Friday, May 22, 2020

Short Takes: Pizza Arbitrage, Open Offices, and more

Here are my posts for the past two weeks:

How Much of Your CPP Contributions are Really a Tax?

Playing with FIRE

Here are some short takes and some weekend reading:

Ranjan Roy explains a pizza arbitrage scheme when a food delivery startup scrapes a restaurant’s website.

Big Caun Man is predicting the death of the open-concept office space.  Organizations love the cost savings of open office spaces.  These savings are very easy to measure.  Much harder to measure is the loss of worker productivity.  Concern about spreading viruses will fade, but workers who need to think deeply, like software developers, can’t get their work done efficiently in open offices.  The constant distractions make it impossible to solve a problem that requires 15 minutes of uninterrupted thought.  One of the touted advantages of open offices, that workers will collaborate better, turns out to be false.  Research at Harvard found that face-to-face interactions dropped 70% after switching to an open office.  This is consistent with my own experience.  It’s hard to talk to anyone when even a whisper disturbs other workers.

Moneysense got together a panel to pick Canadian ETFs again this year.  The list has now exploded to 42 ETFs, reflecting disagreement among panelists.  Amusingly, one panelist took a “hard pass” on another’s pick.  By my count, the article blended opinions from two index investors, three more who use factor tilts, and four active investors.  My own investing approach is between the two index investors and those who believe strongly in factor tilts.

The Rational Reminder Podcast interviews Andrew Hallam, author of Millionaire Teacher and Millionaire Expat.  Andrew is always interesting with his takes on the disconnect between income and wealth, the link between debt and misery, the ways advisors try to talk you out of index funds, and geographical arbitrage.

Robb Engen at Boomer and Echo lists five important investing rules. Don’t miss his excellent response in the comment section to the question about trying to save on MER costs by buying individual stocks.

Canadian Mortgage Trends reports CMHC’s gloomy outlook for real estate.  They see an 18% drop in home prices.  Almost everyone who makes their living from real estate transactions disagrees.  Do they have better insight or are they using motivated reasoning?  Hard to tell.

Nick Maggiulli explains why those who make pointless predictions aren’t punished for being wrong.

The Blunt Bean Counter has a guest post imploring business owners to look at their businesses from an investment perspective rather than just propping it up and risking their personal finances.

Thursday, May 14, 2020

Playing with FIRE

By now, most people have heard of the FIRE (Financial Independence Retire Early) movement. Those who embrace FIRE can be evangelical about it, and critics can be very harsh. To give people a better idea of what FIRE is, Scott Rieckens wrote the book Playing with FIRE: Financial Independence Retire Early, the story of his family’s journey to better align their spending with what they believe is important in life.

It’s easy to criticize FIRE if you see it as a bunch of young white males who have (or had) high-paying jobs and prefer to laze around all day. But FIRE looks very different to different people. Some seek complete financial independence and true retirement, while others just want enough cushion to quit the job they hate and do something they love that might pay less.

The common element in FIRE is striving for financial independence to make it possible to spend your time in a way that makes you happy. However, this requires deep examination of the way you spend your money. Most people don’t want to do this. It’s much more comforting to read an article about why FIRE is bad so we don’t have to examine our lazy and impulsive spending.

Instead of spending much time defending FIRE, Rieckens tries to inspire us by describing his journey with his wife, and giving snapshots of other people’s FIRE journeys. I have little doubt that just about anyone could benefit from better aligning their spending with their goals, even if their ultimate path doesn’t look like mainstream FIRE.

As the author explains, “FIRE isn’t about drinking cocktails on a beach for the rest of your life. It’s about spending your precious years on earth doing something other than sitting behind a desk, counting the minutes to 5 PM, wishing you were somewhere else.”

“The general path to FIRE is to save 50 to 70 percent of your income, invest those savings in low-fee stock index funds, and retire in roughly ten years.” This narrower vision of FIRE gets many people angry. It sounds impossible for any but a privileged few who have massive incomes.

The truth is that almost anyone could be wiser about their spending. Maybe 70% is a stretch, but 20% is certainly possible for most. But it’s far easier to declare such savings impossible than it is to make the changes necessary to spend on things that truly make you happy. It’s ironic that the FIRE approach to spending is most important for those with lower incomes, while FIRE critics use low income earners as the reason why FIRE is flawed.

“FIRE is significantly easier to accomplish if you’re making a higher-that-average salary.” This is certainly true if you try to stick to a fixed schedule, like reaching financial independence at age 40. “But FIRE principles can be applied at any income level. Whether you reach FIRE in five, ten, or thirty years, prioritizing happiness over material objects, and buying back your time are available to everyone.”

Rieckens points to the 4% rule as a guide to when you’ve achieved financial independence. Despite the criticism the 4% rule gets, it’s not too bad as a rule of thumb. The original 4% rule assumed you don’t pay any investment fees and you’d never cut spending if portfolio returns disappoint. If you have low portfolio costs and you’re somehat flexible on your spending, then spending 4% of a portfolio starting at age 50 isn’t too risky. A partial bailout will come around age 65 or so in the form of CPP and OAS for Canadians and Social Security for Americans.

However, very young retirees face other risks. One obvious risk is that the money has to last longer. Another is that it’s hard to have a good picture of your spending for the rest of your life if you’re well under 50. Riding a bicycle to a hardware store to cart things back is great for young people, but eventually becomes difficult at some age. Those who seek extremely early retirement might be better served with a 3% rule.

Rieckens recommends investing in Vanguard index mutual funds, an excellent choice for Americans. Unfortunately, these U.S. mutual funds aren't available to Canadians. But Vanguard (U.S.) and Vanguard Canada have exchange-traded funds (ETFs) Canadians can buy.  Vanguard Canada has a few mutual funds available to Canadians, but with MERs from 0.5% to 0.6%, they're more expensive than Vanguard U.S. mutual funds.

Paula Pant, who is well known in the FIRE community, had some interesting advice. “‘What helps me when I get anxious or scared,’ Paula said, ‘is knowing that I’m not in control of anything. When I truly accept that I have no control, I feel better.’” It’s better to anticipate a range of possible outcomes than to try to guess what will happen or control events to get a particular outcome.

To achieve FIRE, “You don’t have to do anything you don’t want to do! You merely have to align what you want with how you spend.” This alignment takes more work than it might appear. Many people would rather mock FIRE than help themselves.

Monday, May 11, 2020

How Much of Your CPP Contributions are Really a Tax?

A simple view of the Canada Pension Plan CPP) is that it takes contributions from your paycheque, invests your money until you retire, and then pays the money back to you as a pension. However, reality is more complicated. CPP rules result in some people getting more out of CPP than they put in, and some get less. This splits your contributions into part savings plan and part tax.

Your first thought might be that the amount we get from CPP depends on how long we live. However, this is actually a good thing. I’m happy to have an income stream that reduces my longevity risk. I benefit today from the fact that once I start collecting CPP, it will last as long as I live. So, when I say we don’t all get out what we put in, I’m not talking about how long we live.

To get an idea of what I do mean, it helps to look at the short summary in CPP’s 2018 annual report. CPP paid benefits of $44.5 billion, but only $34.6 billion of this went to CPP retirement pensioners. The remaining $9.9 billion went to surviving spouses, people with disabilities, death benefits, and other amounts.

