Wednesday, March 31, 2021

A Life-Long Do-It-Yourself Investing Plan

The financial products available today can make do-it-yourself (DIY) investing very easy, as long as you don’t get distracted by bad ideas.  Here I map out one possible lifetime plan from early adulthood to retirement for a DIY investor that is easy to follow as long as you don’t get tempted by shiny ideas that add risk and complexity.

I don’t claim that this plan is the best possible or that it will work for everyone.  I do claim that the vast majority of people who follow different plans will get worse outcomes.

Most of my readers will be more interested in the later stages of this plan.  Please indulge me for a while; the beginning lays the foundation for the rest.

Starting out

Our hypothetical investor – let’s call her Jill – is at least 18, currently earns less than $50,000 per year, and has a chequing account at some big bank.  She has a modest amount of savings in her account earning no interest.  It’s about time she opened a savings account to earn some interest on her savings, but big bank savings accounts barely pay any interest.

So, Jill opens an online non-registered savings/chequing account at a Canadian bank that is not one of the big banks.  She chooses it because it’s CDIC-protected, transactions are free, and it currently pays much higher interest than the big banks offer.  If this bank ever changes its policy on offering competitive interest rates or free transactions, Jill will just switch to somewhere else that offers better terms.  It’s not worth switching for a small interest rate increase or for a limited-time offer, but if she can ever get say 0.5% more elsewhere, she’ll go.

For now, Jill probably needs to keep a chequing account at a big bank.  Accounts at smaller banks sometimes need to be linked to some other bank account, and you can’t access a bank machine through most smaller banks.  It’s also good to be able to talk to a big-bank teller the rare time you need a certified cheque, to make a wire transfer, or to pay some bill you can’t figure out how to pay online.

Jill also opens a TFSA at the small bank.  It pays even higher interest, and she might as well earn the interest tax-free.  Sometime much later, Jill may want all of her TFSA room devoted to non-cash investments, at which time she can close this TFSA.  But for now her TFSA will hold some cash.

At this point Jill is learning about how TFSA contribution room works.  She’ll find that it’s best not to deposit and withdraw too often because you don’t get TFSA room back until the start of the next calendar year.  She should use her regular non-registered account for more frequent transactions.

This plan will work well for Jill as long as she has fairly short-term plans for her savings, such as going to school.  As long as she will likely need her savings within 5 years, there’s nothing wrong with keeping it in cash earning as much interest as she can get safely and conveniently.

Let’s look at some potential distractions Jill faces on her current plan.

The bank teller says Jill should open a savings account and get a credit card.

Jill needs a good savings account, such as what some small banks offer, not a big-bank savings account that pays next to no interest.  If Jill gets a credit card, she should look for one that suits her needs, not take the conflicted advice of a teller.

All the cool kids are buying Bitcoin.

Jill is level-headed enough to know that she knows next to nothing about investing, never mind wild speculation in Bitcoin, or whatever is currently holding people’s interest.

Savings Start to Grow

At some point, Jill’s savings will grow beyond what she thinks she will need within 5 years.  Perhaps she has graduated, is working full time, and has no immediate plans to use all her savings as a down payment on a house.  She doesn’t carry credit card debt, has paid off her student loans, and has no other debts.  We’ll assume for now that Jill has no group RRSP at work and is making less than $50,000 per year, so that she’s not in a high tax bracket and has no reason to open a self-directed RRSP.  

Jill will still hold some cash savings she might need in the next 5 years in her small bank savings accounts.  Now it’s time to start investing in stocks with her longer-term savings.  Jill knows that stocks offer the potential for great long-term returns, but she has no idea which ones to buy.  Fortunately, she’s heard that even the most talented stock-pickers often get it wrong, so she’s best off just owning all stocks.  This may sound impossible, but the exchange-traded fund (ETF) called VEQT holds just about every stock in the world.  She can own her slice of the world’s businesses just by buying VEQT.  There are a few other ETFs with similar holdings, and it doesn’t matter much which one Jill picks.  (I mention VEQT because it appears to be among the best available stock index ETFs right now; I get no money or other consideration for mentioning it.)

Jill opens a TFSA at a discount brokerage.  It’s okay for her to have both this TFSA and the one holding just cash at a small bank, as long as her combined contributions don’t exceed the government’s limits.  Any savings she adds to this new TFSA she uses to buy VEQT.  That’s it.  Nothing fancier.

The biggest lesson Jill needs to learn while her stock holdings are small is to ignore VEQT’s changing price.  Many people hope that their stocks won’t crash.  This is the wrong mindset.  Stocks are certain to crash, but we don’t know when.  We need to invest in such a way that we can live with a crash whenever it happens.  

Jill should just add new money to her VEQT holdings on a regular basis through any kind of market, including a bear market.  Trying to predict when markets will crash is futile.  She needs to accept that she can’t avoid stock crashes and that prices will eventually rise again.  This lesson is so important that Jill needs a different plan if she will panic and sell the first time VEQT drops 20% or more.  Learning that stock crashes are inevitable and calmly doing nothing different through them is critical for Jill's investment future.  Fortunately, in the coming years, Jill will focus on the safe cash cushion in her savings accounts when VEQT’s price drops.

What distractions could throw Jill off her plan now?

The bank says they can help Jill open a TFSA and invest her money.

The bank is just going to steer Jill into expensive mutual funds that will likely cost her at least 2% per year, which builds up to a whopping 39% over 25 years.  As incredible as it sounds, 39% of her savings and returns would slowly become bank revenue during those years.  It’s no wonder that bank profits are so high.  In contrast, VEQT’s fees are just 0.25% per year, which builds up to just 6% over 25 years.

The smart, sophisticated twenty-somethings are getting rich day-trading on Robinhood.

No, they’re not.  We only hear the stories about rare big temporary successes, not the widespread mundane losses.  Very few traders will outperform VEQT.  Over the long term, Jill will be ahead of more than 90% of investors and an even higher percentage of day traders.

Investing has to be harder than just buying one ETF.

