Tuesday, August 4, 2020

What the Experts Get Wrong about Inflation

“In the following analysis, we assume future inflation of 2% per year.”  How often have you seen something like this in investment projections or other financial analyses?  This kind of assumption leads to biases that can invalidate a financial analysis.

Even the great Benjamin Graham wasn’t immune.  In the early 1970s, he wrote the following in his book The Intelligent Investor:

“Official government policy has been strongly against large-scale inflation, and there are some reasons to believe that Federal policies will be more effective in the future than in recent years.  We think it would be reasonable for an investor at this point to base his thinking and decisions on a probable (far from certain) rate of future inflation of, say, 3% per annum.”

The following footnote was added by Jason Zweig in a revised edition of Graham’s work:

“This is one of Graham’s rare misjudgments.  In 1973, just two years after President Richard Nixon imposed wage and price controls, inflation hit 8.7%, its highest level since the end of World War II.  The decade from 1973 through 1982 was the most inflationary in modern American history, as the cost of living more than doubled.”

Readers may think I’m calling out Graham for his wrong guess about inflation.  This isn’t my point.  Graham’s mistake was that he guessed at all.  Future inflation is unknown.  Just as we treat future stock returns as a range of possibilities, we should be doing the same thing with inflation. 

We might guess that annual inflation over the next decade is likely between 1% and 3%.  But we can’t say for sure that it won’t shoot up above 5%.  You may judge this to be unlikely, but do you really want your financial security to depend on inflation definitely remaining below 3%?

The biggest effect of assuming future inflation to be at some known level is to make long-term bonds seem safer than they really are.  Once we consider the possibility of rising inflation, 30-year government bonds look a lot riskier.

Because inflation affects how much we can get for our money in annual spending, it’s better to focus on investment returns after subtracting inflation (called “real returns”).  Stock markets look volatile no matter how we view them.  Their nominal returns are volatile.  So are their real returns.  Even if we just treat inflation as a known constant, stock returns are volatile.

However, a 30-year government bond looks very different depending on how you think about inflation.  The bond’s nominal return over the full 30 years looks completely safe.  If we assume inflation stays at some fixed level, the bond still looks completely safe.  But if we correctly assume that future inflation is unknown, the bond suddenly looks a lot riskier.

I have no reason to think Graham would make the mistake of investing everything in 30-year government bonds; he understood the risk of high inflation.  But many people who use spreadsheets and Monte Carlo simulation tools don’t understand the implications of fixed inflation assumptions on their simulation results.  Personally, I avoid all long-term bonds.

When we run financial projections assuming fixed inflation, we make bonds (particularly long-term bonds) look safer than they really are.  We need to get out of the mindset of trying to guess a single value for future inflation and treat it as uncertain.

Friday, July 31, 2020

Short Takes: Money Lessons from Cats, Buy Now Pay Later, and more

With my softball league restarting, some golfing, and reading The Intelligent Investor, I haven’t done any writing recently.  But I have had a chance to ask different types of small business owners (who are opening up as much as they can) whether they will be able to operate profitably.  The most common answer is “we’ll see.”  COVID-19 is increasing their costs and forcing them to take fewer customers than they used to take each day.  That’s a deadly combination in any competitive market.  Behind brave faces I suspect many are just hoping to survive long enough to get back to normal.

Here are some short takes and some weekend reading:

Morgan Housel has an interesting description of why cats sometimes survive high falls better than low falls, followed by a jarring attempt to connect it back to a financial lesson.

Preet Banerjee and Derrick Fung
discuss the rise of buy-now-pay-later in online shopping.  Making your life worse is getting more and more convenient.

Boomer and Echo compares the financial aspects of renting versus owning a home.

Friday, July 17, 2020

Short Takes: Credit Hygiene, Defending Buy-and-Hold, and more

Here are my posts for the past two weeks:

The Limits of Offering Investment Help

Think Twice Before Taking a 5-Year Closed Mortgage

A Canadian’s Guide to Money-Smart Living

Here are some short takes and some weekend reading:

Canadian Mortgage Trends explains why you should care about your credit “hygiene” and not your credit score.