Imagine a Canadian with no spouse who worked steadily from age 18 to 65. This Canadian only has access to his or her share of the $34.6 billion for regular benefits plus the $368 million in death benefits. This is a total of about $35 billion out of the $44.5 billion paid from CPP. This person gets no share of the remaining $9.5 billion that is a collection of extra social programs baked into CPP.

To be clear, I’m not opposed to having these extra programs in CPP. We need to take care of those in need. I just think of paying for these extras as a form of tax rather than a form of forced saving for retirement, because one person’s CPP contributions get redistributed to other people.

These extra programs aren’t the end of the redistribution. When you calculate how much you’ll get in CPP benefits, you get certain “dropouts,” which means you don’t have to count some contribution months where your contribution was low. After using your dropouts, you get to use the average of your good contribution months to determine your CPP benefits.

Everyone gets to drop out 17% of their low contribution months. Primary caregivers can drop out any low contribution months while one of their children is under 7. People collecting CPP disability pensions can drop out months while they collect this pension.

It’s time for some estimates. Let’s say that about 40% of Canadians get 10 years of dropouts for children under 7. This is an extra 4 years of dropouts, on average. Out of the 47 working years from 18 to 65, this represents 4/47=8.5% more dropouts. We’re up to 17%+8.5%=25.5% dropouts.

The 2018 CPP report says that there are 338,000 beneficiaries with disabilities, which is about 1.7% of Canada’s workforce. These people get to drop out contribution months while they collect their disability benefits. This brings the total dropouts to about 27%.

Let’s guess that the average dropped out month has 60% of the CPP contributions of the remaining 73% of months used to calculate CPP benefits. So, if the dropouts didn’t exist, regular CPP benefits would drop to 73%+(60%)27%=89% of their current level.

So without dropouts, there would be a 11% drop in the $34.6 billion paid to CPP retirement pensioners, a drop of $3.8 billion. Add in the $9.5 billion in extra social programs baked into CPP, and we get a total of $13.3 billion in CPP benefits not available to our hypothetical Canadian with no spouse who worked steadily from age 18 to 65. This is about 30% of the total paid out by CPP ($44.5 billion) in the 2018 fiscal year.

So, as a rough estimate, 70% of your CPP contributions are your savings, and the remaining 30% is more tax-like. But that doesn’t mean you won’t get a slice of the 30%. All this money gets paid out. If your CPP contributions fluctuated at all over the years, or you’re married, or you have kids, or you become disabled, you’ll get some of this 30% in CPP benefits. Some people will get more than the 30% back and some less. That’s the nature of redistributing wealth through taxes.

I’ve seen analyses showing CPP giving poor investment returns for a Canadian who contributes the maximum to CPP each year. This is because these analyses assume that this Canadian gets none of the 30% of contributions that get redistributed. Another factor is that because CPP benefits are indexed to inflation, the claimed investment returns on our CPP contributions are a “real” return. This means we get this return plus the amount of inflation.

I’m quite happy with the extra programs built into CPP. I benefit a little from the 17% dropout everyone gets. My wife and I will likely benefit somewhat from the CPP survivor benefit, and our heirs will get the death benefits. Overall, we’re unlikely to get all of our 30% back; some of it will go to people with greater need.

One concern I have with CPP is that its costs are too high. Too much of CPP assets go to administration and investment management. But these costs are lower than the investment fees Canadians pay on their own savings. Another concern I have with CPP is that too many people start benefits at age 60 when they’d be better off waiting until 65 or 70 to get larger payments.

CPP is a good program. Its forced savings and redistributions to the needy do a good job of reducing the number of seniors who end up being a burden on taxpayers. Few Canadians can invest with returns as high as CPP gives. I have some concerns about this program, but I’m not concerned that about 30% of CPP contributions are effectively a form of tax.

Friday, May 8, 2020

Short Takes: Risk Tolerance, Proposed Tax Changes, and more

Here are my posts for the past two weeks:

Another Emotional Reason to Take CPP Early

Portfolio Rebalancing Based on Expected Profit and Trading Costs (Redux)

Calculating My Retirement Glidepath

Here are some short takes and some weekend reading:

Boomer and Echo has a sensible discussion about using the recent market crash to learn about your risk tolerance. I made the following comment: “I’m all for people using real experience with losing money in markets to learn about their true risk tolerance. The tricky part is when to change allocation percentages. I’d like a rule something like, you can only reduce stock exposure when stocks are within 5% of making a new high, and you can only increase stock exposure when stocks are at least 20% below the most recent high. The waves of people wanting to do the opposite are predictable.”

Jamie Golombek discusses some tax proposals to help investors in these difficult times. To the best of my knowledge none of these proposals have come from the government, so don’t hold your breath. The first one is to allow people to use their RRSPs like the home-buyer’s plan. You’d be able to withdraw funds up to some limit tax-free, but you’d have to put the money back in the future. Another proposal is to eliminate the superficial capital loss rules for 2020. So, you’d be able to sell stock to crystallize a capital loss and rebuy the stock right away. Normally, the capital loss is disallowed in this case. Another proposal is to allow people to offset regular income with capital losses incurred in 2020. I’m guessing wealthy people could make good use of the proposed capital gains changes.

Justin Bender describes his “Ludicrous” ETF portfolio, the third in a series of four portfolios. I can understand why a money manager would use this portfolio for clients who don’t understand how to measure the risk of their portfolios; they need to be tricked into taking more after-tax portfolio risk. However, I don’t see how it makes sense for a DIY investor who understands this issue to use the Ludicrous portfolio. For someone correctly focusing on after-tax portfolio risk, the Ludicrous asset location decisions send stocks and bonds to the wrong accounts. For more background on these issues, see my earlier discussion.

Doug Hoyes has an interesting take on the possibility of a debt jubilee.

The Blunt Bean Counter uses an example case to show how Alter Ego Trusts and Joint Partner Trusts work and illustrate their advantages.

Big Cajun Man is using his extra time at home figuring out the different ways his expenses have dropped during the pandemic lockdown.

Monday, May 4, 2020

Calculating My Retirement Glidepath

While some people are busier than ever during the pandemic, like health care workers, many of us have extra time on our hands. I’ve used this time to clean up my plan for retirement investing and spending. Here I describe this plan.

Top Level

I’m an index investor with a portfolio invested in stock ETFs and bonds. By “bonds” I mean any type of safe fixed-income investment, including cash savings, GICs, and short-term government bonds; I have no interest in corporate bonds or long-term government bonds. At a broad level, I maintain chosen percentages of stocks and bonds. Currently, my portfolio is about 80% stocks and 20% bonds. However, I plan to increase the bond percentage over time.

When we adjust asset allocation percentages as we age, it’s called a retirement glidepath. The idea of a glidepath is far from new, but most recommended glidepath percentages seem to be just made up numbers, such as bond percentage equal to your age. I prefer to run my portfolio with a small number of fixed rules that make sense to me. Here is one of those rules:

Rule 1: Only invest in stocks with money I won’t need for 5 or more years.

This isn’t new on its own. However, I’ve used it to guide my asset allocation glidepath before and after retirement. It’s not obvious how this rule determines my asset allocation glidepath, but it does.

Before retirement, there was enough demand for my skills that I was confident in my ability to cover my family’s needs with my income. So, beyond some emergency funds to cover a short interruption in my income, I invested all savings in stocks.