In most endeavours, working harder gives better results.  With investing, you need to learn enough to understand the power of diversified, buy-and-hold, low-cost investing.  Beyond that, taking courses in stock picking will just tempt you to lose money picking your own stocks.

VEQT’s price is dropping! What should I do?

Inevitably, stock markets crash.  It’s hard to know how you’ll react until you experience a crash.  If Jill decides she really can’t handle a sudden VEQT price drop, her best course of action is to gut out this market cycle until VEQT prices come back up, and then choose a different asset allocation ETF that includes some bonds to smooth out the ride.  She can then stick with this new ETF into the future.

Rising income

Jill’s income is now enough above $50,000 per year that it makes sense to open an RRSP account at her discount broker.  She also has a group RRSP at work, and she contributes the minimum amount required to get the maximum match from her employer.  She would have participated in this group RRSP even if her income was lower because the employer match is valuable.

Jill figures out how much she’d like to contribute each year to her RRSP at the discount brokerage.  This has to take into account her RRSP contribution limit, her group RRSP contribution as well as the employer match, and the fact that there is little to gain from reducing her taxable income below about $50,000.  If she wants to add even more to her long-term savings than these RRSP contributions, she can save some money in her discount brokerage TFSA.

Next comes the decision about what to own in her self-directed RRSP.  Once again, she buys only VEQT.  Nothing fancier is needed, and most people won’t do as well as just owning VEQT.

When Jill looked into the details of her group RRSP, she was disappointed that the fees were so high; VEQT isn’t one of the investment options.  But she can’t get the employer match without choosing among the expensive funds.  So, her plan is to learn the vesting rules of her group RRSP, and once she’s allowed to transfer assets to her self-directed RRSP without penalties or losing the company match, she’ll make this transfer every year or two.  She’ll be careful to make these direct transfers from one RRSP to another rather than withdrawals.  However, when asking questions about the group RRSP rules, she’ll be careful not to reveal her plans to avoid the expensive fund choices.  The company operating the group RRSP may become less than cooperative if they know Jill has no intention of paying their excessive fees on a large amount of savings.

So, Jill now has VEQT holdings building in her RRSP and TFSA at the discount brokerage.  Her investment plan remains wonderfully simple.  But there are distractions ready to push her off this plan for easy success.

All the savvy thirty-somethings are talking about dividend stocks.

Most dividend investors are poorly diversified, but it’s possible to own enough dividend stocks to be properly diversified.  Does Jill really want to spend her time poring over company financial statements to choose a large number of dividend stocks?  Some people like that sort of thing.  Jill doesn’t.  She’s better off with VEQT.

Now that Jill’s savings are growing, surely she’s ready for a more sophisticated investment strategy.

Just about everyone who tries more complicated strategies won’t do as well as just owning VEQT.  Jill is best off just sticking with her simple plan.  She’s not keeping it simple because she’s not capable of handling something more complex.  It’s just that there’s no guarantee that a more complex strategy will perform better, and she’s not interested in doing the necessary work.  Jill used to be annoyed at people with more complex strategies because it made her feel dumb to have such a simple plan.  But now she just wishes these people well; she knows she has a smart strategy no matter what it sounds like to others.

Buying a home

Jill decides to buy a home in the next couple of years.  The cash she has in her savings account isn’t enough for a down payment; she plans to use all of her investments in her discount brokerage TFSA as well as $35,000 of her RRSP investments through the home buyer’s plan.

Suddenly, money that she didn’t plan to use for at least 5 years has become money she wants to use sooner.  So, she sells the VEQT in her TFSA, and sells $35,000 of the VEQT in her RRSP.  This protects her home-buying plans in case VEQT’s price suddenly falls between now and when she buys her new home.

Jill still wants to earn good interest on her cash, so she checks out the options for cash interest at her discount brokerage.  Unfortunately, the interest rates are not nearly as good as what some small banks offer in their savings accounts.  So, she opens an RRSP at her small bank, and arranges for TFSA-to-TFSA and RRSP-to-RRSP transfers from her discount brokerage to her accounts at the small bank.  She’s careful to make sure she isn’t making withdrawals, but direct transfers.

From now until she buys the home, she directs all new TFSA savings to cash in her small bank TFSA to build her down payment. But she won’t use all her cash on hand as a down payment, because there will inevitably be expenses with a new home.

After buying the home, she plans to direct new savings to paying down the mortgage.  She’ll still participate in her group RRSP, but she won’t contribute to her TFSA or self-directed RRSP for a while.  She wants to get the mortgage down to a less scary level in case mortgage interest rates rise.  Once the mortgage is somewhat tamed, she’ll resume adding to her TFSA and self-directed RRSP, and she’ll invest in VEQT.

New distractions as well as the old ones are ready to push Jill away from her simple plan.

Isn’t it better to invest than pay off the mortgage while rates are so low?

This is good reasoning to a point.  It comes down to how stretched you are.  A quick test is to calculate what your mortgage payment would be if interest rates rise 5 percentage points.  If this payment would cause you serious problems, you’re probably best to pay extra on the mortgage for a while.  With her life ticking along so well, Jill sees no need to add risk.  Once the mortgage principal is down to a more comfortable level, she’ll resume adding to her investments.

Surely it’s finally time for a more sophisticated investment strategy.

Jill’s simple investment strategy is working well, and she’s busy with her new home, her job, and the rest of her life.  There’s no reason to believe a different strategy will work better for Jill.  As we’ll see later, there are ways for Jill to cut her investment costs, but her portfolio still isn’t large enough for the reduced costs to give significant savings, and she’s definitely not interested in doing the extra work necessary to get these savings.

Approaching retirement

Thoughts of retirement are entering Jill’s mind, but she’s not ready to stop working yet.  She’s amazed at how seemingly modest monthly savings have turned into large balances in her investment accounts.  She’s married now, and together with her husband they have 8 investment accounts including non-registered (taxable) accounts, TFSAs, RRSPs, a spousal RRSP, and a LIRA.  Across all these accounts, all they invest in is VEQT.  It couldn’t be simpler for DIY investors.

