Monday, February 25, 2019

Warren Buffett on Debt

In Warren Buffett’s latest letter to shareholders, he comments on companies using debt, but his ideas carry over to personal finance as well.

We use debt sparingly. Many managers, it should be noted, will disagree with this policy, arguing that significant debt juices the returns for equity owners. And these more venturesome CEOs will be right most of the time.

At rare and unpredictable intervals, however, credit vanishes and debt becomes financially fatal. A Russian-roulette equation – usually win, occasionally die – may make financial sense for someone who gets a piece of a company’s upside but does not share in its downside. But that strategy would be madness for Berkshire. Rational people don’t risk what they have and need for what they don’t have and don’t need.

When times are good, it’s easy to make the payments on your debt; potential problems seem distant and harmless. But times can turn bad suddenly. Nearly 20 years ago, many Nortel employees with fat salaries found themselves out of work, unable to find new jobs at even a 30% pay cut. Mortgages, car payments, and lines of credit that seemed well under control became impossible to service.

Does this mean we should be putting our lives on hold and dedicating all efforts to paying off debt? No. But once you have a house and car, your total debt should decrease over time. It doesn’t make sense to keep increasing your debt every time you want a kitchen renovation or a new car.

It can be sensible to invest at the same time as having a mortgage, but balance is needed. If you split your money between extra mortgage payments and RRSP savings, you’re building to a solid future at the same time as de-risking your life. If times turn bad, you’ll be happy to have emergency savings, no car payments, and a moderate-sized mortgage.

One of my family members recently had the happy decision of what to do with a lump sum. She could have invested it all based on common advice that her expected investment return is higher than her mortgage interest rate. But she chose a middle-of-the-road approach. She paid off 30% of her mortgage, established emergency savings, and invested the rest. She’ll be fine whether the economy runs well or poorly.

Friday, February 22, 2019

Your Complete Guide to a Successful and Secure Retirement

It’s not easy to figure out the best way to handle retirement accounts once you’re no longer collecting a regular paycheque. I’ve been working on the best way to handle my own retirement, so I was quite interested to read Larry Swedroe and Kevin Grogan’s book Your Complete Guide to a Successful and Secure Retirement. I’ve appreciated the academic rigour in Swedroe’s other books, and this one proved to be more of the same.

Unfortunately for Canadians, this book is for Americans. Most of the book is relevant to Canadians as well, but detailed discussion of retirement accounts and tax laws are for Americans only. Knowing the rough mappings (IRA, RRSP) and (Roth IRA, TFSA) helps in some cases.

This book leans toward giving advice to high net worth families. It isn’t entirely this way, but some parts are clearly intended to draw in rich clients for the authors’ advisory business. That said, it’s easy enough to ignore these parts and focus on solid advice relevant to people of more modest means.

The retirement topics covered are wide-ranging, beginning with a non-financial discussion of how to handle the big life transition of retirement. “One-third of all men over 65 become depressed within one year of retirement.” Such a sobering statistic should drive near-retirees to follow the authors’ advice on “helping you change the focus from retiring from something to retiring to something.”

One of the planning errors the authors describe is underestimating your needs. “The average person will need to replace 80 percent to 90 percent of their preretirement income.” I find it doubtful that the average person needs this much income to maintain a comparable lifestyle. This is far higher than most other recommendations I’ve seen that tend to range from 50-70%.

Another planning error is that “People often assume that their tax rate will be lower than actually proves to be the case.” I’ve found people tend to overestimate their retirement tax rates. Perhaps this is a Canada-U.S. difference, or maybe it’s a wealthy vs. not so wealthy difference.

The last retirement planning error the authors list is one I’ve seen many times in my own extended family: underestimating the build-up of inflation over time. It’s sad to see an older person trying to get by on a very modest income that used to be enough before the ravages of inflation.

An interesting chapter on “The Discovery Process” showed how talented advisors would draw relevant planning information out of their clients. I think this could be useful for my wife and me. You never know where you disagree with someone before you get them to say what they think.

“As Bill Bachrach says in his book Values Based Financial Planning: not having to worry ‘about your finances is critical to having a life that excites you, nurtures those you love, and fulfills your highest aspirations.’” Having watched how financial worries shrunk the lives of some of my older family members, I agree.