Now that I’m retired, I maintain 5 years of my family’s spending in bonds, and the rest in stocks. By “family’s spending,” I mean the safe amount we can spend based on my portfolio’s size rather than some dollar amount we want to spend.

This safe spending level is something I can calculate based on a number of factors:
  • Portfolio size
  • Holding 5 years of spending in bonds
  • Making the money last until age 100 (I likely won’t live this long, but what matters is how long I might live.)
  • Conservative estimates of stock and bond returns
  • Expected future pensions such as CPP and OAS
  • Expected future large cash flows

As I get older and closer to 100 years old, my safe spending level rises as a fraction of my portfolio’s size. The fraction of my portfolio that is invested in bonds rises as I age as well, which determines my glidepath.

My goal is to plan for constant annual spending in inflation-adjusted dollars. However, if portfolio returns don’t match expectations, I adjust spending. So, my plan gives my spending levels as a percentage of my current portfolio size. Also, I’ll spend more from my portfolio leading up to the start of CPP and OAS, and then I’ll spend less from my portfolio.

I have a full paper, Withdrawal Rates for a Retirement Glidepath, that covers the math of calculating spending levels and asset allocation percentages based on Rule 1 above and the list of other factors.

This paper differs a little from a previous description of my spending plans. The older description was based on the idea that I’d recalculate my spending level and bond allocation once per year based on a set of percentages pre-calculated for each year of my retirement, much like the mandatory RRIF withdrawal percentages. However, I now have a spreadsheet that calculates my spending level and bond allocation in real-time. I now treat my bond allocation as an amount that needs rebalancing whenever it gets far enough away from its target percentage. This can happen in response to fluctuating investments or the slow draw-down of cash as I spend my money in retirement.

The main difference this change makes is that I now maintain roughly 5 years of spending in bonds at all times. My retirement spending used to draw down the 5 years in bonds to 4 years in bonds over the course of the year before I replenished the bonds at the end of the year. With the old plan, I averaged about 4.5 years of spending in bonds, but now I maintain 5 years’ worth. Luckily for me, I made this part of the change before the pandemic, so I benefited from having less money in stocks before the crash.

Unlike many investors, I don’t plan to switch to spending exclusively from bonds when stocks crash; I just rebalance mechanically. However, as I’ve explained before, the rebalancing process naturally shifts spending to bonds when stocks are down.

Although rebalancing a portfolio can produce profits, its purpose is to control risk. The reason we don’t rebalance very frequently is that trading costs can add up. This brings us to another fixed rule:

Rule 2: Limit rebalancing trading costs to 5% of rebalancing gains.

From this rule we can calculate rebalancing thresholds that limit costs but allow us to capture rebalancing gains as asset prices fluctuate. I recently updated my description of my threshold rebalancing strategy. The biggest change is an improvement to calculating rebalancing thresholds when there are two asset classes with significantly different allocation percentages. This applies to my stock/bond allocation.

I have a script that accesses my portfolio spreadsheet to send me an email when I need to rebalance my portfolio. Until recently, such alerts were rare. But during the pandemic, I’ve received several alerts to rebalance between stocks and bonds. It’s not easy to buy back into stocks after they’ve crashed, but doing so has produced profits for me. As stocks rose again, it was easier rebalancing back to bonds, but I still found myself not wanting to sell stocks when they seemed to be rising. However, I’m confident that my mechanical strategy is better than following my gut.

Stock Sub-Portfolio

I view my stocks as a sub-portfolio that consists of Canadian and U.S. stocks. I’ve chosen to hold 30% Canadian stocks (in Canadian-dollar ETFs) and 70% U.S. and international stocks (in U.S.-dollar ETFs). I keep them in balance using the same rebalancing strategy described above for my stocks and bonds.

One of the things I’ve done with the extra time on my hands during the pandemic is to improve the part of my spreadsheet that shows me the exact trades to make in each account when rebalancing. Without the spreadsheet, this can get tricky when I adjust both the stock/bond balance and the Canadian/non-Canadian stock balance at the same time.

U.S. and International Stock Sub-Portfolio

Within my stock sub-portfolio, I think of my U.S. and international stock ETFs as a sub-sub-portfolio. The 70% of my non-Canadian stocks are split 25% in VTI, 20% in VBR, and 25% in VXUS. Before I retired and bought some bonds, I wrote about my reasoning for this allocation. However, any reasonable allocation can work if you stick to it rather than deviate out of fear or greed. Again, the recent work I’ve done on my spreadsheet to calculate rebalancing trade amounts helps here.


I remain satisfied with the investment plan I’ve chosen. Recent changes I’ve made to automate my portfolio even more than it was before should help stop me from making costly mistakes. I tend not to even look at my portfolio value much. My spreadsheet calculates our safe after-tax monthly spending amount in real time. This amount tells me how my investments are performing, and helps us plan how much we can spend on our retirement activities and travel.

Wednesday, April 29, 2020

Portfolio Rebalancing Based on Expected Profit and Trading Costs (Redux)

The idea of rebalancing a portfolio to maintain target asset allocation percentages is simple in theory, but tricky in practice. It is not obvious how far asset class percentages should be away from their targets before it makes sense to rebalance. I have recently improved a scheme that I have now fully automated in my portfolio spreadsheet. Instead of obsessing over my portfolio’s returns, a script emails me when I need to rebalance.

Investors should use any new savings or withdrawals they make as opportunities to rebalance by buying low asset classes or selling high ones. However, as a portfolio grows, rebalancing with new savings and withdrawals is unlikely to be enough to maintain balance when asset classes have big swings.

Common advice is to rebalance a portfolio on a fixed schedule, such as yearly. This has the advantage of allowing investors to avoid obsessing over their portfolios all the time, but has the disadvantage of missing potentially profitable opportunities to rebalance. Computing thresholds automatically in a spreadsheet permits me to ignore my portfolio unless my script emails me. This gives me the advantages of threshold rebalancing without the disadvantage of constant monitoring.

When choosing rebalancing thresholds, most experts advise investors to either use percentage thresholds or dollar amount thresholds. For example, you might rebalance whenever you’re off target by more than 5%, or alternatively by more than $2000. However, these approaches don’t work for all portfolio sizes. Percentage thresholds lead to pointless rebalancing in small portfolios, and dollar amount thresholds lead to hourly trading in very large portfolios. We need something between these two approaches.

Computing Thresholds

When asset class A rises relative to asset class B, and then A drops back down again to the original level relative to B, rebalancing produces a profit over just holding. I compute rebalancing thresholds based on the idea that the expected profit from rebalancing should be 20 times the ETF trading costs.

All the mathematical details of how I compute rebalancing thresholds are in the updated paper Portfolio Rebalancing Strategy. I’ll just give the results here.

I have a sub-portfolio with 3 U.S. ETFs. To keep them in balance relative to each other, the spreadsheet starts by computing the following quantities for each ETF:

m – Current portfolio total value times the target allocation percentage. This is the target dollar amount for this ETF.
s – Bid-ask spread divided by the ETF share price.

Other parameters are

c – Trading commission.
f – Desired ratio of trading costs to expected profits. I use 0.05 so that the expected profits from rebalancing are 20 times the trading costs.