Jill still has a regular non-registered high-interest savings account (HISA); her only TFSA now (at the discount brokerage) holds only VEQT.  The HISA still holds cash she thinks she might need in less than 5 years.  This includes emergency savings and cash for anything expensive she anticipates buying.  Over the years she considered investing some of this cash in GICs, bonds, and other possibilities, but the interest rate on her account remained competitive with these other options, and having the cash ready at a moment’s notice is comforting.

Jill is starting to think about building her fixed-income investments anticipating retiring in less than 5 years.  This fixed-income allocation will include her HISA and some short-term bonds; she’s not interested in taking on the inflation risk and interest-rate risk of long-term bonds.  She chose the ETF called VSB for her bonds.  She plans to build her fixed income holdings slowly until it’s 5 times her annual spending by the time she retires.  All her stock holdings will remain in VEQT.

The family’s stock portfolio is now roughly a million dollars.  Even VEQT’s low 0.25% management expense ratio (MER) costs Jill $2500 per year.  She pays another cost as well: foreign withholding taxes (FWT) on the dividends of non-Canadian stocks.  This impact of this tax burden varies between registered and non-registered accounts and totals $2000 per year for Jill.

It’s possible to reduce Jill’s MER and FWT costs.  For example, there are U.S.-based ETFs that have lower MERs, and when they’re held in RRSPs/RRIFs, the U.S. doesn’t withhold dividend taxes.  Justin Bender has a portfolio he calls Plaid that cuts costs compared to VEQT.  My personal portfolio cuts MER and FWT costs by 0.29% per year compared to VEQT.  Benjamin Felix takes a different path to higher promised returns with his Five Factor Model Portfolio that seeks to give investors higher returns through exposure to known investment factors.  What all three portfolios have in common is their increased complexity compared to Jill’s plan.

So why shouldn’t Jill try to cut costs or get higher returns?  $4500 per year isn’t cheap.  Robb Engen made a compelling case for sticking with a simpler portfolio based on a single asset-allocation ETF, such as VEQT.  I’ll save further comment for the first distraction Jill faces below.

C’mon, don’t be a chump.  It can’t be that hard to run a portfolio that saves costs or boosts returns.

Running a portfolio with multiple ETFs and many accounts is a lot more work than it appears to be.  The complexity apparent in theory grows tenfold in practice.  Every decision we have to make is another opportunity for the recency bias baked into our brains to cause us to buy high or sell low.  Unless Jill would enjoy building a spreadsheet to automate a complex portfolio, it just isn’t worth her time and effort to try to save some of the $4500 she pays per year.  Many people who try to run a more complex portfolio will end up making costly mistakes that outstrip the savings they’re trying to achieve.  I run a somewhat complex portfolio with my big spreadsheet and scripts to send email alerts, but I tell my sons to just buy VEQT.

Why not pick your own stocks and do away with MER costs altogether?

For all but the best stock-picking professionals in the world, people are essentially picking stocks randomly.  Devoting countless hours to researching stocks ends up being no better than throwing darts.  To be adequately diversified, you must own many stocks.  The risks of owning too few stocks can be more costly than the small MER on VEQT.  Jill isn’t interested in devoting her life to researching stocks for what could turn out to be worse results than owning VEQT.

What about gold as an inflation hedge, or real estate for more diversification?

Unlike businesses, gold produces no earnings.  In fact, it costs money to guard gold.  Over the long term, gold returns have been dismal compared to stocks.  The array of businesses held by VEQT have vast real estate holdings.  Jill doesn’t need to buy more real estate.  There will always be investments that come with some sort of story, but Jill doesn’t need them.  She doesn’t need hedge funds, commodities, or IPOs either.


Jill’s thoughts have turned to how best to spend from her retirement savings.  She is maintaining her fixed income allocation in a HISA and the ETF VSB for a total of 5 years’ worth of her family’s spending.  The rest of her portfolio in all discount brokerage accounts is still in VEQT.  She spends from her HISA, and each year she sells some VEQT to replenish her fixed income allocation.

She has decided what percentage of her portfolio she can safely spend each year.  This percentage rises with her age, similar to mandatory RRIF withdrawal percentages.  In the years before she starts collecting CPP and OAS, she actually spends more so that she can live as well now as she’ll live after getting these government pensions.

Jill considered buying an annuity for more income certainty, but the lack of inflation protection in available annuities put her off.  She might consider buying an annuity later in her retirement when inflation will have fewer years to erode fixed payments.

Jill has been following her plan successfully for some time now, but she still faces distractions.

Stocks are sure to crash soon.  Jill has to protect her portfolio now that she’s no longer earning an income.

People are always making scary predictions.  The truth is that nobody knows when stocks will crash or when they’ll shoot up.  Jill has her fixed income allocation to buffer stock volatility.  If a stock market crash would devastate her finances, she probably should have begun retirement with a fixed-income allocation of more than 5 years of spending.  Selling stocks when she’s nervous and buying stocks when she’s comfortable is unlikely to work out well.

An insurance guy has this great variable annuity with guaranteed minimum lifetime withdrawals.  Your money gets invested inside the annuity and if it performs well you get higher payments.  But you always have your guaranteed minimum payments.

Insurance companies invent lots of products that make it seem like you can have your cake and eat it too.  Somehow, rising markets will make you rich, and with falling markets you get your guaranteed income.  To complete the magic, the insurance guy gets a fat commission for selling the variable annuity, and the insurance company makes money too.  All the children in Lake Wobegon are above average.  

Reality isn’t so wonderful.  Commonly, the fees applied to your investments within the variable annuity are very high, which significantly reduces the odds that they’ll perform well enough to give you higher payments.  Further, the guaranteed income typically isn’t indexed to inflation.  Decades of inflation crush the buying power of fixed payments.  It isn’t impossible for a variable annuity to be a good deal; I’ve just never seen one.

This pre-construction condo project pays 12% interest on a second mortgage.  That’s way better than the pitiful 1.5% interest on a HISA.

