Hot Off the Web– March 14, 2011

Personal Finance and Investments

In the Financial Post’s “Canada’s costly mutual funds flunk again: only nation of 22 to get an F on fees”Jonathan Chevreau reports that “An expanded version of a 2009 (Morningstar) global study gives Canada a gentleman’s C+ overall but on fees (Management Expense Ratios) was the only country of 22 to get a failing F.” (I can’t imagine why Canadians continue to buy mutual funds with such corrosive fees, when superior ETF options are so readily available.)

And speaking of mutual funds, Ron DeLogge in “S&P Report: Over 50% of active managers underperform” reports on latest annual S&P money manager performance against indexes. The results show the failure of active managers over 1, 3 and 5 year periods to outperform the indexes. Typically, the longer the period the worse is the active performance. “While the superiority of the indexing strategy speaks for itself, a stubborn army of mutual fund groupies are still selling the fanciful idea that investors need to pick their mutual funds more carefully. Instead of that, the real translation from S&P’s latest data is that people should be indexing their portfolios to the market using low cost index funds and ETFs.” In the Financial Times’ “Absolute return funds ‘a myth’” Chris Flood reports that according to Cerulli Associates ““The term [absolute return] should not be allowed. It is not a guarantee,” said Yoon Ng, senior researcher at Cerulli. “Investors could easily be misled and there could be mis-selling by providers.”EDITOR’S CHOICE  New research by Cerulli showed no single absolute return strategy managed to preserve capital in all market conditions, and returns moved broadly in line with their underlying markets, although volatility was mitigated.” Also, Steve Johnson reports in the Financial Times’ “Hedge fund indices’ accuracy in question”  reports that “the performance of multi-strategy indices whose portfolios included illiquid [or less liquid] strategies was extraordinarily overstated after mid-2008”.  “The databases are subject to multiple biases. We adjust single manager indices down by 4 per cent a year and fund of funds by 1 per cent.” “Prof Malkiel remains convinced of his position. “There are still many biases in the data and published reports overstate returns, so what you see is not necessarily what you get.”“ And speaking of the ineffectiveness of active management you might be interested in reading my take on Ed Easterling’s new book “Probable Outcomes” which contains some interesting historical market data and analysis. His messages: lower than historical returns in the coming decade (might come true) and superior outcomes with active management (unlikely).

Eleanor Laise in the WSJ’s “How to cash out in retirement”reviews” four strategies that could help a retiree’s savings last a lifetime”.  In this sensible article Laise advocates flexibility given the uncertainties associated with market and longevity risk. The four approaches mentioned are: (1) traditional 4% rule (i.e. draw 4% of assets, invested 40% in bonds and 60% in stock, with the first year dollar draw then adjusted annually for inflation) is not a recipe for  success for 30+ years of retirement, especially for those retiring at <65 rather than 65, (2) draw 4% annually of the current value of the portfolio; this leads to a more volatile income stream, but you won’t run out of money, (3) and improvement to this approach might be 4% of current portfolio value with a cap (say max 5% more than previous year) and a floor (say 5-10% lower than the previous year) (sounds interesting, but I haven’t simulated the outcomes, and (4) Financial Engines’ approach which is more along the line of asset-liability management (ALM); start retirement with 80% bonds and 20% stock which is deployed as follows- “65% bonds to create a payout from 65 to 84…a further 15% also goes into bonds, but it’s considered a “longevity reserve”” to be transformed into an annuity at age 85, and 20% stock allocation is gradually reduced to zero with age (an interesting approach, I have to think about this). The article concludes with suggestions for “tax efficiency” like: “tapping taxable accounts fist”, minimize average tax rate by tapping first 401(k) up to 15% tax rate and then tap IRA (not-taxable), etc (e.g. tax loss selling).

Ron Lieber in the NYT’s “A red flag on reverse mortgages” raises more red flags on reverse mortgages, when he writes “It is the saddest of paradoxes: a government-backed financial maneuver intended to free up extra money for struggling older people turns out to have left some widows and widowers on the brink of foreclosure…(when) Some spouses did not put their names on the applications in order to qualify for a bigger loan, without necessarily realizing that they were putting themselves in jeopardy.” Included in the article is a good overview of reverse mortgages, and Lieber recommends that you hire and pay for two counsellors from different organizations before you contemplate signing on the dotted line! (If interested in the subject, you might wish to read an earlier blog of mine Reverse Mortgages )