The dollar amount threshold for rebalancing then works out to the following formula which may seem a little intimidating, but it only has to go into a spreadsheet once.

t = (m/(2f)) * (s + sqrt(s*s + 8*f*c/m)).

So, it makes sense to rebalance an asset class if its dollar level is below m-t or above m+t. As long as there are at least two asset classes far enough out of balance (with at least one too high and at least one too low), it makes sense to rebalance.

This method works fairly well when the target allocation percentages are close enough to equal. The new part of this work that I completed recently is a more accurate method when there are only two asset classes, but their allocation percentages aren’t necessarily close to equal.

This applies to my case in two ways. I view my stocks as a sub-portfolio with one part denominated in Canadian dollars (30%) and one part denominated in U.S. dollars (70%). The U.S. part contains the 3 U.S. ETFs I mentioned earlier. One level above this, I view my overall portfolio as one part stocks (currently about 80%) and one part bonds (currently about 20%). This bond percentage will rise as I get further into retirement.

The new method for two asset classes looks remarkably similar to the old method. Consider the case of stock/bond rebalancing. Let m be the target dollar amount for stocks and b be the target dollar amount for bonds. Let m’ be the harmonic mean of m and b:

m’ = 2/(1/m + 1/b).

Then the formula for the threshold dollar amount is the same as the earlier formula, except that we replace m with m’:

t = (m’/(2f)) * (s + sqrt(s*s + 8*f*c/m’)).

If the stocks and bonds get further away from their target amounts by more than t, then it’s time to rebalance. The full paper gives further details on how the commission amount c and the bid-ask spread s should be adjusted in cases where extra trading is required, such as when rebalancing involves currency exchange with Norbert’s Gambit.

The difference between this two-asset class method and the earlier method is that the new method gives a lower threshold. The old method would give a very low threshold for the asset class with the smaller target percentage, but a high threshold for the other asset class. But we only rebalance when both thresholds are met. So, the higher threshold dominates. The new more accurate method gives a lower overall threshold, so that we can better take advantage of rebalancing opportunities.


It took me a while to work all this out, but now I don’t have to pay much attention to my portfolio. When I have some money to add, I buy the asset class that my spreadsheet says is furthest below its allocation, and occasionally I get an email telling me to rebalance.

Many readers have asked for a generic version of my portfolio spreadsheet, and I’ve tried to produce one a number of times. But, it’s difficult to make it general enough to be useful. I’m happy to answer questions for those looking to create their own spreadsheets, but I’m unlikely to produce a generic version to work from.

Monday, April 27, 2020

Another Emotional Reason to Take CPP Early

For some reason, people seem wired to want to take their CPP and OAS benefits early, myself included. They grasp for reasons to justify this emotional need even though a rational evaluation of the facts often points to delaying the start of these pensions to get larger payments. I recently read about another emotional reason to justify taking CPP and OAS early.

We can choose to start taking CPP anywhere from age 60 to 70, but the longer we wait, the higher the payments. Less well known is that we can start taking OAS anywhere from age 65 to 70 with higher payments for waiting loger. It’s hard for us to fight the strong desire to take the money as soon as possible, and we tend to latch onto good-sounding reasons to take these pensions early.

But the truth is that most of us have to plan to make our money last in case we live long lives. Taking CPP and OAS early would give us a head start, but the much-higher payments we’d get starting at age 70 allow us to catch up quickly. If we live long lives, taking larger payments starting at age 70 is often the winning strategy.

Here I examine reasons to take these pensions early, ending with a longer discussion of the reason newest to me. Many of these reasons are inspired by other writing, such as a Boomer and Echo article on this subject. However, you’ll find my discussion different from what you’ll see elsewhere.

Let’s start with the best reason.

1. You’re retired and out of savings.

This is a good reason to take pensions early if you’re really running out of savings other than a modest emergency fund. However, just wanting to preserve existing savings isn’t good enough on its own. It makes sense to do a more thorough analysis to see what you’re giving up in exchange for trying to preserve your savings.

2. You have reduced life expectancy.

If you’re sufficiently certain that your health is poor enough that you’d be willing to spend down every penny of your savings before age 80, then this is a good reason to take pensions early. This is very different from “I’m worried I might die young.” If as you approach age 80 you would try to stretch out your savings in case you live longer, this has repercussions all the way back to how much you can safely spend today. Almost all of us have to watch how we spend now in case we live a long life. In this case you need to do a thorough analysis to see what you’re giving up in exchange for taking pensions early.

3. You have long periods before age 60 with no CPP contributions.

If you don’t work after age 60, but delay taking CPP until 65, the 5 years without making CPP contributions can count against you. Everybody gets to drop out the lowest 17% of their contribution months in the CPP calculation. So, if you never missed a year of CPP contributions from age 18 to 60, you can just drop out the years from 60 to 65, and you won’t get penalized. But if you had many months of low contributions over the years, then having additional low months from 60 to 65 will reduce your CPP benefits.

I am in this situation. However, from 60 to 65 you go from receiving 64% to 100% of your CPP plus any real increase in the average industrial wage. Taking into account all factors, I expect my CPP to rise by about 47% by delaying it from 60 to 65. This is less than it could have been without the penalty of not working from 60 to 65, but it is still a significant increase.

Delaying CPP further from 65 to 70 is a simpler case. There is a special drop-out provision that allows you to not count the contribution months between 65 and 70. CPP benefits increase from 100% of your pension at 65 to 142% at 70.

CPP benefits rise significantly when you delay taking them. Even if you can’t use your 17% drop-out for all the contribution months from age 60 to 65, you may still benefit from delaying CPP.

4. You want to take the CPP and OAS and invest.

People don’t generally get this idea on their own. It often comes from a financial advisor. You’re unlikely to invest to make more money than you’d get by delaying CPP and OAS, particularly if you pay fees to a financial advisor.

5. The government might run out of money to pay CPP and OAS.

The government might introduce wealth taxes on RRSPs too. Despite what you might have heard from financial salespeople, CPP is on a strong financial footing. Many things may change in the future. It doesn’t make sense to overweight the possibility of cuts to CPP or OAS.

6. You want the money now to spend while you’re young enough to enjoy it.

My wife and I are retired in our 50s. When I analyze how much we can safely spend each month, the number is higher when we plan to take both CPP and OAS at 70. That’s right; we can spend more now because we plan to delay these pensions. It works out this way because CPP and OAS help protect against the possibility of a long life. Larger CPP and OAS benefits protect us even more, so we can spend more now safely. Your situation will be different, but you need to look at the numbers to see if taking CPP early really allows you to spend more now, or if you’ll just end up reducing your spending to preserve the savings you’ll need as you age.

7. A bird in the hand is worth two in the bush.

This isn’t much of a reason, but it sounds clever. However, by delaying the start of CPP from age 60 to 70, benefits typically rise by a factor of between 2 and 2.7 (above the normal inflation increases). So, if taking CPP early is a bird in the hand, then a delayed CPP is more than two birds in the bush.

Here is an example to illustrate how delaying CPP increases payments. Twin sisters Anna and Belle have identical life histories in all the details that affect CPP. Anna just started her CPP benefits of $850/month at age 60. Belle plans to wait until 70 to take CPP. Now fast-forward 10 years to when the sisters are 70. Inflation will grow Anna’s benefits to about $1000/month (assuming continued modest inflation). Belle’s starting benefits will be between $2000 and $2700/month, depending on the details of the sisters’ life history and how much the average industrial wage rises in real terms over those 10 years. Anna got a head start collecting benefits for 10 years while Belle got nothing. But Belle will catch up fast with her much higher benefits. If they live long lives, Belle will be much further ahead.