Tom Bradley at Steadyhand
defends buy-and-hold investing.

Canadian Portfolio Manager explains your ETF’s currency exposure.  (This article has a second part).  Many investors get confused about buying identical baskets of stocks in different ETFs that transact in different currencies.  The situation would get even more confusing if we tried to explain that measuring U.S. companies’ stock returns in U.S. dollars is merely a convention; companies with international operations are affected by changes in many different currencies.

Big Cajun Man
looks at RESP statistics showing that lower income families aren’t opening RESPs, even though they could be getting the Canada Learning Bond without even making an RESP contribution.

Boomer and Echo
discusses the challenge of sticking to your financial goals during the pandemic.

Thursday, July 16, 2020

A Canadian’s Guide to Money-Smart Living

Learning about personal finance makes people anxious.  Combine this with all the details to learn and the process can be overwhelming.  Kelley Keehn and Alex Fisher aim to help people get past these problems with their book, A Canadian’s Guide to Money-Smart Living.  The authors introduce the reader to basic personal finance topics without getting into too much detail.

The book begins by trying to get past emotional barriers to controlling spending and getting readers motivated to learn more about personal finance.  It then covers paying yourself first, record-keeping, planning, mortgages, debts, credit scores, and investing.

There were a number of details in the book I liked.  Many financial writers like to mock the idea that small amounts add up, but not these authors.  “The few dollars you spend on muffins, eating out, or other expenditures that you’re not tracking every day, might not seem like much at the time but mount up over the weeks and months and years.”

With so many people seemingly willing to pay any price for a house, it’s important to hear the downside: “Having too big a mortgage payment for your available cash can be absolutely crippling.”  A similar message about all debt: “More debt always equals less freedom.”

I was surprised to learn that “if you don’t use your account at least every month, your [credit] score can be negatively affected.”  I’m not sure if this applies only to credit cards, or if it’s true for lines of credit as well.  I sometimes go several months using only one of my credit cards, and I haven’t used my line of credit in years.

The book contains a good section on the problem with using a supplementary credit card on someone else’s account.  One of my aunt’s did this.  When her husband died, she had no credit record at all because she was using his credit card account, even though her card had her name on it.

A good point about mandatory minimum RRIF withdrawals: “Withdrawing the money does not mean you have to spend it; all you have to do is report it as taxable income.”

There were a number of parts of the book that could be improved.  One section on how to choose and work with a financial planner needed to start with an explanation of how much money you must have before any planner would work with you.  Another section on life insurance paints a picture of a professional life insurance agent carefully looking after your interests.  In reality, people need to know how to avoid agents who try to sell them whatever product generates the biggest commission.

On the subject of breaking a mortgage, the authors say that a penalty of “three month’s [sic] interest is common,” when mortgage penalties are often in the 5-figure range.  On the subject of mortgage life insurance, the authors fail to mention that typical policies use “post-claims underwriting,” which means they don’t check if you qualify for coverage until after you’re dead.

In an example of a couple getting a mortgage, the authors say that “By paying about $456 weekly [instead of $1982 monthly], for example, they save in interest costs and pay off their mortgage faster.”  This isn’t true for these numbers.  Paying biweekly or weekly shortens a mortgage when the payments are simply divided by two or four, effectively increasing the total amount paid each year.  In this example, the weekly amount is calculated to give the same amortization period as the monthly amount.

In a discussion of whether to pay down your mortgage or contribute more to an RRSP, the authors list 4 factors to consider.  However, they miss the most important factor which is how much financial risk you want to carry forward (in the form of leverage) as you age.

In the “Get to Know Your Banker” section, the authors offer mostly obsolete advice about a personal relationship with your banker.  Curiously, they end the section with the modern reality: “Loans are approved by a computer program these days – it’s rarely a human or personal process.”

The book gives a table showing the letter grading system Transunion uses for credit scores, but goes on to say that Transunion rated a particular creditor as “fair” instead of “B” as shown in the table.  I couldn’t figure out the point the authors were trying to make here.