This is another example of an investment few people really understand.  If the borrower was likely to make the payments, someone who understands this business well would already have invested.  Whoever is selling this to Jill is hoping for a fat commission.  It’s dangerous to chase higher yield on money that’s supposed to be safe.


Jill’s plan was simple and she followed it successfully.  Her most difficult challenges were avoiding distractions and sticking with her plan.  There are many other plans that can work out well too, but constantly switching to shiny new plans won’t work out well.  More complex plans can seem sophisticated, but most people who follow such paths will get worse results than Jill got.

Tuesday, March 30, 2021

Safety-First Retirement Planning

An alternative to managing a portfolio of stocks and bonds through retirement is to use insurance company products such as annuities and whole life insurance to get more predictable outcomes.  Mixed approaches are possible as well.  Wade Pfau, a professor of retirement income, makes the case for income guarantees in his book Safety-First Retirement Planning.  The book is a dry read, but it’s thorough in its explanation of insurance company products.  Pfau’s intent is to persuade the reader that annuities and whole life insurance can help build a better retirement, but the book had the opposite effect on me.

Any reader looking for a deep understanding of income annuities, variable annuities, fixed-index annuities, and whole life insurance along with the vast array of bells and whistles available on these products will find it in this book.  Income annuities are simple enough, but the other insurance products have so many small variants that it seems impossible to compare the products of different insurance companies without a retirement researcher at your side.  “Prospectuses about variable annuities can be hundreds of pages long.”

With so much variation in available products, you may wonder how the author is able to make any general claims about how to use these products well.  The answer is that he made many simplifying assumptions.  The biggest assumption is that the insurance products are “competitively priced.”  This assumption is so at odds with some practices in the real world that the chapters on variable annuities and fixed index annuities begin with disclaimers.

Pfau limits his discussion to “good” variable annuities whose “fees are not excessive” and whose complexity is not used to “hide a lack of competitiveness in the pricing.”  He limits his discussion of fixed-index annuities similarly and further assumes they are “not being sold by an unscrupulous financial advisor only to generate a commission.”

My personal experience with variable annuities and fixed index annuities is limited, but I have waded through the rules for a few of them.  In every case, it was clear to me that the products were not “good.”  They were overpriced and their income guarantees were highly vulnerable to inflation, even if inflation stays at low levels.  I’m not optimistic about finding a “good” variable annuity or fixed index annuity of the theoretical types described in this book.

The only insurance product I’ve ever seriously considered is an income annuity indexed to the Consumer Price Index (CPI), but these seem not to be available in Canada.  I might consider an income annuity without inflation protection late in life when I’m less concerned about inflation uncertainty over decades.  The author hasn’t given me a reason to change my mind on these points.  But this isn’t so much a problem with the book as it is a sign that Pfau’s presentation is thorough and unbiased.

One of the side effects of considering theoretical versions of insurance products showed itself in one example comparing a simple income annuity to managing a portfolio of stocks and bonds.  The conclusion was that the annuity allowed higher retirement spending, but this conclusion depends on being able to buy an annuity for the price Pfau calculates.  I don’t know if that is possible in the real world.

For anyone considering whole life insurance, Pfau makes it clear that you should think of it as a replacement for the bonds in your portfolio.  Further, the main value of whole life insurance is the tax deferral, so it makes most sense for someone who has already maxed out tax-advantaged retirement accounts, but still wants more fixed-income investments.

My expectation before reading this book was that it would cover how to decide on portfolio allocation to stocks, bonds, and annuities based on annuity prices and stock and bond future return expectations.  However, the final chapters on pulling everything together didn’t really cover this.  Any rational means of deciding how much to spend on an annuity would be sensitive to the annuity’s price.

Pfau admits that his “discussion has been based on a simplified model in which future inflation is fixed and known.  There was no possibility for unexpectedly high inflation.”  This is why his analyses don’t call for using annuities whose income guarantees are CPI-adjusted.  But in the real world, decades of inflation uncertainty make annuities with fixed income guarantees much riskier than they appear.

The author attempts to partially justify the lack of focus on inflation-protected income guarantees by observing that “inflation-adjusted spending for many retirees can be expected to decline with age.”  The implication of observing that the average retiree spends less with age is that we should plan our retirement assuming we’ll do the same.  This is like observing that the average adult carries a few thousand dollars in credit card debt, so we should all do the same.  Why should we emulate the behaviour of the average retiree when we know that some retirees overspend early and later have to cut spending?

Overall, this book gives a thorough, unbiased explanation of retirement insurance products.  I’m left with a much better understanding of annuities and life insurance.  In theory, retirees could benefit from certain types of fairly priced annuities and life insurance.  In practice, what I learned only solidified my reasons for avoiding most insurance company retirement products.

Monday, March 29, 2021

Buy Now Pay Later Apps

If your financial life is going well, you’ve probably never used a Buy Now Pay Later (BNPL) app and may not have ever heard of them.  Here I look at what return they make on their money, and who pays them this return.

For a good explanation of BNPL apps, see Preet Banerjee’s video where he covers what they are and why you should avoid them.  In a typical case, if you are online buying a $100 item, you might encounter an offer to pay $25 now, and then $25 more in 2, 4, and 6 weeks.  From your point of view, this looks like an interest-free loan, but the BNPL company might only pay the retailer $94.  So, the BNPL company makes $6 over 6 weeks.

BNPL Returns

For this example, Preet calculates the BNPL company’s return as $6 on $94 invested over 6 weeks (42 days).  This works out to an annual uncompounded rate of (6/94)*(365/42) = 55%.

However, the BNPL company didn’t wait 6 weeks for the whole $100.  In fact, it got $25 of this money right away.  So, we could say that their investment was only $69 for 6 weeks.  This works out to an annual uncompounded rate of (6/69)*(365/42) = 76%.

But this still doesn’t account for the fact that the BNPL company got $25 in 2 weeks and another $25 in 4 weeks.  If we calculate the internal rate of return on investing $69 to get back $25 in 2, 4, and 6 weeks, it works out to 4.29% every 2 weeks.  Compounding this annually gives a whopping 199%!  This assumes that all returns get reinvested.

