What Now? (October 13,2008)

What Now? (October 13,2008)

In a Nutshell

The impact of the recent market drop must be assessed on our financial health and corrective action may be required:

-review current annual spending in detail, and set budget for next near

-estimate expected “must” and “want” expenditures in retirement

-identify the known (secure) pension sources of income

-calculate investments required to secure “must” expenditures and those required for “want’ expenditures

-perform a simple stress test: if you can tolerate a further 50% drop in the value of the equities in your portfolio, and still be able to cover the “musts” and “wants” then you are in a very good financial shape. Otherwise, you should be thinking of possible additional action (working longer or part-time, saving more, rebalancing portfolio, resetting risk tolerance and spending less)

Taking Stock

You, just like me, must be asking yourself: What now. With all this carnage in the markets, no doubt this is very painful to watch and inevitably to have to contemplate its impact on our retirement lifestyle. This is a Black Swan event; Monte Carlo simulations based on historical return statistics (averages and standard deviations) would not have predicted the recent rapid changes in the markets.

Let’s look at the markets as of the Canadian Thanksgiving and U.S Columbus Day weekend (market proxies are shown in brackets): Canadian (e.g. XIU) and US (e.g. VTI) markets are down from recent peak by about 40%, international markets (EFA, EEM) are down about 50%, and some emerging markets like India (IFN) and China/Hong Kong (TDF) by 60-70% (all in U.S. dollars except XIU in Canadian). There are also currency impacts to factor in, like the Canadian U.S. currency exchange; if you are measuring your portfolio in Canadian dollars then you got an unexpected kicker from its recent deterioration. Commodities have not done well either compared to their recent peaks. Securitized gold is only down about 15% from its peak; physical gold bullion and coins are apparently selling at a significant premium (people must be stuffing them into their mattresses).

Depending on your asset allocation (say 50% bonds, cash and a sprinkling of alternatives like gold) and the mix of U.S., Canadian and international assets, and depending on the currency that you measure the portfolio, you may be down from the peak by anywhere about 15-25% (or even more if you had a significantly higher equity allocation). This is very painful, especially if you are already retired, but if the asset mix (strategic asset allocation) was consistent with your risk tolerance you’re likely still ‘OK’!

But each day is a “new day” and as the saying goes, “We are where we are!” The question we obviously should be asking ourselves is:

What now???

Selling now we just lock in our losses. However it is difficult to say how far we are from the bottom.  This is particularly painful depending how much or little of your annual spending is discretionary. We’ll get back to this. The fact is that there is no one right answer applicable to all. We have to get back to basics.

Nevertheless, agonizing over the losses is not very helpful; instead let’s step back and take stock of where we are and focus on what we can control.

Financial Plan

If you don’t have a financial plan, it’s not too late to get one. If you have one and you can’t sleep at night perhaps there was too much risk in your portfolio. Even if you had a plan, given the precipitous drop in the market, it would be advisable to revisit it, especially the risk tolerance section and checking that against the current portfolio size and asset mix (since they both likely changed with the market risk).

Spending- musts ($M) and wants ($W): before tax requirements: ($M+$W)/(1-T)

-review your past year’s spending in detail and set a detailed budget for the next 12 months

-divide expenses into ‘must have’ and ‘nice to have’ buckets. Let’s use $M for the sum of the “must” expenditures, and $W for the want expenditures. These need to be covered after-tax dollars, so if your effective tax rate is T (a little oversimplification), then they become $M/(1-T) and $W/(1-T) pre-tax dollars.

Therefore, your total pre-tax income requirement is ($M+$W)/(1-T)

Pensions- government guaranteed and DB pensions lifetime payment: $G + $DB

-government pensions are assumed as given(e.g. CPP/OAS for Canadians and Social Security for Americans, and we’ll take these as sacred/guaranteed especially since they are especially important since they are inflation indexed). Let’s call the (sum of) expected annual government pension(s) $G.

– if you have a private-sector DB pension plan and your company/sponsor is in good financial condition and likely to stay so, then pension will be paid; if your DB pension plan is significantly underfunded and the sponsor is in a difficult financial situation, then you must at least consider the worst-case scenario (plan sponsor becomes bankrupt) for the annual DB pension payout (e.g. look at published funded level, degrade it by recent deteriorated market events and adjust it for any applicable insurance protection that may be applicable to the fund). A possible starting point, for example, would be if the published funded status of the pension is 70% at last valuation, assume today it is 60% funded, i.e. that you may receive only $0.60 instead of each expected $1 of the pension. If your pension is not (fully) indexed to inflation then you’ll have to make another adjustment for that (recall that over a 30 year retirement 3% annual inflation erodes your purchasing power by 60%, so let’s say purchasing power is degraded on the average by half that or 30%, so now the $0.60 became only $0.42 in inflation indexed terms). Therefore, for each $1 expected pension, after underfunding and inflation adjustment, you might expect $0.42. Let’s call this pre-tax amount $DB. If you were a public-service employee and have a resulting additional defined benefit pension then it probably still secure and inflation protected, so can be counted at the for $1 expected when plugged into $DB. (If you have some un-indexed annuities you can handle it same as a DB pension.)

