Friday, August 28, 2015

Short Takes: Investment Pre-Mortem and more

Here are my posts for the past two weeks:

Reader Question: Market Participation Rate

What Happens to My CPP if I Die Early?

Here are some short takes and some weekend reading:

Jason Zweig suggests a “pre-mortem” to assess your investments before the next panic.

A Wealth of Common Sense gives us some excellent Charlie Munger quotes. In one he says that only the top 3% or 4% of the investment management industry will have good records because the market is mostly efficient.

Big Cajun Man explains how auto-loading your loyalty card can work out badly if someone manages to clone your card.

Canadian Couch Potato explains how planning to ease into the stock market can lead to paralysis if you start thinking about whether now is a good time.

Boomer and Echo takes a Louis C.K.-inspired poke at the excuses we use for not doing the right things with our finances.

My Own Advisor is among the few honest investors in individual stocks when he says “I actually don’t review financial statements or read the daily business news on these companies.” I’ve known many stock pickers who say they’ve done their “due diligence” or “DD,” but very few even bother to look at annual reports and financial statements.

Million Dollar Journey reviews BMO InvestorLine.

Wednesday, August 19, 2015

What Happens to My CPP If I Die Early?

Many complain that they pay into the Canada Pension Plan (CPP) most of their lives but get little or nothing if they die early. They think their estates should get a lump sum as compensation. This thinking is misguided.

Here’s a recent example of this complaint about CPP and the new ORPP by Gail Vaz-Oxlade:
If you imagine an account in the CPP system with your name on it holding all the money you paid in, then it seems logical that your estate should get what’s left of that money when you die.

But what happens if you live unusually long? Your account will be empty. But CPP keeps paying. CPP is taking part of your longevity risk. CPP makes money if you die early and loses money if you live long. This is a fair trade, and you get the security of knowing that the CPP payments will continue for your whole life ticking up by inflation each year.

One of the biggest challenges of handling a portfolio in retirement is longevity risk. If you knew exactly how long you will live, you could plan to spend every penny. But you don’t know. To be safe you have to plan to spend much less to make the money last. With CPP, they take care of all this worry for you.

What would happen if the value of everyone’s CPP benefits were guaranteed to say age 90? By this, I mean that if you live past 90, you keep getting payments, and if you die earlier, your estate gets a lump sum of the remaining payments to age 90. The simple answer is that either CPP benefits would drop a lot or CPP premiums would rise a lot.

So, when someone complains that CPP doesn’t pay out to your estate when you die early, what they are really calling for is a big drop in CPP payments or a big increase in CPP premiums. Don’t fall for this. Whatever problems we may have with our CPP system, having payments stop when you die is not one of those problems.

Monday, August 17, 2015

Reader Question: Market Participation Rate

A reader, Colin, asked a question about market-linked guaranteed investment products. These investment products go by different names: market-linked GICs, market-tracking term deposits, and other similar names. The basic idea is that your principal and a small amount of interest is guaranteed, and you may get some extra interest if certain stocks perform well.

I prefer not to name the particular product Colin is considering, so I’ve edited his question somewhat:
I am looking at a term deposit product. In the description they state ‘Market Participation: 100% or higher depending on the issue.’ Can you describe what they might mean by Market Participation in this context and, in addition, how it could be greater than 100%?
The product Colin is considering is linked to the S&P/TSX 60, which is an index of 60 of the biggest companies in Canada. It guarantees a minimum of 4% interest after 5 years (about 0.79% per year), and may pay more based on a calculation related to the S&P/TSX 60 stock index.

The advertising claims a “Market Participation” rate of “100% or higher.” This sure sounds like you get all the stock returns if stocks go up (or maybe even more than all), but none of the losses if stocks go down. But Colin is right to be suspicious. There are three unpleasant surprises hidden in the detailed calculations.

The first bit of bad news is that the interest upside is capped at 27% over 5 years (4.9% per year). The advertising actually says that the range of annual returns is from 0.8% to 5.4%, but in the real world we have compound interest.

The second piece of bad news is that the S&P/TSX index doesn’t include dividends paid by the companies that make up the index. Dividends are an important part of stock returns that stock owners receive. But investors in this product will not benefit from dividends.

And finally, the returns are roughly chopped in half by an averaging calculation. Instead of just calculating stock returns by looking at prices at the beginning and end of the 5-year period, they take the prices each month for 60 months and average them all. The “return” is then based on the starting stock prices and this average figure. Typically, this will cut returns by slightly more than half. Then this “Average Growth” figure is multiplied by the market “Participation Rate.”

So, the advertised 100% market participation actually consists of removing dividends, chopping the remaining return roughly in half, and then capping it if it still happens to be too high. This is definitely a case where reality doesn’t live up to the marketing.

Saturday, August 15, 2015

Short Takes: Home-Buyer’s Plan Boost, Shifting Financial Goals, and more

I haven’t written much during the past two weeks because I’ve been volunteering to help run the Canadian Little League Baseball Championships. It’s amazing how well some 12-year olds play baseball. But I did manage one post:

Your Retirement Spending Plan is Critical

Here are some short takes and some weekend reading:

Canadian Mortgage Trends reports that the Conservative government is proposing to increase the amount you can withdraw from your RRSP for the Home-Buyer’s Plan from $25,000 to $35,000.

Frugal Trader at Million Dollar Journey gives his financial update a year after reaching his goal of being a millionaire.

My Own Advisor says we don’t need the Home-Buyer’s Plan (HBP) for using RRSP money for a house down payment any more. I think the HBP can be part of a sensible plan to reduce CMHC fees and reduce overall portfolio risk, but only if the mortgage payments plus HBP repayments are sensible relative to total income. Using the HBP to afford a more expensive home is usually a bad idea.

Big Cajun Man examines the decline of defined-benefit pension plans in Canada.

Boomer and Echo offer some advice on saving money through negotiation.

Friday, August 7, 2015

Your Retirement Spending Plan is Critical

From a financial point of view, an adult life has two phases: pre- and post-retirement, or saving and spending. During the saving phase it’s possible to make some course corrections. However, mistakes in the spending phase can do permanent damage to your finances.

If you’ve got a decade or more of work left, it’s possible to make up for low savings by saving more and reducing your investing costs. But if you spend too much in your first decade of retirement, you’re likely to end up with a much lower standard of living permanently.

While working, if you don’t like the plan your financial advisor has for you, you can find a new advisor and make up for past mistakes. But if your advisor puts you on a bad retirement spending plan, by the time you figure out there is a problem, there’s little you can do other than cut spending.

Imagine your 70-year old self finding the advisor you starting working with when you were 35. You say “the retirement spending plan you put me on is no good.” And he replies “get off my lawn,” because he’s retired too. For the most part, he doesn’t have to answer for the outcomes of the retirement spending plans he prepares for his clients.

Now most advisors are decent people who genuinely want to do well for their clients, but all the incentives push in the wrong direction. Retirement spending is a difficult topic and it’s hard to know what the right plan is. Often, advisors will be long gone before it becomes apparent whether their plans are any good. The pressure to earn a living drives advisors to find more clients instead of working hard on spending plans. And finally, clients themselves prefer advisors who tell them they can safely spend more money. This is not a formula for good outcomes.