Hot Off the Web- February 13, 2012

Personal Finance and Investments

In the Globe and Mail’s “ETFs spurring shift to fee-based advice”John Heinzl writes that “Traditionally, many advisers used a transaction-based compensation system in which they earn commissions for executing trades or selling mutual funds. But the move to low-cost ETFs is going hand-in-hand with a shift to fee-based compensation, in which the adviser charges a percentage of the client’s assets instead.. Advisers say it’s a win-win for them and their clients, because costs are usually lower and fees are more transparent than under the traditional system.”  (Just because the advisor compensation is fee based, you must still make sure that you get value commensurate with the fees, the advisor commits to a fiduciary relationship, and the advisor has the experience and knowledge necessary to do the job.)

In the WSJ’s “An annuity can still make sense”Andrea Coombes writes that even in this very low interest rate environment, an inflation indexed annuity might make sense. She quotes an indexed $740/mo ($8,800 or 4.4%/yr) for a female and $800/mo ($9,600 or 4.8%/yr) for a male and mentions the proposed Treasury department changes permitting (encouraging?) that employers offer annuities in 401(k)s. Annuity pros mentioned include: lock in an inflation adjusted cash flow (together with Social Security) to cover “fixed monthly costs” but don’t annuitize more than you need for your fixed costs (“musts”), annuities create a cash-flow discipline (can’t blow the money), cash-flow is for life (won’t run out of money), your kids won’t have to support you if you live much longer than average, annuities are especially valuable for very risk-averse  individuals who can’t or don’t want to be exposed to any market volatility. Annuity cons: premium becomes unavailable for estate, insurance company might go bust over 20-40 years so make sure to check state insurance applicable. The article mentions variable annuities with a guaranteed un-indexed(!) lifetime income (GLIB) as an option for those who do not want to give up control of their assets (but article overlooks to mention the much cheaper longevity insurance/annuity where lifetime income only starts at about age 85. In Canada there are no inflation adjusted annuities offered, though you could delay your CPP to age 70 to secure an increased inflation adjusted income stream.)

In the WSJ’s “Why dividend stocks aren’t the new bonds”Michael Pollock warns that “You can get generous yields…but also considerable risk”. It is important to understand that “Equities don’t behave the way bonds do, and investors face a much greater chance of capital losses with stocks and stock funds” and adds that  “”People may not appreciate that moving from bonds to stocks is a major change in asset allocation”. (Canadians might recall what happened when income trusts were used as bond substitutes.). Also it might be worth remembering that “dividend-paying stocks aren’t always an ideal source of capital growth. The stocks are often mature, and when investors tap them for income they aren’t reinvesting dividends to maximize their returns.” (A dividend intensive stock portfolio also is typically concentrated in 2-3 sectors, so is less diversified than the corresponding market capitalization weighted index.)

In Bloomberg News’ “BlackRock’s Fink says investors should be 100% in stocks” Laurence Fink is reported as opining that “Investors should have 100% of investments in equities because of valuations and higher returns than bonds… Investors who seek the safety of treasury bonds will have minimal returns and will not be able to meet their needs with the U.S. Federal Reserve expected to keep interest rates low… By contrast, equities are trading at the lowest valuations in 20 or 30 years”. (It’s wonderful to hear that Fink is so bullish on stocks, but for retirees who are considering acting on his bullishness may want to temper the 100% to something more consistent with their risk tolerance.) Also Noah Buhayar report in the Financial Post’s “Bonds ‘among most dangerous’ assets” Buffett”that “..low interest rates and inflation should dissuade investors from buying bonds and other holdings tied to currencies….“Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal.””

In WSJ’s “New allocation funds redefine the idea of ‘balance’” Veronica Dagher explores whether the new ‘risk-parity’ also called ‘balanced-risk’ funds bring anything of value to the table. According to Dagher in a traditional 60% stock and 40% bond asset allocation portfolio 90% of the risk come from stocks, whereas ‘risk-parity’ funds attempt to equalize risk among asset classes without sacrificing returns; e.g.  “Half a fund’s assets might be in bonds, a third in cash and the rest split between stocks and alternative assets like commodities. Then, because low-risk investments tend also to yield lower returns, the managers try to juice their returns, usually by adding leverage with futures or other derivatives on some holdings.” (So adding “leverage with futures” and mix in good measure of fees, this must be the sure-fire recipe to investment success-NOT. I’ll stick with a balanced portfolio of fixed income instruments and stocks, consistent with my risk tolerance, implemented with low-cost physical-based broadly diversified ETFs.)