In the NYT’s “When to buy or sell? Don’t trust your instincts” Paul Sullivan reports on another study showing that “investors did not trade in expectation of intense volatility or even during it, which might be rational. They waited until the period of greatest volatility had passed and then looked to do what any adviser would tell them not to do: sell at the bottom or buy at the top” and that the result is much lower investor returns than investment returns (an investor’s actual return as opposed to a mutual fund’s reported return). “Dalbar Inc. of Boston tracks the difference between stated and actual returns and publishes an annual report on it. Data from its 2010 Quantitative Analysis of Investor Behavior showed that the spread between investor and investment returns was narrowing but persisted. In 1998, it was 10.65 percentage points; in 2009, it was 5.03 percentage points. “While investors seem to be learning hard lessons from the past 15 years, the original Q.A.I.B. findings still hold true: Mutual fundinvestors do not achieve the returns cited by fund firms due to their irrational behavior,””

In the Globe and Mail’s “Why the age rule-of-thumb shouldn’t be carved in stone” John Heinzl writes that “Age isn’t the only factor to consider when setting an asset allocation. Investors must also take into account their risk tolerance, health, ability to withstand a financial loss, desire to leave a legacy to their heirs or charity and the low returns available on fixed-income investments, he said… A 70-year-old with a very low risk tolerance, for example, could have as much as 90 per cent in fixed income (70 plus 20). If the person has a very high risk tolerance, the fixed-income weighting could be as low as 50 per cent (70 minus 20)… On the other hand, a 70-year-old investor who is depleting her portfolio at a rate of 7 per cent annually should consider spending a chunk of her nest egg on an annuity that provides a guaranteed monthly payment for life.” (You might also be interested to read my related blog ‘Target-date’ funds vs ‘age-independent’ AA? from a few years ago.)

WSJ Smart Money’s “5 biggest retirement myths” discusses some of the major miscalculations that lend on the doorstep of retirees. The myths include: (1) calculators’ estimate of true cost of retirement ($1M? $1.5M? $2M?) especially surprise major expenses, (2) data indicates that you’ll spend less (say 70%) when you’re old, but it’s not necessarily due to a desire rather than a need to do so, (3) the older you are the more bonds that you need (in reality retirees might still need 50-65% stocks for growth and inflation protection), (4) money lasts longer in cheaper cities (surprises lurk everywhere like sudden tripling of property taxes in FL), (5) government programs provide backstop (unless you deplete almost all of your assets LTC can cost you $75,000 in the US, in Canada much lower in public nursing homes)

In the Financial Post’s “How to buy your kids a house”Jonathan Chevreau looks at four approaches to buying your kids a house and reports that Jamie Golombek recommends “a zero-interest mortgage, which is “easy, tax-effective and guarantees mom and dad can get their money back should they wish.” Alternatively, you could waive principal repayments during the course of the mortgage; ultimately, the parents forgive the debt entirely, essentially gifting the loaned funds to the child.”

In the WSJ’s “Would you buy a life-insurance policy from this machine” Leslie Scism reports that (in the U.S.) “It is getting easier to buy term life insurance without undergoing extensive medical tests. But if you are relatively healthy, you may well have to pay extra for the convenience.’ But Scism suggests that “Before speeding through a deal, check out websites such as Term4Sale.com and FindmyInsurance.com. They provide quick quotes based on your birth date and other personal data. Final rates are subject to underwriting approval.  Price a policy through a direct seller, such as TIAA-CREF (www.tiaa-cref.org) or USAA (www.usaa.com), which are among the nation’s financially strongest insurers and don’t use commissioned agents, which can mean better prices.”

In WSJ’s “When your adviser can’t be trusted”Karen Blumenthal asks “Why is it so difficult to expect that people selling us investment products will put our interests first?” “Much is at stake for consumers, who rely on all kinds of advisers to sort out complex investment options and ensure that they won’t outlive their investments. Expecting those advisers to take into account clients’ best interests should be a basic tenet of the business. Many industry groups are supporting a uniform standard. With brokers often offering the kinds of advice that investment advisers provide, “we’re now getting close to regulations that catch up with reality,” says Ira Hammerman, general counsel of the Securities Industry and Financial Markets Association, a trade group. Yet some insurance groups oppose such a standard, saying that new regulatory burdens on their members will raise costs and could reduce products and services offered.” Blumenthal suggests: ask those offering ‘advice” or sales pitches if they are “acting under fiduciary standard of care”, insist on disclosure of all conflicts, fees, ask cost including those built-in, ask what is advisor’s strategy and qualifications. (or perhaps just don’t deal with an advisor who is not acting as a fiduciary.)

