Hot Off the Web- December 5, 2011

Personal Finance and Investments

In the Journal of Financial Planning’s “The tyranny of compounding fees: Are mutual funds bleeding retirement accounts dry?”(The answer is absolutely…YES!) Stewart Neufeld shows that: “The financial services industry share of market returns increases with the length of investment period. For annual performance lags of 250 basis points (bps), the industry share over 10 years is about 46 percent on average; over 50 years it increases to 74 percent. Smaller degrees of underperformance increase investor shares substantially: 50-bp lags result in an average investor share of 90 percent for 10-year investment periods and 77 percent after 50 years… The author recommends that pension plan fiduciaries be required to select default investments with a management expense ratio (MER) as low as possible, ideally no greater than 10 bps. Also, financial advisers should direct client funds to similarly low-cost investment vehicles.” (This is a most damning indictment of the financial industry in the U.S., and implicitly even more damning of Canada’s higher cost financial industry. Can you imagine that such corrosive products of any other industry would not have been outlawed in civilized countries? The evidence of the damage caused by this industry is mounting and the word is spreading, and it is inevitable that eventually the right thing will be done to protect the average investor against the negative value added by the industry.)

Also on the subject of a parasitic financial industry is John Shmuel’s Financial Post article “Financial industry has become increasingly bloated: NYU Stern prof”in which he reports that U.S. bank wages and profits which ranged from 2% in 1870 to 5% in 1980 have become 9% of GDP by 2010 despite massive efficiencies brought on by adoption of IT. He concludes that unless there is some evidence found (none so far) indicating better pricing or risk-sharing in the market “the finance industry’s share of (U.S.) GDP is about 2% higher than it needs to be and this would represent an annual misallocation of resources of about $280-billion for U.S. alone.”

One of the key numbers necessary to make a credible financial plan is the assumed age of death for the purpose of the plan. In the Journal of Financial Planning’s “Mortality assumptions: Are planners getting it right?”Cheryl Krueger shines some light on current practices of planners, and differences in life expectancy ages for “Social Security” based vs. “Annuity 2000” based data; the latter being 3-4 years longer than the former. In a survey of planners it was reported that the average planning age for 65 year olds was 91.7 for males and 94 for females. (The joint life expectancy of a couple would even be longer than that of a female of same age, further increasing the safe planning age. For a 65 year old couple, a “planning age” of at least 95 would be appropriate, as there is at least a 25% probability of one of the couple living past 95.)

In the third interesting article from the latest issue of the Journal of Financial Planning entitled “Three ideas for preserving the financial security of new retirees” Mathew Greenwald, reviews growing threats facing new retirees in the current environment (lower equity returns, potential tax increases, reductions in entitlements, higher potential inflation and dismal housing markets). These new threats are in addition to the traditional retiree risks: withdrawal rate risk, sequence of returns risk and longevity risk (and inflation risk). Greenwald suggest that the plan or ‘road map’ (as he calls it) should include: “the specific asset levels clients should aim to have at each specific year of their lives—the road they must follow. Clients would be told in advance what would be required if their assets fall below that level in terms of reduced spending, possible sale of their home and downsizing, and new and more conservative investment strategies. With this approach, clients will be in a better position to monitor their financial situations and avoid overspending. They will have a specific target to shoot for and will know in advance the consequences of missing the target.” (It sounds like a very good idea that as part of the financial plan, people get advised of what contingency action will be available should assets fall below target levels.)

In the NYT’s “The 50-50 solution” Jeff Sommer discusses whether you should take any action depending on the latest economic news. He writes that “When the latest news tempts you to move your investments around, take a deep breath. Unless you need the cash soon, the best course of action may be inaction. That’s the import of a recent study by the Vanguard Group. Assuming you’ve already set up a diversified portfolio, sitting tight may make the most sense… The study, titled “Recessions and Balanced Portfolio Returns,” used the official recession dating of the National Bureau of Economic Research to compare market returns throughout the up and down phases of the business cycle from 1926 through June 2009. During expansions, the model portfolio had average real returns, factoring in inflation, of 5.6 percent, compared with 5.3 percent during recessions.” (Thanks to RD for referring the article.)

In WSJ’s “A home-insurance trap?”Leslie Scism reports that people are mistaken when they assume that home-insurance policies are all the same; however a new study “found instances where policies now differ “radically with respect to numerous important coverage provisions.”” An examples of differences is “a standard ISO policy insures against “risk of direct physical loss to property” …vs. a much more restrictive “sudden and accidental direct physical loss.” The article suggests that the only realistic option to consumers is to deal with “an experienced and reputable insurance agent to cut through the confusing language”. (No indication is given on how you find such an agent.)