Among the things to consider when deciding whether to buy GICs is “where are interest rates going?”  This is bad advice.  Trying to predict future interest rates is a waste of time.  Currency experts trade trillions of dollars based on interest rate expectations.  An average person trying to outsmart them is just gambling.

“While funds with high MERs may be worth it because of the professional managers they use, it means that those managers need to work that much harder to earn you a decent rate of return.”  All the evidence says that trying to find managers who can overcome high MERs over the long run is futile.

For RESPs, you can open multiple plans, “but, as with the other tax shelters, each plan must follow the maximum contribution rules.”  A reader could easily be confused by this.  The authors mean that the total contribution to all RESPs can’t exceed the maximum per beneficiary.

The last quarter of the book contains several typos that show a lack of attention to detail.

Overall, this book might be helpful to personal finance novices.  The best parts are the early sections designed to motivate people to improve their finances and give them tools for changing bad habits.

Monday, July 13, 2020

Think Twice Before Taking a 5-Year Closed Mortgage

The internet is full of debates about whether to take a mortgage interest rate that is fixed or variable.  However, what gets less attention is whether the mortgage is open or closed.  The most common fixed-rate mortgages are closed, and this means you’d have to pay a penalty if you break your mortgage.

I can already hear most people saying “but I’m not going to break my mortgage, so I don’t have to worry about penalties.”  However, the future can surprise us.  If breaking a mortgage cost us a finger, we’d think a lot more carefully about what might happen to make us break our mortgage: job loss, job moves to another city, divorce, health problems, bad neighbours, and more.

Mortgage penalties aren’t as bad as losing a finger, but they can be bad enough.  Suppose you took out a 5-year mortgage at TD Bank 2 years ago, and it has a remaining balance of $300,000.  According to Ratehub’s mortgage penalty calculator, the cost to break your mortgage would be $16,463!

Lenders deserve some compensation if you break a closed mortgage, but a penalty this big far exceeds any reasonable compensation.  The way they justify it is to do the calculations based on “posted rates,” which are much higher than the interest rates people typically pay.  The gap between the posted rate and the real rate is highest for 5 year mortgages, and gets smaller for shorter mortgages.  This declining gap size is what pumps up the mortgage penalty calculation.

So, when you’re trying to decide whether you’ll come out ahead with a fixed or variable rate mortgage, think carefully about what might happen that would force you to break your mortgage.  A mortgage penalty can easily be larger than the cost difference between fixed and variable interest rates.

Thursday, July 9, 2020

The Limits of Offering Investment Help

Family, friends, and blog readers often ask me for investment advice.  The challenge with helping these people is that even if the advice I give is good, the results they get can end up being disappointing.

Many times I’ve agreed to look at a person’s portfolio.  The most common problem I see is high mutual fund costs with little meaningful financial advice given in return for those costs.  Another problem that’s less common is a portfolio that is too concentrated in a small number of stocks.

In most cases, it’s obvious that the investor would be better off in the long run with a very simple portfolio holding nothing but one of Vanguard’s asset allocation ETFs (VEQT, VGRO, VBAL, VCNS, and VCIP).  This isn’t the only good way to invest, but it’s better than most people’s existing portfolios.

So, if I were to give one-time advice, in most cases it would be to sell everything and buy an asset allocation ETF.  I might add some advice on not timing the market and avoiding tinkering.  However, this would leave a big problem.  Dan Hallett explained the problem well on a recent Moneysaver podcast:

“I have long been convinced that I could lay out exactly what somebody needs to do, and the vast majority of them would get in their own way.”

If the people coming to me for advice are willing to change their entire portfolios to match my suggestions, what will happen the next time the stock market is down and they ask someone else for advice?  The answer is they’d make another big change in portfolio strategy.

Jumping around from one strategy to another is a bad idea, even if we’re jumping from good strategy to good strategy.  We tend to want to make changes after our current strategies have had a bad period.  We end up in a buy-high-sell-low cycle.