But what if we want to calculate the uncompounded return where the BNPL company makes a single investment and never reinvests returns?  The easiest way to think of this is to imagine the BNPL company entering into a series of $100 purchases where they invest $69 on each purchase to get back $25 in 2, 4, and 6 weeks. We will treat $2 from each payment as profit, and the remaining $23 as a return of the BNPL company’s working capital.

Suppose the BNPL company starts with $138 to invest.  They immediately invest $69 in one online purchase, leaving $69 of their capital uninvested.  Two weeks later, they get back $23 of their capital (and a $2 return), and they invest another $69 in a purchase, leaving them $23 of capital.  Two more weeks later, they get back $46 of their capital (and a $4 return), and they invest another $69 in another purchase (with no leftover capital).

From here on, every two weeks the BNPL company gets back $69 of their capital to invest in another purchase, and they get a $6 return.  They can continue this indefinitely having 3 purchases on the go at all times, all with just the initial $138 of working capital.  If we constrain the BNPL company to winding up all transactions by the end of the year, their total return on $138 is 26 payments of $2, $4, $6, $6, $6, …, $6, $6, $6, $4, $2.  This is a total return of $144, and an annual uncompounded return of 144/138 = 104%.

If we just focus on the steady-state condition where the BNPL company makes $6 every 2 weeks on a $138 investment, the uncompounded return is (6/138)*(365/14) = 113%.

So, which return value is correct?  I’d say the uncompounded return is 113%, and the compounded return is 199%.  Either way, this is well over the usury level of 60%.  However, it’s not at all clear who, if anyone, is being charged this interest.  The deal looks interest free to the consumer, and it looks like a 6% fee to the retailer.

Who Pays for BNPL Returns?

If we look at the retailer and customer as a single entity, they accept $94 from the BNPL company and return $100 spread over 6 weeks.  So the retailer and customer as a combined borrower are paying usurious interest rates in this example.  But it’s not easy to define how they are treated as individuals.

Ultimately, the high cost of the BNPL “service” has to be paid by some combination of consumers and retailers.  Who pays depends on how much the retailer is able to increase prices to cover this cost.  Sadly, it’s not just the consumers who use BNPL apps who pay this price.  When retailers raise prices, everyone pays more no matter how they pay.

Friday, March 26, 2021

Short Takes: CRA Accounts, Asset-Allocation ETFs, and more

I enjoyed Nassim Taleb’s take on Bitcoin (below).  He doesn’t hold back.  There’s a huge difference between pricing Tesla cars in Bitcoin vs. asking for the Bitcoin equivalent of the car’s price in U.S. dollars.  He also says those who believe Bitcoin is a store of value are “ignorant.”  In a different tweet, he says that if you return your car, Tesla has the option to refund you the Bitcoin you paid or the dollar equivalent Bitcoin amount (whichever is less, presumably).  This doesn’t sound like much of a commitment to Bitcoin by Tesla.

Here are my posts for the past two weeks:

Pre-Construction Deals Create a Dishonesty Option

How to Account for High Stock Prices in Retirement Spending

TurboTax Gets Medical Expense Optimization Wrong

Mutual Fund Deferred Sales Charges are Designed to Hide Bad News

How Much Savings Do You Need to Delay Starting CPP and OAS Pensions?

Here are some short takes and some weekend reading:

Rishi Maharaj has a sensible take on the security problems with online CRA accounts that have left nearly a million Canadians locked out.  “The CRA should be commended for surveilling which usernames and passwords are being sold by fraudsters and proactively freezing those accounts. But that’s where the plaudits end.”

Boomer and Echo answers reader questions about asset allocation ETFs and their fees.

Ben Felix explains the elements of good financial advice on the latest Rational Reminder podcast.  Spoiler: it’s not picking stocks or investment managers.  As usual, his ideas are well thought out, but the hard part is quantifying the value of the advice, which will be different for each investor.  Even if Ben’s advice is superior to your own choices in more ways than just portfolio size, the question is whether his advice is enough better to overcome its cost.

Wednesday, March 24, 2021

How Much Savings Do You Need to Delay Starting CPP and OAS Pensions?

Canadians who take their CPP at age 60 instead of 70 “can expect to lose over $100,000 of secure lifetime income, in today's dollars, over the course of their retirement,” according to Dr. Bonnie-Jeanne MacDonald in research released by the National Institute on Ageing (NIA) and the FP Canada Research Foundation.  However, those who retire before 70 need savings to tide them over until their larger CPP pensions start if they want to live at least as well in their 60s as they do later in retirement.  Here we look at the amount of savings required by a retired 60-year old to be able to delay CPP and OAS pensions.

We’re used to thinking of CPP and OAS pensions as just a few hundred dollars per month, but a 70-year old couple just starting to receive maximum CPP and OAS pensions (but not any of the new expanded CPP) would get $61,100 per year, rising with inflation for the rest of their lives.  If the same couple were 65 they’d only get $43,700 per year.  If this 65-year old couple had taken CPP at 60, their combined CPP and OAS would be $32,700 per year now.  The incentive for delaying the start of CPP and OAS is strong.

We can think of the savings needed to delay the start of CPP and OAS pensions as the price of buying larger inflation-indexed government pensions.  This price is an absolute bargain compared to the cost of buying an annuity from an insurance company.  Those in good health but worried about “losing” if they delay pensions and die young can focus on the positives.  Delaying pensions allows retirees to spend their savings confidently during their 60s knowing that their old age is secure.  Taking small pensions early can leave retirees penny-pinching in their 60s worried about their savings running out in old age.