8. You’re wealthy and have a complicated tax reason for taking OAS at 65.

OAS claw-back can make tax planning complex. There are situations where people can preserve some of their OAS from claw-back by taking it at 65 instead of 70. As long as the analysis takes into account all material factors, then this can be a good reason to take OAS at 65.

9. You don’t want to leave your spouse destitute if you die young.

This is the new reason I read about in Jonathan Chevreau’s recent MoneySense column, where he focuses on the potential loss if a spouse dies young. I’ll focus the rest of this article on this new reason.

The basic idea of delaying CPP and OAS is to spend some of your savings before age 70 in trade for guaranteed higher CPP and OAS benefits after you’re 70. But what if you’re married, and you die just as you’re getting to age 70? You’ve been spending more of your savings because you haven’t started your CPP and OAS benefits, and suddenly your pensions are gone. Do you really want to leave your spouse destitute?

This is a powerful emotional image. I certainly wouldn’t want to leave my wife broke after I die. For anyone looking for an emotional reason to take their pensions early, this is a good one. However, in my usual style, I prefer to think through the numbers.

If I die at age 70, my family’s after-tax safe spending level would drop for 3 main reasons:
  • Loss of most of my CPP (my wife would get a small CPP survivor’s pension instead)
  • Loss of my OAS
  • Higher income taxes due to my wife having to declare all family income rather than splitting it between the two of us
I routinely analyze my family’s finances based on the plan to delay all pensions to age 70. This time I’m looking at what happens with this plan if I die at age 70. To start, I calculate my wife’s CPP survivor pension using Doug Runchey’s explanation. Then I eliminate my CPP and OAS and calculate how much extra income tax my wife would pay when we would no longer split our income between us.

The result is that if I die at age 70, our family after-tax safe spending level would drop by 23%. This sounds bad, but the family expenses would drop by more than 23%. I wouldn’t be eating at home or in restaurants. She wouldn’t need my car and all its associated expenses. She’d save the cost of my mobile phone, my golf trips, my clothes, and many other things. From a purely financial perspective, if I died my wife’s standard of living would rise. If my wife died, the decrease in family after-tax safe spending level would be less than 23%, so my standard of living (from a purely financial point of view) would rise as well.

So, there is no reason to worry about my wife’s finances if I die (or vice-versa). But suppose I decide I can’t stand the thought of a 23% drop in safe spending level, and I plan to start CPP and OAS pensions as early as possible. Then our family safe spending level starting right now would go down a few percentage points. For the rest of the time we’re both alive, we wouldn’t be able to spend as much. This is the cost of taking pensions early. The gain of taking pensions early is that if I die at 70, my wife’s standard of living would rise by even more than it would rise under our existing plan. This is a bad trade for us.

Of course, our situation isn’t universal. Other couples will get different results. If one spouse would actually see a serious drop in standard of living if the other died young, finding a way to prevent this bad outcome makes sense. However, Chevreau’s article (where he quoted retired advisor Warren Baldwin) takes it as given that one spouse would be in financial trouble if the other died. My main point is that you need to think this through rather than get too hung up on the emotional image of a grieving spouse who is destitute.

I’ve made several references to doing a “thorough analysis” to see if you’d benefit from delaying CPP and OAS. This isn’t easy. The most common mistake I see people or their advisors make begins with “Let’s assume you have an average life expectancy.” This is usually a mistake. If your wealth is vast enough that you’ll never spend it all, and you just want to maximize your expected legacy, then assume whatever you like. But if you’re trying to make your savings last your lifetime, then you have no choice but to plan for a long life because it might happen. I’ve seen enough sad cases of people running out of money late in life.

I expect the most common reaction to this information will be “Yeah, well, I’m taking CPP and OAS as soon as I can, because [reason that ignores the upside of delaying pensions].” I certainly thought this way before a more careful analysis. But the benefits of delaying these pensions are clear for my situation. My guess is that the majority of healthy people with enough savings to live comfortably until they’re 70 would benefit from delaying CPP and OAS.

Friday, April 24, 2020

Short Takes: Rebalancing, Oil, and more

Here are my posts for the past two weeks:

Mortgage Deferral Cost

$10,000 Interest in Pictures

Worried about Your RRSPs? So is CRA

Asset Allocation: Should You Account for Taxes?

Here are some short takes and some weekend reading:

Dan Hallett explains that rebalancing a portfolio isn’t about trying to catch the bottom. If an asset is outside its allocation range, then it’s time to rebalance.

Tom Bradley at Steadyhand has an interesting take on oil cycles. He says that while the coronavirus is making the current cycle “far more dire,” “There will be many cycles between now and when it’s replaced by renewable alternatives.”

Canadian Mortgage Trends says that it’s getting much harder to refinance a mortgage. They also see some early indications of real estate prices dropping.

Preet Banerjee explains the Canada Emergency Wage Subsidy and has a calculator on his website for working out how much subsidy your organization can get.

Big Cajun Man has some new RDSP information that seems to be good news.

Boomer and Echo has a guide to the Canadian ETFs worth considering.

Andrew Hallam explains how to beat the performance of the world’s most famous hedge fund.

Thursday, April 23, 2020

Asset Allocation: Should You Account for Taxes?

We can only buy food with after-tax money, so it might seem obvious that we should take into account taxes in any financial decision. However, Justin Bender, portfolio manager at PWL Capital, has some reasons why you might ignore income taxes when when calculating your portfolio’s asset allocation.

Justin has created a series of excellent articles going over a great many issues do-it-yourself (DIY) investors need to understand. The articles are organized as a series of portfolios with decreasing costs, but increasing complexity. The portfolio names are inspired by the comedy movie Spaceballs: Light, Ridiculous, Ludicrous, and Plaid. My focus here is on accounting for taxes in your asset allocation, but this is only a small part of the many useful ideas Justin explains in this series.

The main difference between the latter two portfolios in the series is that the Ludicrous portfolio ignores taxes when calculating asset allocation, and the Plaid portfolio takes taxes into account in what is called after-tax asset allocation (ATAA). The Ludicrous portfolio is fairly complex, and Plaid adds an additional layer of tax complexity. It’s certainly possible to create a simpler portfolio than Plaid while still retaining ATAA. The question we address here is whether you should want ATAA.

Let’s consider a simple example to illustrate ATAA. Suppose you have $100,000 worth of stocks in a TFSA, and $100,000 worth of bonds in an RRSP. Your asset allocation appears to be 50/50 between stocks and bonds. However, this is ignoring taxes. Suppose you expect to pay an average of 25% tax on RRSP withdrawals. Then your RRSP is only worth $75,000 to you after tax. You have $25,000 less saved than it appears, and your stock allocation is $100,000 out of a total of $175,000, or about 57%. So, your ATAA is about 57/43, and your portfolio is riskier than it appears.

Some might object that we can’t know our future tax rate on RRSP withdrawals, so they conclude that it’s best to ignore taxes. However, with before-tax asset allocation, you’re implicitly assuming that the tax rate will be zero, which is almost certainly very wrong. It’s far better to come up with a best guess, like the 25% in this example, than to use zero. There are other much more sensible arguments in favour of ignoring taxes in asset allocation than this one.