These problems place limits on who I’m willing to help with their investments.  Unless I’m confident I’ll be around to stop people from getting in their own way, my advice becomes part of the problem instead of a solution.  So, I’ve only helped a modest number of people very close to me.

Some financial advisors might applaud my choice saying that financial advice should be left to the professionals.  However, only a minority of financial advisors are part of the solution rather than part of the problem.

Friday, July 3, 2020

Short Takes: Tesla, Reducing Stock Allocation, Retirement Strategies, and more

I had to laugh watching Elon Musk gloat on Twitter about Tesla’s recent success and rising stock and the effect it’s had on short sellers.  “Tesla will make fabulous short shorts in radiant red satin with gold trim.”  He’s not a fan of the U.S. Securities and Exchange Commission (SEC): “Will send some to the Shortseller Enrichment Commission to comfort them through these difficult times.”  “Who wears short shorts?”

Here are my posts for the past two weeks:

Investing Perfection

Talk Money to Me

Here are some short takes and some weekend reading:

David Aston says now is the time to reduce your allocation to stocks if you couldn’t stand the recent stock market turmoil.  The best advice is to stick to a financial plan and its asset allocation percentages, but for those who’ve learned that they just couldn’t stomach the 30% drop in stock prices, the best move is to wait until stock prices have recovered before selling off some stocks.  Today’s higher prices are giving these investors their opportunity.  Unfortunately, it was when stocks were low that social media was filled with bad advice to reduce your stock allocation.

The Rational Reminder Podcast interviews retirement expert Fred Vettese who has done excellent work on finding retirement strategies that can work for you rather than working for banks, insurance companies, mutual fund companies, and their salespeople.  I’ve written before about some areas where I disagree with Vettese, but I consider these differences to be minor.  Following his advice is very likely to give a good outcome.  The main area of disagreement concerns spending patterns as we age.  I’ve read the same studies Vettese references, and what I see is data that mixes together retirees who made their own choices of how much to spend with some retirees who were forced to spend less as their savings dwindled prematurely.  The net effect is that if we back out data from forced spending reductions faced by some people, retirees’ natural tendency to spend less as they age will start later and be less severe than the full data set appears to show.  This is disappointing news for people looking for the green light to retire with less saved and to spend freely in their 60s.  However, we need to ask ourselves whether we want to model our own retirements on the experience of others who made their own choices, or whether we want to include a component of forced spending reduction from dwindling savings.  All that said, though, Vettese’s retirement plans are better than most I’ve seen.

Christine Benz
has some excellent advice for young investors just starting out, as well as a few words for more experienced investors.

Robb Engen at Boomer and Echo says COVID has eliminated any chance of meeting his stretch goal of becoming a millionaire by the end of 2020.  But, he says “I won’t get kicked out of the personal finance blogger guild if it takes a few extra months to make it.”  The housing and stock markets may have something to say about it taking only a few extra months.  This illustrates the problem with getting too tied to net worth goals.  Robb has the right attitude of not being too concerned.  We have some control over our incomes and saving rates, but no control over the prices of volatile investments.  In the long run a net worth target can be a reasonable goal, but in the short run, it’s more of a hope.

Big Cajun Man gives an overview of the Registered Disability Savings Plan (RDSP) along with links to more details.

The Blunt Bean Counter
describes his experiences working from home.

Friday, June 26, 2020

Talk Money to Me

The best financial advice I’ve heard sounds impossible to most people.  To reach these people, you have to offer them small improvements to how they handle their finances, and you have to avoid making them feel bad about their past choices.  This is the approach Kelley Keehn takes in her book Talk Money to Me: Save Well, Spend Some, and Feel Good about Your Money.

The best car advice I know is to pay cash for cars.  The financial benefits of saving up for cars and buying modest cars are enormous.  However, most people think this is impossible.  And once they’ve built a lifestyle with debt, paying cash for a car may well be impossible.  Keehn’s focus is on steering her readers to doing research on cars and car financing before entering a showroom.  This will have her readers making somewhat less financially damaging car choices.  So, she’s looking to help people a little with advice they might follow instead of giving great advice that few will follow.