The table below shows the amount of savings a retired 60-year old requires to delay starting CPP.  This table is based on a number of assumptions:

  1. The current maximum age 65 CPP pension is $1203.75 per month.  Before you take your CPP pension, it grows based on national wage growth as well as an actuarial formula, but after you take it, it grows with “regular” inflation, the Consumer Price Index (CPI).  We assume wage growth will exceed CPI growth by 0.75% per year.
  2. We assume the retiree is entitled to the maximum CPP pension.  Those with smaller CPP entitlements can scale down the savings amounts.  For example, someone expecting only 50% of the maximum CPP pension can cut the savings amounts in half.
  3. We assume the retiree holds savings in an RRSP/RRIF so that withdrawals will be taxed in the same way that CPP pensions are taxed.  Retirees using savings in non-registered accounts won’t need to save as much because they only need to match the after-tax amount of CPP pensions.
  4. The retiree is able to earn enough on savings to keep up with inflation.  (Online banks offer savings account rates that put the big banks to shame.)  The monthly pension amounts in the table are inflation-adjusted; the retiree’s savings will grow to cover the actual CPP pension payments.
  5. We assume the retiree doesn’t have a workplace pension whose bridge benefits end at age 65.  This bridge benefit replaces some of the savings needed to permit delaying CPP and OAS.
CPP % of  Inflation-Adjusted  Months of Savings
 Start   Age 65 CPP  Monthly CPP Spending from  Needed at 
Age Pension Pension  Personal Savings  Age 60
60 64.0% $770 0 0
61 71.2% $863 12 $10,400
62 78.4% $958 24 $23,000
63 85.6% $1054 36 $37,900
64 92.8% $1151 48 $55,200
65 100.0% $1250 60 $75,000
66 108.4% $1365 72 $98,300
67 116.8% $1481 84 $124,400
68 125.2% $1600 96 $153,600
69 133.6% $1720 108 $185,800
70 142.0% $1842 120 $221,000

Unlike CPP, you can’t start your OAS pension until you’re at least 65.  But you can delay it until you’re 70 to get larger payments.  The table below shows the amount of savings a retired 60-year old requires to delay starting OAS.  The table is based on a number of assumptions:

  1. The current maximum age 65 OAS pension is $615.37 per month.
  2. We assume the retiree is entitled to the maximum OAS pension by living in Canada for at least 40 out of 47 years from age 18 to 65.
  3. We assume the retiree won’t want to live poor before age 65, which means spending from savings from age 60 to 64 to make up for not receiving OAS.
  4. We assume the retiree holds savings in an RRSP/RRIF so that withdrawals will be taxed in the same way that OAS pensions are taxed.  Retirees using savings in non-registered accounts won’t need to save as much because they only need to match the after-tax amount of OAS pensions.
  5. The retiree is able to earn enough on savings to keep up with inflation.  The monthly pension amounts in the table are inflation-adjusted; the retiree’s savings will grow to cover the actual OAS pension size.
  6. We assume the retiree doesn’t have a complex tax reason (e.g., OAS clawback) that makes it better to take OAS early.

OAS % of  Inflation-Adjusted  Months of Savings
 Start  Age 65 Monthly OAS Spending from  Needed at 
Age  OAS Pension  Pension  Personal Savings  Age 60
65 100.0% $615 60 $36,900
66 107.2% $660 72 $47,500
67 114.4% $704 84 $59,100
68 121.6% $748 96 $71,800
69 128.8% $793 108 $85,600
70 136.0% $837 120 $100,400

An example of how to use these tables

The Harts are 60 years old and recently retired.  They have $400,000 combined in their RRSPs.  Their CPP contribution histories entitle them to a 70% CPP pension each, and they’re both entitled to a full OAS pension.  They’ve decided to hold back $100,000 of their savings as a reserve or emergency fund, but are willing to spend the remaining $300,000 during their 60s in exchange for much larger guaranteed, inflation-indexed CPP and OAS pensions for the rest of their lives.  They’re tempted to reserve even more of their savings, but this would mean lower guaranteed income.

The Harts don’t want to live poor now just so they can have more income later.  So, we first go to the age 65 row of the OAS table to see that they need to spend $36,900 each from 60-64 to make up for OAS not starting until 65.  This leaves $226,200 of their savings to “buy” more CPP.  We began with OAS because starting OAS at 60 isn’t permitted.  We then focus on CPP because delaying CPP boosts pensions more than delaying OAS.  Only if we can delay CPP to 70 do we go back to the OAS table to choose a later OAS start age.

Because their combined CPP entitlement is 140% of a single maximum CPP pension, we divide $226,200 by 1.4, to get $161,600, and look up this amount in the right column of the CPP table.  We find that the Harts can delay CPP until they’re about 68.  So, the plan is to spend one-eighth of the $226,200 each year for 8 years (so CPP can start at 68) plus an extra one-fifth of $73,800 each year for the first 5 years (because OAS will start at 65).

So the Harts now have a plan.  But their lives might not play out exactly as they expect.  As they approach 65, they will apply for OAS, but they might apply for CPP before or after age 68, depending on how much they spend in the coming years, their portfolio returns, and changes to their needs for a savings reserve or emergency fund.  They will be guided by watching their RRSP balance to make sure it doesn’t drop below a sensible reserve amount.

The maximum savings required by a 60-year old to delay pensions to age 70 is $221,000 for CPP and $100,400 for OAS, for a total of $321,400.  This doubles to $642,800 for couples. Those with at least this much saved are able to maximize guaranteed inflation-indexed government pensions that will last as long as they live.  Those whose CPP or OAS pensions are less than the maximum won’t need to have as much saved.  Those who retire before age 60 will need to use more savings to tide them over until CPP and OAS pensions begin.

Although Canadians have many reasons for taking their CPP and OAS pensions early, the only reasons that stand up well to scrutiny are very poor health and lack of savings.  Here we showed how much retirees must have saved to tide them over to the start of enlarged CPP and OAS pensions.

Monday, March 22, 2021

Mutual Fund Deferred Sales Charges are Designed to Hide Bad News

Mutual fund investors caught by deferred sales charges (DSCs) understand their downside.  They’d like to sell their funds but face penalties as high as 7% if they sell.  DSCs are set to be banned across Canada (but only restricted in Ontario) in mid-2022.  Until then, mutual fund salespeople masquerading as financial advisors can still sell funds with DSCs to unsuspecting investors.