Real Estate

In Florida loony property tax world, a couple of the Florida state Senate and House resolutions S-390 and H-381 propose: (school levies aside) reduction from 10% to 3% in the cap on non-homesteaded residential and commercial property tax value, freezing homestead property tax values even if they are lower than market value in years when market values decrease and a 50% tax value reduction for first time homesteaders’ property purchases. If my understanding of these bills is correct, the most important effect, while not creating a level playing field for non-homesteaders, at least reduces the possibility of the ravages inflicted upon then during the 2000-2006 period when there was an orgy of spending increases by municipalities and counties on the backs of out-of-state non-homesteaded property owners (who could not vote and saw their taxes increase by 15-25% a year) while the homesteaders’ taxes were increasing at less than 3% a year. If the current proposals end up on a Constitutional amendment and are passed by a popular vote (which might happen only if these are all bundled together into a single Yes/No vote) then it might turn into a win-win-win for Florida, homesteaders and non-homesteaders. (Let me know your thoughts, but I am not giving odds on its outcome. Thanks to W. Levison one of the long time Florida property tax reform activists.)

And speaking of Florida’s dysfunctional property tax system, Willie Howard in Palm Beach Post’s “Broke cities in Palm Beach County look for creative ways to raise money”reports that in some cities massive reductions in property tax revenue due to significantly lower property values, coupled with recently increased homestead exemption from $25,000 to $50,000 and already significantly ratcheted up spending between 2000 and 2006 on the backs of non-homesteaded residential and commercial property owners, has led them to consider creative ways to raise additional revenue. “Removing levies for fire protection from property taxes and charging fees to every property owner is one thing local cities are considering as a new source of revenue. Another bonus: more room under a state-­imposed cap to raise tax rates again.” (Can you think of a more screwed up property tax scheme anywhere else in the U.S.? At least Florida’s voters are finally paying attention to the unconstrained spending increases of cities and counties. Some good might actually come from this mess.)

Pensions

Jonathan Chevreau in the Financial Post’s “Vulnerable to your employer’s insolvency?” writes about a research report from UBC professor Ronald Davies in which he say that despite the reasonable expectations that current regulatory environment protects private sector pensions, that is not the case because “current pension regulations allow underfunding to occur. He examines possible policy alternatives that could provide retirees more security than  commonly raised options like reforming insolvency laws or introducing a national pension benefit guarantee scheme” According to the report summary,  “regulations often encourage practices that lead to questionable risk-taking in pension asset investment, and obscure some of the risks being carried on plan balance sheets” but  Davis says “Defined-benefit pension plans do not offer complete security; there are policy alternatives (e.g. target-benefit plans are mentioned as a future potential replacement of defined benefit plans) that would clarify this and are more likely to improve pension security than would the much-discussed options of reforming insolvency law or introducing a national pension benefit guarantee scheme.” Instead in the report summary effectively indicates (my interpretation, not his words but I’ll paraphrase somewhat liberally) that private sector DB pension plans are government policy enabled./sanctioned/encouraged scams played on Canadians due to: poor governance, opaqueness of pension plans, inadequate regulation and regulatory oversight, conflict of interest driven assumptions by actuaries and inappropriate investments by investment advisors, inefficiencies (high costs) of smaller plans. (I have discussed the “systemic failure’ of Canada’s pension system in Systemic Failure in Canada’s Private Pensions: Who could have prevented it? What could be done now? ) Yet after all that, he still surprisingly concludes that “The mechanism by which the shortfall arises does not involve any deliberate evasion of a statutory duty while giving a preference for other creditors; rather, it is merely the result of a difference between actual experience and actuarial forecasts of economic conditions.” To my mind I can’t believe that nobody broke the law in some way or shape, it may be just that there are even more conflicts of interest at play than even those already contemplated. Alternatively, the law needs to change including the insolvency laws to insure that, if all else fails, already earned DB pension liabilities (i.e. deferred wages) have priority over other unsecured creditors and/or the state establishes an insurance scheme to protect those deferred wages, as in other developed and civilized countries. Concern about the difficulty of negotiating such insurance schemes, because Canada’s Federal-Provincial separation of powers, is a cop-out. Why are politician elected in the first place? Is it not to act in the best interest of the Canadian public and to put in place, if not yet done so, the necessary laws to protect the population from abuse of power, conflict of interest, scams and to punish/deter future undesirable social behaviour by those who have (explicit or implicit) fiduciary and professional responsibility to look after workers’ pensions. (In the interest of full disclosure, I have not yet read the whole report, but plan to do so and when I find more ‘gems’ I will share with you. Thanks to PK for bringing article to my attention.)