A more extreme example of good but useless advice is to not be a shopaholic.  Keehn offers practical steps to spending less money while scratching the shopping itch.  The book covers several other areas with advice designed to steer people to better choices.

Keehn mentions an interesting issue that never occurred to me.  As companies gather information about our spending histories, we could be forced to share these spending histories.  For example, we could be forced to share our spending history at the U.S. border to see if we’ve ever bought cannabis.

On the subject of asset allocation, Keehn treats your career and future income as a component of your portfolio.  How steady your income is affects how you should invest the rest of your money.  One caution I’d add is that we tend to underestimate how risky future income really is.  Few jobs and careers are as safe as people think they are.

There are a number of details in the book that I found confusing or where I disagreed.  On credit reports: “If you order a free report …, your score will not be listed, so it won’t be as useful; I’d suggest always paying for the full report.”  I think it’s better to learn how elements of your credit history affect your score, and work on improving your financial habits.  As your credit report improves, your score will take care of itself.  I don’t see the need to pay to see a score.

On making credit card and line of credit payments, I found “Always pay the minimum every month” jarring, until I realized the intended meaning was “at least the minimum.”  Apparently, some people think that if they make a payment of double the minimum one month, they can skip the next payment.  As the book explains, it doesn’t work this way.

Among the ways of holding some available cash, Keehn includes money market mutual funds.  These aren’t as safe as they seem.  A high-yield savings account is a better idea.

Despite repeated mentions of the importance of an emergency fund, we get this advice: “If you’re able, then it makes sense to invest those funds and rely on a line of credit if an emergency were to arise.”  Just two pages later we get “Your lender can even take your credit away entirely if your credit score drops dramatically.”  Counting on borrowing money in an emergency is how many people get themselves into big debt troubles.  Emergency funds matter.

In a checklist for different types of insurance, the book includes “Do you have insurance on your credit cards, and is it right for you?”  Naive readers could be left thinking that they should get credit card insurance.  In reality, the question should be whether you’ve made sure you don’t have credit card insurance.

The book refers to the “miss a payment” option on a mortgage as a “handy feature.”  This feature of a mortgage feels more like another tool for banks to keep people permanently in debt.

In answering the question about houses “What can you afford?”, the book goes through the usual explanations of gross and total debt service ratios.  Unfortunately, these ratios leave people thinking they can buy a far more expensive  house than is best for them.  Banks lend money without caring whether you’ll end up house poor.  It isn’t until a few pages later that the book mentions that you might not want to borrow as much as a bank will lend on a mortgage.

On the subject of mortgage insurance, the book fails to mention post-claims underwriting.  The insurance company doesn’t check if you qualify for insurance until after you’re dead.  Not knowing if you’re really covered is a huge negative for mortgage insurance.

Numbers in a few places didn’t seem to make sense.  In one place, the annual interest rate on a payday loan is over 500%, but only 47.71% in another place.  In another figure illustrating costs on a 14-day $300 loan, the figures for lines of credit, overdraft protection, and a credit card cash advance imply annual interest rates of 50%, 62%, and 64%, respectively.  Even if we make the loan period a month, the annual percentages are 23%, 29%, and 30%, which still seem too high.

The book includes a glossary with some definitions that seem strange.  For example, a dividend is “A financial bonus for investing in a company (when you buy a preferred share).”  This seems like an attempt to write for the masses, but it didn’t work out well.

This book is useful for helping people who don’t handle money very well, which is most people.  I found a number of things that seemed odd, but none are central to the mission of giving people practical tips for improving their finances.  For anyone looking for financial advice that doesn’t seem too extreme, this book fits the bill.

Tuesday, June 23, 2020

Investing Perfection

Perfect is the enemy of good. – Voltaire quoting an Italian proverb, 1770

In my career as an engineer/mathematician, I worked with some people who had trouble declaring a design “good enough.”  They’d want to keep tinkering endlessly.  They couldn’t stand to stop work knowing that some part of the design could still be improved.  This drive to tinker and improve things served them well in some ways and hurt them in others.