Before DSCs existed, it was common for advisors who sold mutual funds to get a “front-end load,” which is a fancy term for giving some of an investor’s money to the advisor or the advisor’s employer.  So, an investor might invest $50,000 with an advisor, but the first account statement might show only $47,500.  The missing $2500 was a 5% front-end load offered as an incentive to the advisor to hunt for mutual fund buyers.

Not surprisingly, investors didn’t like to see a big chunk of their savings disappear like this.  Mutual funds had a problem.  They needed to give commissions to advisors so they would sell mutual funds, but investors didn’t like to see some of their money disappear.  The solution to this dilemma came in two steps.

Raising Annual Fees

Mutual funds charge annual fees to investors called the Management Expense Ratio (MER).  MERs are expressed as a percentage of invested assets, and while they seem small, they build up to intolerable levels over decades.  Many mutual fund investors don’t know about MERs and don’t notice their corrosive effects.

One way to cover the cost of advisor commissions is to simply raise a fund’s MER.  This works well when investors stay for the long term.  When investors stay longer than 5 years, a one percentage point  increase in the MER covers a 5% up-front advisor commission.

But what happens when an investor sells out of the fund after less than 5 years?  In this case, the mutual fund can’t recover the advisor commission.  Even, worse, advisors would have an incentive to move investor money frequently from fund to fund to collect more commissions, and investors wouldn’t mind because it wouldn’t cost them anything.

Deferred Sales Charges (DSCs)

Someone had the bright idea to charge investors penalties when they leave a fund too soon.  Today, it’s common for DSC funds to charge investors as much as a 7% penalty for withdrawing their money in the first year.  This penalty typically declines each year until it’s gone after investor money has been in a fund for 7 years.

So, investors end up paying advisor commissions one way or the other.  Either the investor stays in the fund for a long time paying high MERs, or the investor leaves early and pays the deferred sales charge.  Advisors still have an incentive to move investors’ money from fund to fund to generate more commissions (called “churning”), but many investors would notice the hefty DSC charges.

Mutual funds and advisors often tell potential investors that DSCs are an incentive for investors to focus on the long-term, but the truth is that DSCs are a way to pay advisors to sell mutual funds in a way that is invisible to most investors.  This magic trick of hiding hefty advisor commissions gets advisors through the early stages of the relationship with a new client.  Problems don’t appear until the client tries to leave.

It’s not a stretch to say that the introduction of DSCs led to the mutual fund explosion that started around 1990 in Canada.  Once mutual fund fees were pushed further from investors’ view, sales took off.


So, if an advisor is trying to sell you a DSC mutual fund, you’re being asked to accept high annual fees for as long as you own the fund, and if you try to sell early, you’ll get hit with additional fees.  It’s not hard to see why this might not be in your best interests.

Thursday, March 18, 2021

TurboTax Gets Medical Expense Optimization Wrong

One of my family members often helps her friends file their income taxes with TurboTax.  For a couple she helped (let’s call them the Greens), she entered their medical expenses the way she thought was best.  Then TurboTax offered to “optimize” the medical expenses.  So, she tried it.  The result was that the Greens owed almost $2000 more in taxes.  So much for optimization.

Optimizing medical expenses is surprisingly tricky.  You get to decide which partner in a couple makes the claim.  The Greens have unusually large medical claims this year.  When Mr. Green claims them, the total taxes owing for both of them is nearly $2000 less than when Mrs. Green claims them.  But TurboTax insists that Mrs. Green should claim them.  What went wrong?

The answer begins with how medical expenses affect your taxes.  First, your claim is reduced by 3% of your net income, but this reduction is capped at $2397 (in 2020) for higher earners.  So, if both Mr. and Mrs. Green had high incomes, it wouldn’t matter much who claims the medical expenses, because they would each get the same increase in non-refundable tax credits, and the tax reduction you get from non-refundable tax credits is a fixed percentage.

However, the $2397 cap on the medical expense reduction isn’t relevant to the Greens.  So, their reduction is 3% of the net income of whoever makes the medical claim.  So, it would seem that it’s better for the lower-income partner to make the claim.  This appears to be what TurboTax did because Mrs. Green’s net income is a few thousand less than Mr. Green’s.

The problem is that Mrs. Green wouldn’t owe much tax without the medical claim.  They’re called “non-refundable” tax credits because they can’t cause your total tax owing for the year to go below zero.  So, if Mrs. Green makes the medical claim, she gets more non-refundable tax credits than Mr. Green would get, but this doesn’t help because her taxes only go down very modestly.

It’s better for Mr. Green to make the medical claim in this case.  But the fun doesn’t end there.  It turns out that the medical claim is so large that much of it is wasted by having Mr. Green claim it all.  They could split the claim, but this leads to two separate 3% of net income deductions, and it wouldn’t help Mrs. Green much anyway because she is already paying very little tax.

It turns out the best answer is to have Mr. Green claim just enough of the medical expenses to reduce his taxes owing to zero.  Then they can use the rest of the medical claims next year.  The rule is that you can claim medical expenses for any 12-month period that ends in 2020.  So, Mr. Green should choose an end date that includes just the right amount of medical expenses to eliminate any tax he owes for this year.  Then the Greens can use the remaining medical expenses next year.

All of this is very specific to the Greens’ particular situation.  The important thing is to understand how the rules work to be able to optimize other situations.  Deciding how to claim medical expenses is tricky and, apparently, TurboTax doesn’t help.

Tuesday, March 16, 2021

How to Account for High Stock Prices in Retirement Spending

I have a spreadsheet that calculates how much I can spend each month during my retirement.  However, lately I’ve felt that I really should back off somewhat from this amount because stock prices are so high.  After all, it doesn’t make sense to spend lavishly now and cut way back after a stock market crash.  Here I describe what I’ve done to account for high stock prices.

My spreadsheet estimates my safe monthly after-tax spending amount, rising with inflation, that would consume all my savings by age 100.  It assumes that total stock returns are 4% above inflation each year, before taxes and other portfolio expenses.  The spreadsheet calculates this spending amount daily as I age and my portfolio level changes (not that I need to check it this often).  I chose a 4% real stock return because it is a little lower than the historical long-term average.  This provides a modest buffer in case future returns are below the historical average.