In the Financial Times’ “Public sector pensions must be reformed”John Hutton recommends: replacement of final salary by career average DB plans, link pension age to state pension age, set a “clear cost ceiling for public sector pension schemes” and strengthening of regulation and oversight in the UK.. He says that the proposals will make “public service pensions schemes fairer, more flexible and more transparent. They will also continue to provide adequate levels of retirement incomes – in my view the principal purpose of any good pension scheme…to chart a course that addresses the concerns about sustainability and affordability, but which does not involve an inevitable downward spiral in pension provision for the millions of people who serve our country well.”

In benefits Canada’s “Should pension funds administer PRPPs” April Scott-Clarke reports that the “CEO of the Ontario Municipal Employees Retirement System, went on the record saying that the government should open up the administration of the new pooled registered pension plans (PRPPs) to more than just “regulated financial institutions.” “Right now, it’s insurance companies and the banks,” Nobrega told CTV. “I would suspect that the federal government would be wise to include a broader range of providers other than simply the banks and insurance companies, because pension funds do have the muscle and investment systems to do it.” Along the same lines CARP’s Susan Eng in “Public option for pension security- PRPPs not enough”suggests “A practical solution is staring all of us in the face – allow people to buy into a separate fund run by the existing not-for-profit pension funds like the CPP, OMERS, provincial Teachers Funds and the like. With their size and experience, they can offer low-cost, reliable defined benefit pensions – which, coincidentally, is what we’ve been asking for. Monies contributed by individuals and their employers, would be invested in a diversified fund but separated from the fund managers’ other holdings.”

Things to Ponder

In the Financial Times’ “Insurance, society and profits” there is a discussion about what is the right way to provide insurance. Should pricing of insurance be based what is the preferred approach by insurers or what might be considered a “social vision of insurance”? “Justice, knowledge and sex: the debate over discrimination in insurance covers some heavy ground… These factors (like race, sex, genetics or state of one’s health) all correlate with differences in the probability of making a claim, but regulators and lawmakers have decided that it is more just to ignore that. Their approach reflects a social vision of insurance: it is a way to share the burden of ill fortune… The insurers’ vision is better for competition; providers strive to reduce prices for clients who are less likely to make claims. More sophisticated analysis (“granular” is the buzz word) also allows poor risks to buy insurance, albeit at a high price… insurance will be less a private and voluntary arrangement and more an instrument of social policy.” (At least in the EU)

Dianne Nice in Globe and Mail’s “Ottawa issues warning about online budgeting sites” reports that “Ursula Menke, Commissioner of the Financial Consumer Agency of Canada, said she has not received any complaints of fraud or abuse stemming from financial aggregation services (e.g. Mint), but warns consumers to use such sites with caution, and to make sure they read and understand both their financial institution’s online banking user agreement and the privacy policies of the financial aggregator. Some financial institutions’ user agreements clearly state that users will be responsible for unauthorized transactions if they provide other parties, including financial aggregators, with their passwords and account information.”

In Bloomberg’s “IMF says global bank regulation is failing, Handelsblatt reports” Brian Parkin reports that “banks remain too big and their businesses more complex”, “We are at the moment even less well-prepared than when the crisis erupted in 2007” and “investors are switching to financial institutions that are less regulated, such as hedge funds, in search of profit, creating new risks for the financial system.” Also, to make things worse, according to CNNMoney report “SEC fights for its Wall Street watchdog role”the SEC instead of a necessary increase in funding to improve its oversight and enforcement role, is at risk of cuts that would cripple its ability to do the required job. (Thanks to CFAInstitute Financial Newsbriefs for recommending)

Tara Perkins in the Globe and Mail’s “Manulife unit battles U.S. ‘life settlements’ industry” reports that Manulife “is being sued in a California district court for allegedly trying to stop customers from selling their policies”. Insurance companies traditionally count on life insurance policies to lapse before its purchaser dies, because (s)he  no longer needs it or can no longer afford it. The life settlement industry has emerged to take over policies which might otherwise lapse or even encourage individuals to buy new large policies for the purpose of immediately reselling them. (If you are interested in the topic you may want to read my earlier blog Life Settlements(Beware!))

And finally, in WSJ’s “Pimco’s Gross dumps Treasurys ahead of end of Fed bond buying” Gongloff and Zeng  report that Mr. Gross slashed his US government debt positions to zero and raised its cash level to 23% in his flagship fund, but (at least in the short-term) the Globe and Mail reports that “Bond market shrugs off PIMCO ditching U.S. government debt” which some attribute to ongoing European sovereign debt problem and political instability in North Africa and Mid-East; of course there is also the all important question in David Berman’s Globe and Mail article “Could China follow Bill Gross?” .