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.

Conclusion

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.


Conclusion

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.