, consider themselves retired. Another significant source of money coming in is inheritances.

All these sources of post-retirement income cause retirees to draw less from their savings in early retirement to allow larger withdrawals later when they stop earning side income. This is true even for retirees who seek the largest steady inflation-adjusted spending level they can get throughout retirement.

Another factor that increases median savings levels is that some retirees have savings is in the millions and have no intention of spending all their money. Many retirees intend to leave a legacy.

If we account for the intention to leave legacies and the fact that many retirees continue to earn some income in the early phase of retirement, the gap between actual inflation-adjusted savings 18 years into retirement (median of 88%) and recommended level (57%) would shrink. How much it would shrink is hard to guess without further data on post-retirement incomes and intentions concerning legacies.

However, median figures hide the range of outcomes. You can drown in a river whose average depth is only 4 feet. These statistics include a very large number of U.S. retirees who are overspending and will run out of money. The EBRI study says that of retirees who started with at least half a million dollars, 18 years later 12% have less than one-fifth of their money left, and 32% have less than half. These retirees are at risk of running out of money before they run out of life.

The Victory Lap Retirement book and Vettese’s article promote the idea that retirees aren’t spending enough. In fact, there is a group who don’t spend enough, and another group who spend too much. We need to find a way to direct different messages to these two groups. Unfortunately, it’s the overspending group that is most likely to take comfort from books and articles claiming that retirees don’t spend enough.

Thursday, June 27, 2019

Switch: How to Change Things When Change is Hard

In my quest to better understand how to help people manage their money better, I followed a reader’s recommendation to try a psychology book by Chip Heath and Dan Heath called Switch: How to Change Things When Change is Hard. They explain how human nature makes change difficult, and they offer techniques for overcoming these difficulties.

The book begins with the observation that “Your brain isn’t of one mind.” Kahneman called the two parts of our minds System 1 and System 2, but the Heaths prefer a different analogy: “our emotional side is an Elephant and our rational side is the Rider.” Making changes requires getting the Elephant and Rider in agreement.

We can see the tension with a personal matter such as getting out of debt. The Rider might want spend less, but the Elephant would rather go out to eat than cook. You might think that we’d only have to deal with people’s rational sides to make changes at an organizational level, but you have to appeal to people’s Elephants if you want anyone to care enough to change their behaviour. Even executives need to care about a new idea at an emotional level to move on it.

A common theme in the book is that “What looks like resistance is often a lack of clarity.” When you’re trying to get people to change their behaviour, it’s vital to be crystal clear about what they should do. Any confusion makes it easy to just slip back into familiar old patterns.

Another common theme is the “Fundamental Attribution Error.” We have a tendency “to attribute people’s behavior to the way they are rather than to the situation they are in.” We tend to declare change impossible because of people’s natures when the right prodding can lead to big changes.

Only small parts of the book are directly relevant to financial matters. In one section, the authors are positive about the “Debt Snowball Method.” This is where you pay off small debts first rather than going after the debts with the highest interest rate. The reason is a matter of motivation. Being able to cross a debt off a list provides motivation to keep going. Paying off $200 of a $5000 credit card debt leaves us at risk of giving up.

There are nine steps the authors offer for making a “switch.” Here are four of them.
  • Rather than focus on problems, look for bright spots and encourage more of what is going right.
  • Script very specific changes rather than thinking about the big picture.
  • Find a way to make people feel strongly about the needed change.
  • Shrink the change to a first step that isn’t daunting.

The authors tell compelling stories, and their writing is page-turning. My first reaction is that the book’s methods must work well, but I can’t be sure because I haven’t tried to use them yet. I think the book is worth reading because it gives readers a different way to think about motivating change in themselves and others.

Friday, June 21, 2019

Short Takes: CPP Active Management, Portfolio Rebalancing, and more

Here are my posts for the past two weeks:

Should CPP Exist?

Credit Card Hopelessness

Living Debt-Free

Here are some short takes and some weekend reading:

Andrew Coyne explains the active vs. passive management issue for the Canada Pension Plan. He also digs into discrepancies in the claimed recent outperformance.

Canadian Couch Potato explains why it’s not necessary or desirable to rebalance your portfolio more than once per year. This advice is for those who rebalance based on time. I prefer threshold rebalancing, which is rebalancing whenever my portfolio is sufficiently far from its target percentage allocations. This is really only recommended if you can automate the process. It doesn’t make sense to do all the necessary calculations every day just in case you hit a threshold. I have my portfolio spreadsheet set up to send me an email when it’s time to rebalance, so I never have to look at it.

Tom Bradley at Steadyhand reminds us to focus on what really counts in investing. Hint: it’s not the short term.

The MoneySaver Podcast interviews Dan Bortolotti, the Canadian Couch Potato. They discuss passive index investing, ETFs, Robo-Advisors, and getting started investing.

Frederick Vettese shows in one example scenario that deferring CPP to age 70 is better than buying one of the new Advanced Life Deferred Annuities (ALDAs).

The Blunt Bean Counter explains the rules for the pension income tax credit.