Although I’m able to reduce my spending by quite a bit if stocks crash, I’ve had the feeling lately that my planning may be too optimistic.  This left me not fully trusting my spending figure, which defeats its purpose.

The question was what I should do about this situation.  Some people are calling for a market crash and are selling all their stocks.  I don’t engage in this type of market timing.  I’m not going to change the way I invest; I just want a more realistic idea of how much I can safely spend each month.

As I write this, Robert Shiller’s well-known Cyclically-Adjusted Price-Earnings (CAPE) ratio sits at about 35.  The only time since the 1870s when it’s been higher was around the year 2000 dot-com boom when it reached about 45.

What if I assume that the CAPE will decline from today’s level to, say, 20 by the time I’m 100?  This is a decline of about 43%.  For a 50-year old, this works out to about 1.1% per year (1.4% for a 60-year old).  It seems reasonable to reduce my expectation for stock returns by this calculated annual amount. This gives a steadier spending level if the CAPE comes back to earth.

Now my spreadsheet grabs the current CAPE value from a table online and calculates the annual decline that reduces the CAPE to 20 by the time I’m 100.  It then reduces the 4% real return I expect from stocks by this CAPE adjustment amount.   (If the current CAPE goes below 20, I don’t add an amount to the 4% return.)  I was surprised to discover that this change reduced my spending level by less than I expected.

This change has two positive effects.  The first is that it should make the calculated spending level in my spreadsheet less volatile.  If stocks crash, my reduced portfolio size lowers my spending level, but it also gives higher assumed future returns (because the CAPE adjustment will be lower), which raises the spending level.  My spending level will still drop after a stock market crash, just not by as much as before I changed my spreadsheet.  

More importantly, the second positive effect of this change is that I trust that I can safely spend the amount indicated on my spreadsheet.  I’ve eliminated that nagging feeling that high stock prices invalidate my calculations.

This is the biggest change I’ve made in some time to my financial plans in retirement.  I won’t predict it’s the last, but I’m feeling good right now about trusting my spreadsheet to have me spending the right amount.

Sunday, March 14, 2021

Pre-Construction Deals Create a Dishonesty Option

If you buy a pre-construction home, both you and the builder are committing to a price in advance.  This can be a good deal for both parties in that you and the builder get some certainty in the price you’ll pay.  However, once the home is built and we see which direction housing prices moved during construction, we find out whether you or the builder came out ahead on the fixed price agreed in advance.  This creates incentives for dishonesty.

If housing prices rise before construction is finished, the builder would rather cancel the deal with you and sell the home to someone else for a higher price.  In theory, the contract you have in place prevents the builder from getting out of the deal.  In practice, there are manoeuvres the builder can try to get out of the deal with you.  The more housing prices rise, the greater the builder’s incentive to break the deal.

This creates a “dishonesty option.”  For a builder prepared to get out of the deal with manoeuvres of questionable legality if there’s enough money at stake, the original deal with you looks like a financial option, similar to a stock option.  If housing prices are flat or fall, the builder just fulfills the contract with you.  But if housing prices rise sufficiently, the builder plays games to get out of the deal.  So, from the beginning, the contract with you came with a dishonesty option to get either the contracted price or more.

This is just one of the many reasons it makes sense to do business with honest people.  I’ll leave it as an exercise for the reader to decide which recent headlines inspired this article.

Friday, March 12, 2021

Short Takes: Bleak Future in Fixed Income, SPACs, and more

I got interested in a math problem and haven’t written anything about money lately.  A researcher thought there was a mistake in a 50-year old paper about trying to choose the largest number in a sequence, but it turns out the old paper was right, and the researcher was considering a subtly different problem.  Retirement has allowed me to indulge obsessions like this now and then.

Here are some short takes and some weekend reading:

Warren Buffett’s annual letter to shareholders is out.  He says “bonds are not the place to be these days.”  “Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.”

Tom Bradley at Steadyhand explains why the odds with SPACs are stacked against the individual investor.  He also had an interesting take on why Canadians’ net worth isn’t rising as much as it seems.

In a recent Rational Reminder podcast, Ben Felix explains some interesting ideas for retirement simulations to capture serial correlations in stock returns.   Retirement simulators test the likelihood that a particular financial plan succeeds.  Few such retirement simulators take into account the fact that long-term returns tend to be lower starting from high stock prices.  Ben describes a method of changing the expected stock return for each time period based on the current CAPE (Shiller’s Cyclically Adjusted PE ratio).  If I understood correctly, the simulator would still sample from a probability distribution to choose the return for the next time period, but the mean of this distribution would be a function of the current CAPE.

Alexandra MacQueen explains the payday loan industry, including how it operates within the law.  There’s little doubt that payday loans pick the pockets of many people who are falling off the cliff to bankruptcy or a consumer proposal.  I’d like to know what proportion of payday loan customers actually use the service the way the industry claims: as a way to smooth out temporary financial problems.  Evidence for this would be the proportion of customers who pay off their payday loans and stay away from bankruptcy or a consumer proposal for, say, a year.

John DeGoey makes a good point about lowering our return expectations for the coming decade.  Some may take this to mean that it’s time to sell in anticipation of a market crash.  I don’t do this.  I just use lower future returns when deciding how much to save (pre-retirement) or spend (post-retirement).

Canadian Couch Potato takes a look under the hood of Horizons One-Ticket ETFs.  One thing that got my attention is the costs baked into the trading expense ratio:  “the three one-ticket ETFs reported TERs between 0.15% and 0.18%, pushing their overall costs to 0.29% to 0.34%.”  Another concern I have is the risks with the swap structure.  Even if we only expect a once-in-a-century 10% loss, this amounts to a 0.1% annual cost.

Preet Banerjee interviews Alyssa Davies to discuss how couples can talk about money.  Preet revealed that he’s going to be a stay-at-home dad.

The Blunt Bean Counter explains how to claim your home office on your 2020 tax return.