In CFA Magazine’s “Goal-based reporting and traditional performance metrics” Charles Opincar argues that while traditional performance reporting (e.g. absolute and relative returns, benchmark comparisons and risk-adjusted return) is still relevant, investors have need for experientially meaningful or goal-based reporting. For example he suggests that metrics be reported measuring important goals for retired individuals, such as: a target spend rate sufficient to meet realistic spending requirements without encroaching (very much or at all) on the principal or at least not exhausting retirement income before death and asset allocation consistent with maintaining/growing portfolio; the metrics could be accompanied by ‘out-of-bound’ warnings to help with behavioural adjustments. He also suggests that an optimal spending rule might combine stable elements (“a percentage of the previous year’s spending plus an adjustment for inflation”) with market elements (“a long-run sustainable rate of distribution multiplied by the market value of the portfolio”). Furthermore Opincar suggests a layering of assets with cash at the base, followed by ‘stable assets’ in the middle and (a smaller) ‘growth assets’ layer on the top; he notes that “the asset mix is viewed from the perspective of liquidity and requirements for stable spending stream as opposed to traditional view of asset allocation (namely risk diversification). (Some would argue that such goal-based performance metrics might be even more important that the traditional ones.)

In the Globe and Mail’s “An inheritance should be a windfall, not a financial plan”Preet Banerjee writes” What a morbid thought: banking on the death of a loved one to salvage your inability to be self-sufficient…one of the many flaws of incorporating inheritance into your financial plan: the double edged sword of longevity risk. It’s a risk to your plan if your parents live longer since not many people increase their net worth after stopping work. The longer they have to consume, the lower your inheritance. But you have to balance that with the fact that your financial plan’s success is dependent on the death of a loved one. Beyond that, factoring an inheritance into your plan without having discussed your parents’ intentions is another mistake. How do you know they haven’t decided to leave everything to your sister? Or to charity?” Banerjee recommends that inheritance shouldn’t be part of the financial plan; instead consider it a windfall.

In the Globe and Mail’s “In the final stretch and time for a reality check” Mary Gooderham lists 9 steps to a healthy retirement to be taken about 5-years before retirement, including: your assets and liabilities, sources of retirement income, expenses in retirement, “what ifs”, estate planning and others. (Not a bad qualitative list.)

Real Estate

In the Financial Post’s “Canadian home prices rising again” Garry Marr reports that Canada’s realtors introduced a new housing sector index: “CREA says the new index uses a “sophisticated statistical model” that takes into account such quantitative measures as the number of rooms in a home and such qualitative measures as whether or not it has a finished basement. The model also considers location, measuring proximity to schools and hospitals, even golf courses, when comparing prices. The index will divide the information into different categories that include single-family homes — split into one-storey and two-storey homes, — townhouse or row units, and apartments”. On the same topic Jon Cook in the Globe and Mail’s “Canadian home prices up in January: CREA”indicates that the report announcing the new index showed no prices, only percent changes…All markets reflected a trend of slowing townhouse and apartment prices, while single-family dwellings remained steady. In January, townhouse units fell 0.4 per cent and apartment units slumped 0.2 per cent. Those declines were offset by a 0.5 per cent increase in prices for both one- and two-storey single family homes. (Is Canada’s CREA a reliable source for pricing information (probably just as good as the U.S. based NAR stats and predictions over the past decade), have they presented how the calculations are being done, etc, etc…)

The Economist opines in “Canada’s housing market: Look out below”that “After years of lecturing America about loose lending, Canada must now confront a bubble of its own”. “In total, 173 sky-scrapers are being built in Toronto, the most in North America. New York is second with 96… Speculators are pouring into the property markets in Toronto and Vancouver. “We have foreign investors who are purchasing two, three, four, five properties”…” (Haven’t we seen this before? Déjà vu all over again?)