“The investor should consider tailoring the portfolio to gain specific exposure to the currency in which the expenses are incurred.” This is the reason I am somewhat overweight in Canadian and U.S. stocks.

One interesting aspect of retirement planning the authors advocate is making a “Plan B.” This is pre-planning what actions you’ll take to reduce expenses if your investment returns disappoint. It was this type of planning that kept me working longer. I worked extra time at high wage instead of waiting until I’ve been retired a decade and need to find a job likely paying one-quarter my previous wage.

The authors place a lot of emphasis on Monte Carlo simulations to look at a range of different retirement outcomes you could have. This is good to a point, but these simulators usually bake in the assumptions that returns follow lognormal distributions and that annual returns are independent. “Although stock returns do not fit exactly into a normal distribution ..., a normal distribution is a close approximation.” Actual data show that normal approximations aren’t good at the extremes, and that annual return independence breaks down over decades. It’s not clear that you’re really helping yourself by seeking 95% certainty that your plan will succeed. Long-term stock returns don’t tend to be as wild as simulators assume.

The authors are more conservative with withdrawal percentages than many others are: “we recommend that at age 65 you consider withdrawing just 3 percent a year from your portfolio, adjusting that each year by the inflation rate. You could increase that to 4 percent if you have options that you would be willing and able to exercise that would cut expenses should the portfolio be severely damaged by a bear market. If you are older than 65, the safe withdrawal rate increases as the portfolio does not have to support as many years of spending. At age 70, you can increase the safe withdrawal rate to 3.5 percent; at age 75 to 4.5 percent, and at age 80 to 6 percent.”

The failure of active management is well known, and the example portfolios worked out in the book are based on passive index investing with a heavy dose of factor-based investing. After starting with a portfolio A and optimizing it into a factor-based portfolio B using historical factor returns, the authors admit that “there is no way that, in 1982, we could have predicted the allocation for Portfolio B would have produced returns so similar to the allocation for Portfolio A. We might have guessed at a similar allocation, but we cannot predict the future with anything close to that kind of accuracy. This is an admission that the optimization method used future information. Actual portfolio construction must be based on guesses. I’m skeptical that heavy use of factors in Dimensional Fund Advisors (DFA) funds offers much advantage over simpler factor tilts available with Vanguard funds at lower cost.

There are four alternative funds where the math says returns are weakly correlated with other factors. In theory, these funds offer a way to get a safer, high-yielding portfolio. In practice, they scare me: alternative lending, re-insurance, variance risk premium, and alternative risk premium.

On the subject of tax-advantaged accounts (RRSPs in Canada), take the example of Mary who is in a 25% tax bracket: “The right way to think about it is that Mary never owned 100 percent of her $1,000 investment. She owned 75 percent of it; the government owned the other 25 percent. The government let Mary invest its share of the money until she withdrew her share.” Many people have a hard time understanding that their RRSPs are not entirely their own. Consistent with this way of understanding RRSP taxes, the authors advocate focusing on after-tax asset allocation.

I had never heard this term before, but I’m currently in the “black-out” phase of investing. This means I’m retired, but not collecting any government pensions, and have no required withdrawals from RRSPs or RRIFs. It’s in this phase that it’s important for many retirees to make some RRSP withdrawals to take advantage of low tax rates on low income.

On the subject of filing for Social Security benefits (CPP and OAS in Canada), “Being alive without sufficient assets to support an acceptable lifestyle is almost unthinkable for most people. Protecting for longevity always weighs the decision towards filing as late as possible.” I agree.

On the subject of reverse mortgages, “The lender can begin the foreclosure process if you fail to pay real estate taxes or homeowner’s insurance, or allow the house to deteriorate.” Of course, it’s very common for old people to have problems maintaining a house properly. Once a lender is owed nearly as much as the house is worth, the incentive for foreclose becomes strong.

There is a very interesting section later in the book on elder abuse. “According to The True Link Report on Elder Financial Abuse 2015, the amount stolen from elders each year in the U.S. is more than $36 billion.” The authors demonstrate that preventing abuse by family members and others is challenging.

An appendix tries to scare wealthy readers into seeking an advisory firm. To go it on your own, “You need advanced knowledge of probability theory and statistics, such as correlations and the various moments of distribution (such as skewness and kurtosis).” I have knowledge of these things, but I seriously doubt I’ll ever use them in planning my own retirement.