David Parkinson in the Globe and Mail’s “Canada’s CIPF: The surprise winner in protecting investors”explains the differences in treatment of MF Global investors in the U.S. and Canada resulting from coverage differences under SIPC and CIPF. The Canadian CIPF covers accounts for losses up to $1,000,000 with no limit to the cash portion of the reimbursement, whereas in the U.S. SIPC covers only $500,000 per account and only $250,000 cash. In addition CIPF covers stocks, bonds, futures or currencies whereas SIPC only covers stocks and bonds.

In the Globe and Mail’s “Mutual funds: What bay Street doesn’t want you to know”Rob Carrick discusses high mutual fund fees and the limited availability of F-class funds with MERs in the 1.0-1.5% range which exclude the ‘advisor’ trailer fee of the order of 1%; thus typical Canadian equity mutual funds come with a 2-2.5% annual anchor that investors drag around. (The so called ‘low-cost’ mutual funds without trailers are still in the 1-1.5% per year range, or 3-10x the cost of a passive ETF covering the same asset class, so I still can’t figure out why investors keep buying actively managed funds when the overwhelming evidence indicates that there is no sustained value added, and after costs you will trail a passive approach. So what’s the point? Forget about mutual funds; just build your portfolio from low-cost traditional broad asset class ETFs. If you are in doubt about this conclusion, please re-read the first article discussed above in this section.)

Real Estate

The September Canadian Teranet-National Bank House Price indexwas flat MoM and up 7.4% over previous year; Toronto was up (again) at 0.5% for the month and 8.5% for the year, whereas Vancouver was flat for the month and up 10.4% for the year.

The just released September 2011 S&P Case-Shiller Home Price Indices indicates that the US “home prices did not register a significant change in the third quarter of 2011, with the U.S. National Home Price Index up by only 0.1% from its second quarter level. The national index posted an annual decline of 3.9%, an improvement over the 5.8% decline posted in the second quarter. Nationally, home prices are back to their first quarter of 2003 levels… Three cities posted new index lows in September 2011 – Atlanta, Las Vegas and Phoenix. Seventeen of the 20 cities and both Composites were down for the month. Over the last year home prices in most cities drifted lower. The plunging collapse of prices seen in 2007-2009 seems to be behind us. Any chance for a sustained recovery will probably need a stronger economy.”


Canada’s DB pension beneficiaries are eagerly waiting to hear the outcome of the Supreme Court’s take on an earlier Court of Appeals of Ontario decision which essentially indicated, according to the Blakes Bulletin on the subject entitled “Supreme Court of Canada agrees to hear Indalex Appeal”, that under the “deemed trust” concept a pension fund wind-up deficiency at time of sponsor bankruptcy has priority over other creditors and that Indalex (in this case) breached its fiduciary duty to pensioners as a result of its conflict in its roles as plan administrator and  employer/sponsor. The Globe and Mail article “Supreme Court to hear high-stakes pension case” reports that “the decision will be especially important in two areas – clarifying the rights of pension plan members to a priority claim on assets, and clarifying the fiduciary duties of directors who must balance the company’s needs against their new duties to the pension plan”.(The “deemed trust” argument (unfortunately) was not called into play on behalf of Nortel’s pensioners, but who knows, perhaps a favourable Supreme Court ruling might open the door for the federal government to reconsider the long needed BIA/CCAA changes to recognize the priority of pension plan shortfall over other creditors in sponsor bankruptcy and eliminate the potential conflict of interest in the dual role of the employer as pension administrator and sponsor. This would be the right thing to do. So, while the Supreme Court’s decision to hear the appeal of the case might be hopeful news for corporate Canada, it will unfortunately result in a delay for Indalex pensioners. In context of Nortel pensioners, one might think of this as (either flogging a dead horse, or alternately that) you haven’t lost until you have given up; but perhaps something good will result from this for Nortel’s pensioners if the Supreme Court upholds the Appeals Court decision and helps fix Canada’s systemically failed pension system; the Canadian government has failed to fix the broken pension system via much needed legislative changes, so perhaps the Courts can fix it. It is not the best way to go, but a fix is desperately needed. But there is something rotten in a system that will pay bondholder 100%+ (see next story) whereas pensioners will get 59% (plus some scraps after the scavengers get through with the Nortel carcass). Yet the government is just sitting and watching…or perhaps not even watching; many would call that truly irresponsible behaviour.)