In the Financial Post’s “Foreclosure deal may trigger home seizures, heal housing market” in a Bloomberg report Gopal and Gittelsohn write that “The US$25-billion settlement with banks over foreclosure abuses may trigger a wave of home seizures, inflicting short-term pain on delinquent U.S. borrowers while making a long-term housing recovery more likely… With today’s agreement, banks are likely to resume property seizures… “The shadow of the settlement hung over the market for a year now.”” The $25B deal with the banks might increase to $45B has elements of  principal reductions which if successful might lead to a larger program and foreclosure=prevention initiatives, but initially will lead to an increase of foreclosures after a 34% drop in foreclosures last year mostly awaiting robo-signing resolution. The hope is that the effect of the deal will be an acceleration the cleanup of the undigested backlog of hidden and visible underwater home inventory. However in the Palm Beach Post’s “$8.4B from foreclosure settlement to help homeowners” Kimberly Miller reports that “Florida’s share of the settlement is second only to California… The settlement does not grant criminal immunity to banks.” But one foreclosure attorney is not impressed: “This is a $5 billion settlement being called a $26 billion settlement,” he said. “They were going to lose that money no matter what.” (Doesn’t sound like a lot of money given the scale of the problem, but if it accelerates clear-out of inventories of foreclosed and to-be-foreclosed properties then it will help bring market back to some normalcy.)

Pensions

In the Globe and Mail’s “Ottawa looks abroad for OAS pension solutions” Bill Curry writes about approaches used by other countries to deal with Canada’s aging demographics: e.g. many developed countries declared a gradual increase in pensionable age starting in 10+ years to allow people to adjust, followed by a longevity adjusted pensionable age thereafter, other experts (Whitehouse) suggested that “a higher pension age could however be used to augment the value of benefits. (Not mentioned was a proposal is being circulated by (long time activist for recognizing the essential unpaid work of homemakers toward CPP benefits) Bev Smith from Alberta argues that if problem is decreasing ratio of workers-to-retirees then why not encourage Canadians to have more babies; in about 20 years that might significantly improve the problematic ratio.) Bill Curry in the Globe and Mail’s “There is no old age security ‘crisis’”, reports that Parliamentary Budget Officer Page indicates that “when measured as a percentage of Gross Domestic Product, the PBO says the cost is manageable. In an interview, Mr. Page said the retiring baby boomers should not come as a surprise to the Prime Minister or government officials…” You might also be interested in reading my new blog on the subject ” OAS vs. Pension Reform” where I argue that the OAS debate is a diversion from the push for meaningful pension reform and from the almost universal condemnation of the proposed PRPP as a solution. We must stay focused on pension reform.

In the Financial Times’ “UK pension body warns that annuity market is on the brink of failure” Debbie Harrison writes that a report entitled “Treating DC members fairly in retirement”indicates that (in the UK): there are “systemic flaws in annuity pricing and rate transparency”, “…annual cohorts of annuitants lose an estimated £500m-£1bn of aggregated lifetime income”, with the imminent surge in DC plan participation due to introduction of auto-enrolment unless the pension (insurance) industry undertakes immediate reform government intervention will be inevitable. DC scheme are designed and operated consistent with 80-90% of the members being ‘defaulters’, then at retirement they are expected to make an annuity decision which requires “an above-average level of literacy and numeracy and an understanding of inflation and morbidity trends”. Furthermore not only there is inadequate regulatory framework but there is regulatory disconnect between the pre-retirement DC world and the post-retirement annuity world, and “annuity system for DC schemes endorses the inappropriate transfer of risk from the “knowledge community” of employers, trustees and providers, to those least capable of making informed choices”. The report recommends a requirement “all schemes to provide a default member support service, which actively helps members to choose the annuity type and then makes the purchase in the open market”. (At least the U.S. and U.K. are trying to deal proactively with the massive onslaught of retirees who have been forcefully shifted from DB to DC plans, and then have to come up with a post retirement decumulation plan that will provide them with a lifetime of income. In Canada, the answer is the PRPP!?! Who is working on Canada’s “pension reform”? Do they even understand the fundamental issues that need to be addressed?)

In the Financial Times’ “QE adds to gloom for pension savers”Matthew Vincent discusses the impact of UK’s aggressive quantitative easing (QE) program which artificially lowers interest rates to abnormally low levels “With annuity rates falling by about 25 per cent as a result of QE, over a million pensioners will be permanently poorer for the rest of their lives…” and even “Defined-benefit pensions are particularly at risk from low interest rates, as it becomes increasingly expensive for schemes to generate the income needed to match the pensions being paid out,” The article also discusses the perverse effects of the QE driven low interest rates; not only people’s fix income assets do not earn a fair return during the accumulation cycle, but those who choose to annuitize end up with much lower income from annuities, and those who select “level annuities” will get their income eroded by the corrosive effect of the QE induced inflation. “Hymans Robertson said retirees choosing an index-linked annuity now would stand to benefit from QE-fuelled inflation.”