What difference does the asset allocation calculation method make?

One difference we’ve already seen is that it can mask your portfolio’s true risk level. Another is that it drives your asset location choices. The Ludicrous portfolio (that does not use ATAA) tends to fill RRSPs with bonds and leave stocks in taxable accounts, while the Plaid portfolio (that uses ATAA) tends to fill RRSPs with stocks and leave bonds in taxable accounts.

From the Ludicrous point of view, any gain in RRSPs will ultimately be heavily taxed, so we prefer to have stocks with their greater growth potential in taxable accounts. From the Plaid point of view, we know that the portion of RRSPs that really belong to us (the $75,000 in the example above) grows tax-free because the government portion ($25,000) grows to cover any taxes owning. So, we prefer to have stocks with their greater growth in RRSPs.

Which asset location method will give you the better retirement?

It depends. Justin says that the Plaid portfolio “is officially the most tax-efficient portfolio in the bunch.” If we control all portfolios to the same true risk level, “we find that the adjusted Ludicrous portfolio actually ends up with a lower after-tax portfolio value and return than any of our other portfolios.”

However, Ludicrous can make up for its shortcomings by taking on more risk. As we saw in the simple example above, not using ATAA leads to thinking the portfolio asset allocation is 50/50, when it’s really 57/43. By taking more stock risk, Ludicrous increases its expected returns. So, a riskier Ludicrous portfolio is expected to beat a lower-risk Plaid portfolio.

Of course, you could just change your Plaid asset allocation to 57/43 and get better returns than a Ludicrous portfolio at the same true risk level. So, the answer to the question of whether ATAA will give you a better retirement depends on your behaviour. Will you take more risk if you don’t use ATAA? If you use ATAA and put stocks in your RRSP, will you be more likely to lose your nerve and bail out of stocks when you see high volatility in your RRSP, even though part of these swings are really the government’s risk and not yours?

Reasons to ignore taxes when calculating asset allocation

1. Investor Behaviour

“The Ludicrous portfolio is the winner from a behavioural perspective, but a loser from a tax-efficiency perspective. The Plaid portfolio ... is the winner from a tax-efficiency perspective, but a loser from a behavioural perspective.”

Justin has extensive experience with his clients. They tend to view their RRSPs as entirely their own, and too much volatility in a stock-filled RRSP makes them nervous and prone to bailing out at a bad time.

The Ludicrous portfolio approach to asset location might even help some nervous investors who could benefit from more portfolio risk. Their portfolios appear less risky than they are, which helps calm them while the higher true risk level is better able to take them to their investment goals.

Fortunately, these behavioural concerns don’t apply to me. I know the government effectively owns a splice of my RRSP. I maintain a spreadsheet of my portfolio, where I make the after-tax view of all accounts prominent.

2. Regulation

Justin wrote that the Plaid portfolio has the disadvantage of “regulatory constraints due to higher before-tax equity risk.” So, it appears that regulators require Justin to measure portfolio risk on a before-tax basis. This is a major constraint for a professional portfolio manager, but as a DIY investor, it doesn’t concern me.

3. OAS claw-back

With stocks in your RRSP, you could end up with a large RRIF and be subject to OAS claw-back from large future RRIF withdrawals. This certainly has the potential to hurt portfolios with RRSPs full of stocks, but I think it’s likely to just shrink the advantage of keeping stocks in RRSPs rather than flip the balance to give the edge to keeping stocks in taxable accounts.

In simulations of my own portfolio that take into account OAS claw-back, the clear winner was to use ATAA and fill RRSPs with stocks. However, this only applies to my situation; we don’t know for certain about other circumstances.

One mitigation method I’m using against high taxes rates on future RRIF withdrawals is to make small RRSP withdrawals each year now that I’m retired but nowhere near age 71 when RRIF withdrawals are forced. These lightly-taxed withdrawals have the disadvantage of reducing future tax-free growth in my RRSP, but have the greater advantage of reducing high taxes and OAS claw-back on future large RRIF withdrawals. Again, the size of these small withdrawals that gives lifetime tax advantages is highly specific to my situation.

This is a complex area, but I’m skeptical that it’s common for OAS claw-back to be likely to tip the scale in favour of filling RRSPs with bonds and taxable accounts with stocks. There might be cases where it helps to put Canadian stocks in taxable accounts to take advantage of the dividend tax credit, but it’s tough to beat tax-free stock growth in RRSPs.

4. Simplicity

There is a lot of advantage to keeping a portfolio simple. It’s amazing how even a simple-looking starting plan can become complex when you apply it to a real portfolio.

Justin’s Ludicrous portfolio is quite complex, and Plaid just layers on some more tax complexity. My own portfolio is simpler than Justin’s Plaid portfolio. It’s possible to embrace ATAA and its associated asset-location strategy and still simplify other aspects of the portfolio.

The main challenges ATAA brings are deciding on estimates of future taxes, discounting each account type with these tax rates, and taking any after-tax rebalancing amounts and calculating the before-tax amounts before placing trades. I certainly wouldn’t want to do all this by hand. That’s why I have all these calculations built into a spreadsheet. Building such a spreadsheet isn’t for everyone, but now that mine is done, my portfolio management is easy.

A very simple way to get the advantages of ATAA for the many investors who run their portfolios without worrying much about rebalancing or exact asset allocation percentages is to just use the asset location rules of the Plaid portfolio. This mostly means keeping bonds out of RRSPs. This only works as long as they remember that a slice of their RRSPs really belong to the government and they don’t load up on too many bonds.

Most DIY investors probably shouldn’t look past Justin’s Light portfolio, particularly if they have less than about $250,000 and little in taxable accounts.

5. Industry Bias

This wouldn’t apply to Justin, but the investment industry is much more concerned about its own revenues than whether their clients meet their investment goals. This is hardly surprising. After all, most people are much more concerned about their own salary than their employer’s goals. It’s not a crime to care more about yourself than others, as long as you still treat others, such as your clients or employer, fairly.

The investment industry makes the same money on RRSP assets as it makes on assets in TFSAs or taxable accounts. There may be some differences in administration costs, but they are small compared to the differences that income tax in different account types makes to investors. It’s hardly surprising that the bulk of the investment industry wouldn’t care much about investors’ taxes, particularly if almost all investors don’t understand these issues.

6. Momentum

Different ways of doing things always look a lot harder than just continuing to do what you’ve always done. The investment industry isn’t looking for make-work projects, and adopting ATAA methods is unlikely to make them more money. This might apply to Justin least given that he did so much work on the many details of his Plaid portfolio.


Justin’s conclusion is that “I personally use [the Ludicrous] asset location strategy in client accounts, mainly because the Plaid asset location strategy is not practical.” He cites investor behaviour, regulation, complexity, and unknown future tax rates as reasons for this impracticality.

The investor behaviour concern doesn’t apply to me. I’ve lived through stock market crashes in 2000, 2008, and 2020 without any panic selling. Justin’s regulatory constraints don’t apply to me either as a DIY investor.

The complexity of taking full account of taxes was a concern for me before I automated most of my portfolio decisions and actions in a spreadsheet. I rarely have to look at it, a script emails me when I need to do something, and it calculates trade amounts for me. I also combat complexity by making other aspects of my portfolio simpler than Justin’s Plaid portfolio.