When it comes to investing, it’s a bad idea to get paralyzed seeking the perfect strategy instead of just getting started.  Perfecting your investment strategy is quite unimportant when you’re just getting started with small amounts of money.

I’ve been investing my money for decades now, and there’s never been a time when I thought I was doing it perfectly.  Sometimes I’ve just had a feeling I wasn’t doing something right.  Other times I knew exactly what I wasn’t doing well, but didn’t yet know how to improve it.

I’ve always been at ease with this situation as long as the “mistake” wasn’t too severe.  Fortunately, while my portfolio was small, mistakes weren’t too painful.  Paying high mutual fund MERs today would eat at me, but it wasn’t that big a deal when my portfolio was 5% of its current size.  I’ve given myself a pass for past mistakes and have never been in a panic to correct them along the way.

But this doesn’t mean I don’t bother to improve things.  As my savings have grown, I’ve figured out various improvements (reducing MERs with U.S.-listed ETFs, reducing foreign exchange costs with Norbert’s Gambit, improving my asset location strategy, etc.).  I learned about these things at my own pace and didn’t agonize over past inefficiencies.

This attitude makes it easier to learn new ideas.  If you have a strong emotional need to do everything perfectly, then finding a good new idea requires you to admit that your old ideas weren’t as good.  Some people prefer to defend the status quo rather than improve.  Often new ideas aren’t really improvements, but I like to remain open to the possibility of genuine improvements.

By being at ease with the fact that your investment history isn’t optimal, it’s easier to adopt good ideas.  It’s quite freeing to simply say, “what I’m doing now isn’t as good as I thought it was, and I plan to make improvements in my own time.”  For those just starting out investing on their own, it’s okay to learn as you go.

Friday, June 19, 2020

Short Takes: Billionaire Bashing, Asset location Debates, and more

A promoter sent me a press release announcing that billionaires increased their net worth by $584 billion since the start of the pandemic.  I guess I’m supposed to be outraged that they profit while everyone else suffers with job losses, sickness, and death.  Coincidentally, the “start of the pandemic” lines up with the bottom of the stock market crash.  If we use VTI as a proxy for billionaire wealth, these investors lost about $780 billion in the month before the pandemic started.  Suddenly the outrage melts away.  I’m all for improving equality of opportunity, but I don’t see how this misleading garbage will help.

Here are my posts for the past two weeks:

Questions for Your Financial Advisor

Borrowing to Invest

Here are some short takes and some weekend reading:

Justin Bender
completes his podcast series of 4 portfolios with different asset-location strategies.

Robb Engen at Boomer and Echo says that asset location isn’t worth worrying about.  I certainly agree with this conclusion if we are talking about the typical poor asset location advice telling us to put bonds in RRSPs.  This advice comes from a schizophrenic analysis that assumes tax rates are zero when calculating asset allocation, but tax rates suddenly take on realistic values when assessing investment performance.  It makes more sense to judge the value of strategic asset location based on a sensible strategy.  Roughly speaking, such a sensible strategy takes assets in the order U.S. stocks, international stocks, Canadian stocks, and bonds, and then fills accounts in the order RRSPs, TFSAs, and non-registered accounts (some variation may be needed depending on tax rates, account sizes, and position sizes).  Not worrying about asset location is certainly easier, which is valuable.  In my own case, I find that using strategic asset location simplifies my portfolio somewhat because each of my accounts has fewer holdings.  This reduces the number of trades required for deposits, withdrawals, and rebalancing.  I simplify further by not holding strictly to optimal asset location when small deviations reduce the number of trades I need to perform.

Big Cajun Man
tells us what to do with found money.  If you follow his advice, your future self will thank you.

Tuesday, June 16, 2020

Borrowing to Invest

Borrowing money to invest is like weaving through traffic.  You'll get to your destination sooner as long as nothing bad happens. – MJ, 2020

The case for leverage (borrowing money to invest) seems compelling.  You can borrow money at 3-4% interest, and invest it in stocks that will probably make 6-8%.  What’s not to like?