The U.S. based Society of Actuaries generated a set of educational briefs addressing “the major decisions encountered in retirement”. These can be accessed at “Pension-Post Retirement Needs and Risks”and they address some of the key retirement decisions including: when to retire, special women’s issues in retirement, when to claim Social Security, designing a monthly paycheck, asset allocation, and finding a trustworthy advisor. (Well worth reading educational material for both Canadians and Americans.)

In the Financial Post’s “Savings Squad: PRPPs will put savings in the wrong shelter” Malcolm Hamilton writes that “Canadians earning less than $20,000 a year don’t need to save for retirement… Canadians earning $40,000 a year who contribute 4.5% of earnings to a TFSA instead of contributing 6% of earnings to an RRSP will increase their post-retirement income by about $3,000 a year, after tax, with no appreciable change in their pre-retirement disposable income…. (and) Canada used to have one of the best retirement systems in the world. Now, with each new layer of gratuitous complexity, it is beginning to look like a mess. Is there a better way? Yes, but first we must decide what we are trying to do.” (I agree with Hamilton’s view that that PRPP doesn’t address the key issues of “pension reform” (i.e. adequate savings, low-cost accumulation and decumulation vehicles, low-cost longevity insurance and protecting earned DB pensions if sponsor goes into bankruptcy with an underfunded pension plan) but Canada’s pension system is not ‘beginning’ to look like a mess, instead Canada’s pension system is in systemic failure and absolutely nothing of substance has been done to fix it after years of studies, reports, recommendations, etc. In fact after almost unanimous condemnation of the PRPP proposed by the government, they have now succeeded in suppressing this criticism by diverting the attention of the public and media from pension reform to OAS. And, we fell for it, instead of continuing to keep the focus on required pension reform we dutifully allowed the media focus shift to OAS.)

Things to Ponder

In Washington Post’s “Unemployment drop still leaves low skilled workers behind”Michael Fletcher reports that “If the unemployment rate counted the 2.8 million people who want jobs but have stopped looking, it would sit at 9.9 percent rather than its current 8.3 percent…Employment prospects are modestly improving for college graduates, for instance, but dimming for those who have a high school diploma or less… The uneven nature of the recovery is particularly evident in states such as Florida that have struggled to rebuild parts of the economy that hire large numbers of less-educated workers… state-wide, the implosion of the housing industry has put more than 350,000 construction workers, and untold numbers of real estate agents and mortgage brokers, out of work since July 2006.”

In WSJ’s “SEC launches inquiry aimed at Private Equity”Gregory Zuckerman reports that the SEC “…launched a wide-ranging inquiry into the private-equity industry that examines how firms value their investments, among other matters… private-equity law enforcement today is where hedge-fund law enforcement was five or six years ago…” (PE may be getting more attention also since general partners receive their 20% share in the 2/20 compensation structure as capital gain taxed at 15% rather than income, even though they did not put their capital  at risk to get that  gain.)

In WSJ’s “This is your brain on a hot streak”Jason Zweig warns that “The investing mind comes with built-in machinery that sizes up the future based on a surprisingly short sample of the past… None of this means you shouldn’t own stocks. It simply means you shouldn’t rush into buying more just because the market has had a flashy rise. Decisions made in haste usually turn out to be mistakes—and big decisions made in haste almost always turn out to be big mistakes.”

And finally, in the Financial Times’ “People now see it is a system for the rich only”(financial industry insider) GMO’s Jeremy Grantham writes that “in the US our corporate and governmental system backed surprisingly by the Supreme Court has become a plutocracy, designed to prolong, protect and intensify the wealth and influence of those who already have the wealth and influence.” A combination of no real increase of US wages in the past 40 years enabled by and coupled with globalization, meaning replacement of US based manufacturing with Chinese labor “with higher math scores…at one fifth the cost” resulted in historically high corporate margins. Grantham concludes that the normal productivity gains of the past 40 years have been abnormally divided between workers and the very rich and corporations, with workers getting none of the benefits “while the top 0.1 per cent has increased its share nearly fourfold in 35 years to a record equal to 1929 and the gilded age”. (Is such a state a stable equilibrium?)