As for unknown future tax rates, ignoring taxes in calculating asset allocation is the same as assuming taxes are zero. This is further off the mark than any guess at future tax rates would be. It’s better to make your best guess than forget taxes entirely.

Overall, Justin’s reasons for using his Ludicrous portfolio are sensible on balance given his position. His clients’ lack of understanding of these issues as well as regulatory constraints make his decision clear. However, most of his reasons don’t apply to me, so I use after-tax asset allocation in running my own portfolio.

Monday, April 20, 2020

Worried about Your RRSPs Tanking? So is CRA

It’s tough to watch your hard-earned savings dwindle in the COVID-19 stock market crash, particularly if you’re retired or getting close to retiring. For this older crowd, retirement savings mostly means declining RRSPs or RRIFs. But I have some good news.

When you withdraw from your RRSP or RRIF, the amount becomes taxable income for the year. This leads to paying income taxes on the withdrawal. Suppose you’re destined to pay 25% tax on your withdrawals. Then you might as well think of your RRSP or RRIF as being 75% your money and 25% CRA’s. CRA is right there beside you watching its share bounce up and down over the years.

So, if you’ve seen your tax-deferred savings drop $100,000 recently, only $75,000 of it is your loss. The remaining $25,000 is CRA’s loss. Focusing on CRA’s loss might make this whole experience a little less painful.

Many thanks to Justin Bender at PWL Capital for inspiring this article when he told me “During the March 2020 downturn, I didn't read a single article saying [what is explained here].

Wednesday, April 15, 2020

Tuesday, April 14, 2020

Mortgage Deferral Cost

COVID-19 has a lot of people hurting, personally and financially. The federal government has pushed a sensible measure onto the big banks: mortgage deferrals. Most people who take a deferral have little choice, but this doesn’t change the fact that these deferrals have a cost. Interest keeps building on a growing mortgage balance during the deferral.

Let’s look at an example. Suppose you have 20 years left on a 3% mortgage whose current balance is $300,000. You’ve just made your monthly payment of $1661, and the bank grants a deferral on your next 6 payments. What effect does this have?

To begin with, your mortgage balance will increase to $304,500 in 6 months. Banks may plan to have borrowers increase future payments to catch up, or they may just extend the amortization period with the same payments. Let’s assume the latter case.

How many more payments will you have to make at the end of your mortgage to make up for the 6 deferred payments? The answer is just under 11. That’s 5 extra payments. Keep in mind, though, that these payments will be smaller in real terms because of inflation over the next 20 years.

An extra 5 payments of interest is no fun, but it’s not the end of the world. The bank isn’t doing you much of a favour, but it’s not severely punishing you either. Many people have much bigger concerns right now than a modest extension of their mortgage’s amortization.

Friday, April 10, 2020

Short Takes: 1000-Foot View of COVID-19, Buying Low, and more

Here are my posts for the past two weeks:

How a Retirement Plan Responds to Market Volatility

Annuities are Great, in Theory

It’s Really Not Rocket Science

Rebalancing Does Its Job

Here are some short takes and some weekend reading:

Mr. Money Mustache puts the current pandemic into perspective. It takes a 1000-foot view to see that we’ll come out of this just fine. I wish I had more confidence that the number of COVID-19 deaths won’t be higher than current estimates.

Ben Carlson has a cool chart showing that “the retirement contributions you make into the stock market during a market crash will invariably be the best purchases you ever make.”

Ben Rabidoux predicts that big banks will not offer HELOCs starting before the end of April in this Debt Free in 30 podcast with Doug Hoyes. He says this will include widespread taking away of any undrawn balance room on existing lines of credit. Ben also predicts that the non-permanent resident population will shrink, and this will reduce demand for real estate.

Big Cajun Man explains why you should get a My CRA Account if you don’t already have one. Don’t wait too long if you have a need for one; there’s a step that involves waiting for postal mail.

The Blunt Bean Counter summarizes the government subsidies for individuals and businesses, and he explains why emotions are a poor guide to investing.

William J. Bernstein says stocks are “returning to their rightful owners” (the wealthy), and that the current system of having people manage their own retirement portfolios “needs dynamite and replacement with a system that actually protects workers, their families, and their retirements.”

Morgan Housel explains how we react to cycles of bad then good news.

Robb Engen at Boomer and Echo discusses the possibility of delaying retirement as a response to COVID-19’s effect on stock markets and the economy. One thing I would add to his remarks is to be careful about planning to find part-time work during retirement. This may be lower-paying and harder than you think, particularly if your health deteriorates. You may be happier working an extra year at your full pay than trying to make the same amount of money spread over several years of part-time work.

Thursday, April 9, 2020

Rebalancing Does Its Job

The COVID-19 stock market crash has certainly thrown off the balance of my portfolio.  Like most investors, my fixed-income savings haven’t done much, but my stocks have been jumping around crazily.  So far, I’ve stuck to my plan to rebalance my portfolio to fixed percentages of stocks and fixed income whenever they get out of range.  This has worked out surprisingly well, but I’m not feeling particularly good about it.

When I was working, I had an all-stock portfolio invested in a few broadly-diversified Vanguard index funds.  I didn’t have to rebalance my portfolio much, because my stock ETFs tended not to get wildly different returns.  Now that I’m retired, I have an allocation to fixed income (cash, GICs, and short-term government bonds). My fixed income definitely gets different returns from stocks, particularly during the recent stock crash.  I’ve had to rebalance a few times.

The thing about rebalancing is that it has you buying whatever has gone down and selling whatever has gone up, so you rarely feel good about it while you’re doing it.  I took a look at my recent rebalancing trades and discovered that they’ve produced a profit large enough to buy a modest car. 

To be clear, this didn’t happen because I made some brilliant market moves, and it didn’t happen because there is anything special about my investment plan.  My simple strategy is broadly similar to what dozens of investment books recommend.

These profits should be cause for celebrating, but where did this extra money come from?  When we make money on short-term stock trades, we haven’t contributed anything to society; the money had to come from some other traders who lost money. 

So, I’ve made some money from people who panicked, or who had to sell after a job loss. No doubt some were “readjusting their asset allocation” or “reducing their portfolio volatility.” This sounds smart, but it still amounts to selling low. The other side of my profits came from selling to those buying back in after stocks rose again.  I’m happy to have the money, but I’m not celebrating.

Monday, April 6, 2020

It’s Really Not Rocket Science

The latest book in the not-rocket-science series from Tom Bradley at Steadyhand Investment Funds is out (get the free PDF of It's Really Not Rocket Science).  Like the previous two books (It’s Not Rocket Science and It’s Still Not Rocket Science), it’s a collection of Bradley’s excellent articles on various aspects of investing.  Unlike many investment professionals who seek to make investing seem complex and mysterious, Bradley’s writing is clear.

Disclaimer: I did not receive any compensation from Steadyhand to write this review other than a free copy of the book.

Here are a few parts of the book that struck me as notable:

Nobody can predict the market, but “I see professionals who regularly defy all logic and evidence by explaining the unexplainable and predicting the unpredictable.”  I’ve told many people that nobody can predict the market. What baffles me is that many nod their heads in agreement and immediately ask “Where do you think the market is going?”  Investors need to learn to stop asking, and stop listening to the answers if others ask.