Other questions the authors ask about your ability to plan your own retirement are far more relevant: “Do I have a strong knowledge of financial history?” “Do I have the temperament and the emotional discipline needed to adhere to a plan in the face of the many crises I will almost certainly face?”

Although I’ve tended to focus on aspects I the book I disagreed with, most of the contents are excellent. Swedroe’s opinions on any subject are always well thought out and have significant academic backing. Deviate from his recommendations at your peril.

Friday, February 15, 2019

Short Takes: Low-Income Retirees, Not for Profit Credit Counselling Debt Collectors, and more

Here are my posts for the past two weeks:

Emotional Money Choices

CPP and OAS Breakeven Ages

Here are some short takes and some weekend reading:

Preet Banerjee and Liz Mulholland appear on TVO to discuss financial realities and strategies for low-income retirees. Preet also interviewed the team from Passiv who offer a service to keep your DIY portfolio at a discount brokerage balanced for only $5 per month.

Doug Hoyes and Ted Michalos say that not-for-profit credit counselling agencies are now just debt collectors funded by lenders. I’d be happy to read a rebuttal, but they make a very compelling case.

Canadian Couch Potato gives us a new Excel spreadsheet for rebalancing portfolios of ETFs. The new feature is that it handles ETFs that consist of more than one asset class, such as the new all-in-one ETFs. This spreadsheet will certainly help DIY investors, but I prefer to use Google spreadsheets because they can look up stock prices. I just have to record changes in the number of ETF units rather than enter dollar amounts every time I want to rebalance.

Andrew Hallam makes the point that the currency an ETF trades in doesn’t affect the performance of its underlying investments. I’d go even further. If you buy Canadian stocks, you’re making less of a bet on the Canadian dollar than it seems. Same applies to buying stocks in other countries.

Wednesday, February 13, 2019

Emotional Money Choices

My wife and I are savers, and I like to think we make mostly rational financial choices. But there are a few less than rational things we do with money that make us happier. I’m not saying it’s irrational to seek happiness, but the reasons for these choices are definitely on the emotional side.

Over-saving for retirement

We saved quite a bit more than we needed to retire to the life we want. We could have quit our jobs earlier, but nagging doubts about whether we had enough drove us to work longer. It’s quite reasonable to save some extra as a buffer, particularly if you have a high-paying job and you’d make much less trying to re-enter the workforce years later. However, we went well beyond a reasonable safety buffer.

But if we hadn’t over-saved, we would have felt uncomfortable, and we likely would have reduced spending on pleasures like travel. So, given our conservative financial natures, I think we made the right choice, even if it is somewhat emotional.

Large savings account

In an attempt to balance our individual net worths, we’ve saved my wife’s income and spent from mine. A side effect of this choice is that money needs to flow from accounts I control to accounts my wife controls. When she has to ask me for money, it makes her feel a little like she’s begging and has to justify her spending.

As far as we’re both concerned, all the money we have belongs to both of us, but this feeling of being less adult remains if she has to ask me for money. So, we opened an EQ savings account that pays good interest and filled it with enough cash that she won’t have to ask for money for more than a year. We consider this cash to be part of the fixed-income part of our portfolio.

We’d probably make a little more interest if we moved some of this cash to GICs, but the trade-off is worth it to us.

Real-time safe spending level

I created a spreadsheet that calculates our safe monthly spending level using near real-time market data. It’s good to know how much you can safely spend from your portfolio, but seeing the amount change in near real-time is clearly overkill.

However, when markets start dropping enough that it becomes a subject of conversation with friends and on social media, we tend to start having those nagging doubts about whether we’re spending too much. Being able to look at the spreadsheet and see a monthly spending figure that’s still clearly above what we spend gives us peace of mind. I think we’d likely curtail spending if we didn’t have the spreadsheet.


Whether we call these choices emotional or irrational, we’ve found they make our lives better. To those with different money personalities, these choices might seem strange, but I suspect we all make some financial choices to compensate for our emotional sides.