In WSJ’s “Playing defense amid debt drama” Matt Wirz reports that “Some investors have been buying up bonds of Nortel Networks…in bankruptcy, betting they will make money when the bankruptcy proceeds are distributed… Trading in bonds of Nortel, the defunct Canadian telecommunications equipment maker, surged in July when the company’s patent portfolio sold for an unexpectedly high $4.5 billion. Prices of the debt jumped from 95 cents on the dollar to 114 cents, where they remain.” (In the meantime, Nortel’s Canadian pensioners already had an over 40% reduction in pensions and lost the health and life insurance. So bondholder 114 cents on the dollar, US pensioners protected up to about $54,000/year and UK pensioners protected to 90-100% of pensions; do you get the idea that Canada is the only country that provides no protection of Canadian retirees and the Canadian government and CCAA Court are doing nothing to protect Canadian pensioners. At 59 cents to the dollar on pensions and perhaps 15-20 cents to the dollar on life, health and disability claims, you might wonder if there is something wrong with Canada’s bankruptcy laws and court system, yet the Canada’s government refuses to act to change Canada’s bankruptcy laws.)

In Rotman International Journal of Pension Management’s “DC 20/20: Pathways to a secure retirement” Rick Wurster describes what he calls key “levers” to help DC plan participants achieve their objectives: “raising savings rates through plan automation (auto-enrolment at minimum of 6% or even 9% with auto-escalation), “excess returns through active management” (he appears to refer to the inclusion of “less efficient” small-cap, emerging markets and global stocks and bonds vs. the exclusive use of the “more efficient” US large-caps- you could call that diversification rather than active management), “flexible asset allocation structures” (“professionally managed…premixed investments can be a great improvement over self-direction” including target-date and the associated glide-path risk, and at “times when valuations are high are also likely to be times when balances have benefited from strong returns, meaning that participants need less future return from the capital markets and therefore can bear less investment risk – that is, less equity risk”), “better risk balance in a plan’s investment menu”, “adding absolute- or total-return investments to a plan’s menu or premixed options”, and “decumulation (or distribution) strategies involving the use of deferred annuities” (automated distribution process with payout strategies and, since there is a 50% chance that one of a 65 year old couple will live to 95, deferred annuity to cover expenses between ages 85-95 are very useful to reduce the possibility of running out of money). (You don’t have to agree with all the “levers” mentioned, but it’s a good starting list; Wurster could have included low-cost as an essential lever in the list, if he did I missed it.)

Things to Ponder

In the Financial Times’ “What makes a rogue trader?” John Gapper discusses the Darwinian instinct driving rogue traders’ actions. “Rogue traders’ behaviour is financially stupid – traders are trained not to double their losses but to set risk limits and to retreat from risky positions when they face danger. Biologically, however, doubling is sound. Starving animals should gamble in search of a food windfall, even though each has only a small chance of success. Most will fail, but some will survive and reproduce.” (Interesting read!)

In IndexUniverse’s “Alternative Beta- The third choice” Jason Hsu of Research Affiliates (home of “fundamental indexing”) provides a slew of data arguing the benefits of “fundamental indexing” and questioning the validity of cap-weighted indexing given that they believe that markets are inefficient and cap-weighting “over-allocates to expensive stocks and under-allocates to cheap stocks”. Hsu argues that given the dismal performance of both passive and active approaches in the past decade, the answer may lie in the “third option” of “fundamental indexation”. He then looks at various “strategy indexes” designed to offer investors passive (?) investment vehicles that are grounded in the hypothesis of market inefficiency”. He covers the period of 1964-2009 for U.S. and 1987-2009 for global strategies. For the indicated periods, “all of the alternative betas surveyed produced excess returns”. He concludes with: “We assert that investors should go to greater lengths to diversify their equity portfolio. The past 10 years have brought considerable pain to both sides of the equity active–passive aisle. The third choice of alternative betas — even the simplest such as Equal-Weighting—would have resulted in a far better outcome. Will history repeat? Nobody knows. However, we think the evidence is far too compelling to ignore. We suggest moving alternative betas up your to-do list.” (I continue watching with interest…but I am not sold yet due to capacity and cost considerations, as well as questions about “will history repeat” and potential questions about the time period looked at.)

And finally, in the Financial Times’ “A wise man knows one thing- the limits of his knowledge”John Kay discusses the prognostications of “lesser men” based on models built on guesses about missing data, on the assumption that the future will be just like the past, or on data extrapolation, all leading to “extravagant flights of fantasy” which only convey the “limits of the imagination of the people who have undertaken them”. He concludes with “We do great damage by claiming to know things that are not known, by asserting certainty in the face of uncertainty and ambiguity, and by attaching a veneer of rationality to decisions that have in fact been made on other, rarely articulated, grounds. (Well put!)


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