Therefore the total pre-tax pension income will be the sum of the government pensions and the DB pensions: ($G+$DB)

Required income from investments- $II=($M+$W)/(1-T) – ($G+$DB)

difference between the total pension income, ($G+$DB), and the pre-tax amount required pre-tax expenses ($M+$W)/(1-T), must be made up from investment income (let’s call the investment income $II)

Investment assets – Assume that we can safely draw 4% from a balanced portfolio, then you need invested assets ($IP) of 25x the required income ($II)

-take stock of the asset side of your balance sheet- stocks, bonds, real estate investments (excluding you home, unless you are planning to convert it into cash that you can live on) and assume that from a balanced portfolio you can draw 4% inflation adjusted a year over about 30 years without running out of assets.

Required portfolio size and breakpoints where you must start implementing changes:

So let’s look at a specific example:

T=0.25, $M=50K and $W=25K; therefore ($M+$W)/(1-T)=100K or $M/(1-T)=$66.7 for “must” and $W/(1-T)=33.3 for “want” expenditures.

$G=15K, $DB=20K ($G+$DB)=35K

Then required pre-tax income from investments, $II= 100K-35K=65K. And of the $65K, $31.7K is needed to cover the remaining “must expenditure (together with the $35K of pensions, the entire $66.7K of must expenditures) and $33.3K is desired for “want” expenditures. By multiplying by 25 (assuming 4% annual draw), we get the size of required investment portfolio ($IM+$IW)=$1,625K. This is composed by $IM=$792K (31.7×25) and $IW=$832K to cover the “must” and “want” expenditures of 31.7K and 33.3K, respectively (over and above the expected pension income)

Then there are some important breakpoints to consider. If your investment portfolio $IP is:

$IP > ($IM+$IW) then you have sufficient assets to cover “musts” and “wants”

$IM < $IP < ($IM+$IW) then you must scale down your “wants” or run the risk of exhausting your portfolio

$IM > $IP then you don’t have enough to cover even the “musts”

So, if the size of your portfolio exceeds ($IM+$IW)=$1,624K you can continue your spend rate.  If your portfolio drops below $1,624=($IM+$IW), then you must cut back on your “wants”. As the portfolio starts moving closer to $IM=$792K, the manoeuvrability room is decreasing in case of adverse events (market swoons, unanticipated major expenses). A stricter adherence to the budget would be necessary, and a more conservative investor might even explore gradually annuitizing part of the portfolio via an indexed annuity if rates are favourable.

What now???

If you are working

-if you are working, keep working at least until you investment portfolio reaches ($IM+$IW) or more; delaying retirement is the best way to deal with the current exceptional state of affairs; this may sound painful, but working longer means, not only are you adding to your assets, you are also not spending down existing assets, and your assets need to support fewer years of retirement

-increase your savings rate- this not only increases size of your investment portfolio, but it also reduces your current spend rate and thus gets you acclimatized to lower retirement spend rate

-if you are retired, you may get a part-time job to generate supplementary income

Spend rate

-analyse last year’s spending in detail and separate into “musts” and “wants”.

-reduce expenses as much as possible, and set a detailed budget for next 12 months

Financial Plan

If you don’t have one, create one. If you have one, review it for current context (e.g. has your risk tolerance changed?


– if you are working, secure sufficient cash to cover a minimum of 6-12 month of expenses

– if retired, secure sufficient cash to cover a minimum of 2 years of expenses and a further 3 years in a ladder of fixed income securities for years 3,4 and 5

-rebalance portfolio to current view of risk tolerance (strategic asset allocation); this may mean adding more equity content (in which case you may want to do it in a series of 3-4 increments)

-if assets are greater than those required to meet “musts” and “wants” ($IM+$IW), especially if one is in or near retirement, one may even choose to reduce risk in the current volatile environment (i.e. only take as much risk as needed to achieve objectives; if the expected return associated with a 35% equity content is sufficient, perhaps that would be appropriate for this individual)

Concluding Scenario Analysis- Assume another 50% drop in value of equities from here

If current investment portfolio is balanced at 50% stock and 50% bonds and cash, what is the impact of another 50% drop in stock portion? Does the total asset picture (in this case down another 25%) cross a breakpoint that requires action (e.g. drops below ($IM+$IW)? If yes, what will be the required action: you won’t be able to take that “wanted” holiday trip, or will you have to rent or sell your condo?

If the drop pushes the portfolio too close or even below $IM, what are options? Perhaps risk tolerance has changed (willingness and/or ability to take risk was reduced), then perhaps a more conservative asset allocation must be implemented.

If with this further drop of 50% from this point, you are still left with an investment portfolio ($IP) which is greater than ($IM+$IW), then you are in relatively comfortable position (i.e. spending relative to assets)


Updated October 19, 2008

P.S.  I received another suggested action at this time from a couple of independent sources, both pointing in the same direction. The message was essentially the same:

-“this is an excellent time to make changes to your portfolio, your capital losses become a asset when you realize a capital loss that can be used back 3 years and carried forward indefinitely. Many people did not want to make changes when they had unrealized capital gains, should consider it now.” (from Ken Hawkins of www.secondopinions.ca), and

– “identify and sell the losers among my investments. I almost simultaneously bought equivalent amounts of securities similar but not identical to the securities that I had sold. The result: I crystallized the capital losses for tax purposes, while I remained invested in the market.” (from Ken Kivenko of http://canadianfundwatch.com  who forwarded to me the newsletter of http://www.independentinvestor.info).


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