Monday, February 4, 2019

CPP and OAS Breakeven Ages

The default age to start collecting CPP and OAS is 65, but Canadians are allowed to defer these pensions until they’re 70 in return for permanently higher payments. The internet is filled with analyses of how old you have to live to come out ahead by delaying benefits. The mistake people make is in how they use these “breakeven” ages.

Suppose you work out that your CPP breakeven age is 85. If you don’t live that long, you’ll get more if you take CPP early, and if you live longer, you’ll get more by delaying CPP to age 70. There are many factors that feed into calculating a breakeven age, including how aggressively you invest, but let’s just use age 85 as an example.

Worrying about the breakeven age only makes sense if you have enough savings to live on until at least age 70 without one or both of CPP and OAS. If you don’t have enough savings, you have little choice but to start taking government pensions before your savings run out.

We’ll assume that you do have enough savings to live until at least age 70. It’s tempting to then guess whether you’re likely to live to your breakeven age (85 in this example) and let that guess drive your decision of when to start collecting CPP. But that’s not the right way to think about this important choice.

Suppose you work out that if you knew for certain you’d live to exactly 85, you can safely start spending $50,000 per year. At $50,000 per year plus cost-of-living adjustments each year, you expect to run out of savings at 85 whether you take CPP early or late (that’s what the breakeven age means).

Of course, there’s that nagging doubt: what if you live longer? Maybe you’re not likely to live longer, but do you really want to take a chance on having no savings left at age 85? So, you decide to spend a little less than $50,000 per year.

So, now you’re savings are likely to last past age 85. But how much longer depends on when you take CPP. Delaying to age 70 makes your savings last longer than if you take CPP at 60 or 65. Suppose that by lowering your spending, your savings will last until you’re 90 if you take CPP at 60, but will last until you’re 95 if you take CPP at 70. It seems obvious now that taking CPP at age 70 is the better choice.

Looked at another way, if you decide you don’t want your money to run out until you’re 95, then delaying CPP to age 70 gives you a higher safe spending level. But this isn’t just more spending when you’re old; you get to spend more right from the beginning of your retirement. It may seem paradoxical, but choosing to delay government pensions to age 70 can make it possible to safely spend more in your 60s.

However, if your plan is to spend so much less than your safe spending level that your money will last indefinitely whether you take CPP early or late, then you’ll be leaving money to your heirs no matter how long you live. Whether you should take CPP and OAS early or late comes down to whether you want to maximize your estate for an early death or maximize it for a late death.

So, the right way to think about a CPP or OAS breakeven age is to first ask yourself if you’re willing to spend down all of your assets by your breakeven age. If not, then you’re safe spending level is highest if you delay taking CPP or OAS until you’re 70.

Friday, February 1, 2019

Short Takes: Credit Score Obsession, Joint Account Benefits, and more

Here are my posts for the past two weeks:

Happy Go Money

My Investment Return for 2018

Preet Banerjee features prominently in this week’s short takes and weekend reading:

Scott Terrio explains how trying to optimize your credit score can make your finances and your life worse. Credit scores measure your profitability to banks. You are the product, not the customer.

Joint bank accounts curb wasteful spending according to a study by the University of Notre Dame’s Mendoza College of Business. My wife and I aren’t spenders, and we’ve always found joint bank accounts about as appealing as sharing a toothbrush. But this study could partially explain why some couples are adamant that joint bank accounts are the way to go.

Preet Banerjee explains research results on what motivates us to save for retirement. It turns out many people are more interested in helping their families than helping themselves.

Preet Banerjee interviews Dr. Avni Shah who explains research into how we feel pain of payment and how it affects our willingness to spend and how much we enjoy our purchases.

Fintech is leaving too many people behind. If there were more competition in financial services, customers would be better served.

Retire Happy explains some common investment mistakes made by retirees. This is an excellent guest post by Jason Heath.

Big Cajun Man looks at how to reduce his portfolio concentration as he nears retirement.

Robb Engen at Boomer and Echo discusses whether clients will abandon robo-advisors in the next stock downturn and what the robo-advisors are doing to try to prevent loss of clients.

The Blunt Bean Counter explains how to use his estate organizer to make things easier on your heirs. I’m helping with an estate right now, and I have little confidence that we’ll be able to find all assets. It’s hard to find things if you don’t know they exist.

Blair Crawford reports a simple but effective gift card scam.