The answer is “the unexpected.”  Anything that forces you to sell your investments while they’re down can cost you a lot of money.  You could be forced to sell when you lose your job due to problems with your boss, your company, or the whole economy.  Or your lender could demand its money back.  You can’t anticipate every possible reason why your stocks might crash at the same time as you’re forced to sell.

It’s true that such problems are likely rare.  But they don’t have to happen often to make leverage look like a bad idea.  Selling when your stocks are down 30% gives back a decade of expected excess stock gains above loan interest.

Using just a modest amount of leverage is like a little weaving through traffic: it probably isn’t too unsafe.  But as you borrow more to magnify returns trying to make more money, the odds of blowing up increase, just as the odds of crashing increase as you weave faster through traffic.

I’m not 100% against leverage, but investors should enter into it with their eyes open.  Most analyses touting the benefits of leverage don’t include the possibility of something going wrong.  But things going wrong is normal in life.  Stock markets crash.  People lose jobs.  With too much leverage you can end up without money to invest during future good times.  To thrive you have to first survive.

Monday, June 8, 2020

Questions for Your Financial Advisor

“Don’t ask a barber whether you need a haircut.” – Daniel S. Greenberg, 1972

We’re all guilty of coming to conclusions that line up with our self-interest.  However, it’s not always as obvious as in the case of a barber who always thinks people need haircuts.  Often we don’t even recognize that we’re guilty of being influenced by self-interest.

Financial advisors, like the rest of us, have biased reasoning.  Here I answer some common investor questions from the point of view of a most financial advisors.

Do I need a financial advisor?

Yes.  How else can I make a living?  People with advisors end up with more savings than those without an advisor.

Do I need to save more for retirement?

Yes.  That way you’ll have more money invested with me, and I’ll collect more fees.  You don’t want to run out of money in retirement.

How much do I pay in fees?

You shouldn’t think about that.  It’s an obsession of mine, but if you think about it, you might insist on paying me less.  The more important question is whether you’re getting good returns.

Should I borrow so that I can invest more?

Yes.  This will increase my Assets Under Management (AUM) and I’ll collect more fees.  Your investment returns will more than cover the interest payments.

Should I keep my pension or withdraw its commuted value to invest with you?

You should withdraw the commuted value to increase my AUM.  I can invest it for you to make more money than your pension will pay.

Should I take CPP and OAS as early as possible?

Yes.  Then you’ll sell less of your investments in the next few years to keep my AUM up.  The government might cut these pensions.

All the answers serve the advisor’s interests, but it takes some knowledge to be able to tell if they serve your interests.

Friday, June 5, 2020

Short Takes: Ken French Interview, Tighter Mortgage Rules, and more

Over the past two weeks, I started four different posts, but they were all leaning too negative to publish. It’s tempting to write about the various types of bad financial advice I see, but it’s better to hold up examples of good advice. Hopefully, I’ll have something to say in the coming fortnight.

Here are some short takes and some weekend reading:

The Rational Reminder Podcast interviews Professor Ken French of the well-known Fama-French 3-factor asset pricing model.

CMHC is tightening their mortgage rules as of July 1. One change is to reduce the Gross and Total Debt Servicing ratio limits to 35% and 42%, respectively. These percentages still seem very high to me. I would never want to live that close to the edge.

CDIC has extended their coverage to foreign cash and term deposits of more than 5 years. Unfortunately, the coverage limit remains $100,000, where it’s been for 15 years.

The Blunt Bean Counter explains financial and estate issues with blended families.

Moshe Milevsky argues that COVID-19 has increased uncertainty in how long we’ll live, and that this increases the economic value of annuities. This makes sense. The risk of dying soon is higher, and it seems plausible that the dispersion in our remaining lifetimes is higher. However, the Canadian annuity market remains opaque and without options for indexing to the Consumer Price Index (CPI).

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.