“I’ve never seen anyone, professional or amateur, get [market timing] right consistently enough to make it pay.”  Again, many people will nod in agreement and immediately ask what others think is going to happen in the markets. Contradictions abound.

“The toughest decision in investing” is deciding when to get back into the market after you’ve jumped out.  This applies even if you were lucky enough to jump out before a market drop. As stocks start to rise again, you’ll be “under a lot of stress after missing out on years of good returns.”  You’ll be “heavily invested in [a] negative view,” and you’ll be “waiting for something that will never occur — the perfect time to buy.” Advice from Bob Hager: “Picking the bottom of the market is virtually impossible.”

On hedge funds, “As it turns out, the managers have done much better than the clients.”  Buying a hedge fund because it makes you feel special can be an expensive ego boost.

Bradley’s article on where returns come from is excellent.  The most important factor is how the markets perform. Then it’s your chosen mix of stocks, bonds, and cash.  Third is the costs you pay. “Being an old stock analyst, it kills me to say this, but security selection, whether it’s done by a professional manager or yourself, comes in a distant fourth on the list.”  Finally the wildcard is investor behaviour, which could slot in anywhere in the hierarchy of importance for your returns. With discipline, behaviour hurts you very little. With impulsive changes of strategy, your behaviour could be the most important determinant of your dismal returns.

Whether you’re a DIY investor or work with an advisor, Bradley’s essays are worth reading.

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.

Monday, March 16, 2020

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

It’s not easy to know your true investment risk tolerance. Fred Schwed explained this problem wonderfully in his book Where are the Customers’ Yachts?:

“There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description that I might offer here even approximate what it feels like to lose a real chunk of money that you used to own.”

Now that the stock market has tanked and investors are learning what it feels like to lose money, experts like financial planner Jonathan Bednar are saying “This is a great time to re-evaluate your true risk tolerance,” and “If you are nervous then you may be taking on more risk than you are really comfortable with and should rebalance into a more conservative portfolio.”

This advice amounts to “sell stocks while they are low.” The best time to figure out that you don’t have the stomach for a stock market crash is while prices are still high. It’s now too late to reduce your stock allocation without permanently locking in losses.

Unfortunately, when stocks are soaring it’s far too easy to convince yourself that your risk tolerance is high. So maybe we need a different strategy. Perhaps we should record videos of ourselves saying how we feel after stocks crashed, and set a calendar reminder to watch this video annually. The next time stocks are soaring again, maybe the video will help us lighten up on stocks while prices are still high.

In the meantime, we have a choice to make. Either sell stocks and permanently lock in losses, or try to gut it out until the recovery and reduce our stock allocation at better prices.

Friday, March 13, 2020

Short Takes: COVID-19 and a Life Insurance Primer

Here are my posts for the past two weeks:

My Asset Allocation in Retirement

The Ultimate Guide to When to Buy and Sell Stocks

Here are some short takes and some weekend reading:

The Canadian government is providing useful COVID-19 information. I’ve heard many opinions that Canada isn’t doing enough, and others saying that the risk is overblown. Amusingly, I heard one person with both of these contradictory opinions.

Preet Banerjee explains the different types of life insurance in more detail than the usual superficial explanations. Broadly, there are two types: term life insurance and permanent life insurance. There are many subcategories of permanent insurance. No one type of insurance is inherent;y good or bad; what matters are the numbers. I don’t claim to have investigated every type of life insurance, but when I’ve dug into the numbers, anything that wasn’t term insurance looked quite bad. I’ve had many insurance salespeople tell me there are good kinds of permanent insurance, but they’ve never been able to provide me with the details of an available permanent insurance policy that turned out to be a good deal.

Thursday, March 12, 2020

The Ultimate Guide to When to Buy and Sell Stocks

We’ve all heard that we should buy low and sell high. But when are stocks low and about the rise, and when are they high and about to fall? Here we reveal the secrets to when to buy and sell.

We begin with the short answer and then explain more fully.

When to buy. When you have the money.

When to sell. When you need the money.

The stock markets as well as markets for bonds, real estate, currencies, and other investments are complex systems controlled by many people whose collective actions cannot be predicted with accuracy. So we have to make choices without accurate predictions.

So, when I have money I want to invest, I don’t pay the slightest attention to my predictions about the near future (or anyone else’s predictions). Knowing that stock markets are volatile, I don’t invest any money that I think I’ll need within 5 years. When I do have some money to invest, I do so right away and don’t think about whether today is a good day.

Now that I’m retired, I sell stocks much more frequently than I used to. But I’m guided by the same principle. I try to predict how much money I’ll need over the next 5 years. If my current fixed income investments are too low to cover these needs, I sell some stocks right away without any regard for whether today is a good day.

This approach works best for index investors who own almost all stocks. Those who buy individual stocks have the additional problem of figuring out which stocks to buy or sell. I don’t worry about that. A happy side effect of this investment approach is that I don’t have to listen to any talking heads making stock market predictions that are just guesses anyway.

Sunday, March 8, 2020

My Asset Allocation in Retirement

Occasionally, I get questions about my portfolio’s asset allocation now that I'm retired. I’m happy to discuss it with the understanding that nobody should blindly follow what I do without thinking for themselves.

When it comes to the broad mix of stocks/bonds/real estate, my answer used to be very simple: 100% stocks. But now that I’m retired, I do have a fixed-income allocation that consists of high-interest savings accounts, GICs, and short-term government bonds.

My current mix is roughly 80% stocks and 20% fixed income, but I plan to increase the fixed income component over time. The way I think of it is that I have 5 years of my family’s spending in fixed income and the rest in stocks. Over time as I spend down my portfolio, the fixed income percentage will rise. For example, it will be up over 22% in a decade.

Some investors use a “bucket” strategy that resembles my approach, but there is a crucial difference. These investors typically plan to make active decisions about which bucket to withdraw from each year for spending. I don’t do that. I spend from my fixed income allocation and mechanically refill it without any regard for my opinions on the near future of the stock market.

When the stock market drops significantly (as it has recently), the drop in my portfolio makes the fixed income percentage grow above 20% faster than my family’s spending reduces it. In these situations, I can end up buying back some stocks to rebalance.

What I call my family’s monthly spending is calculated from my current portfolio size (less expected taxes). Currently, I take 20% of my after-tax portfolio and divide by 60 months. So, when my portfolio goes down, our monthly safe spending level goes down. So far this hasn’t been a problem for us because we rarely spend as much as my spreadsheet says we can spend. I guess that’s good for our sons’ inheritance.

My stock allocation consists mainly of 4 exchange-traded funds. The only exception is that after applying all my asset location rules, I still need more stocks in my taxable account where I’ve chosen to just buy the all-in-one fund VEQT instead of the 4 ETFs.

I’ve been asked why I don’t invest in real estate. The main reason is that I don’t expect it to outperform stocks over the long run. We’ll see over the coming decades if I turn out to be right about that. I do own a house, but I don’t think of it as part of my portfolio.

Overall, I’m pleased to handle my finances with a set of mechanical rules that can be coded into a spreadsheet. Some time ago a reader showed me how to have a spreadsheet email me if some aspect of my portfolio was out of balance and needed attention. So, I have little reason to monitor my finances on a daily or even weekly basis. Life is good.