Hot Off the Web– July 17, 2009

Pensions

Jason Kirby in Maclean’s “Demanding Times” dissects the differences between public and private sector pension systems in Canada and suggests that “any sober analysis of the numbers shows most government workers do enjoy a distinct advantage over their private sector counterparts. Government workers enjoy enviable pay, more luxurious benefits and in almost all cases, astonishingly better pensions.” In one analysis two couples, all of the same age and same $50,000 earnings, end up with equivalent retirement savings of $240,000 in the private sector and $1.2M in the public sector. This is not only as a result of very generous inflation indexed DB pensions in the public sector, but also due to the “appalling and immoral” discriminatory tax treatment of the retirement savings of private vs. public sector employees. Then to top it off, according to Kirby, 80% of public sector workers have “gold-plated” DB pension plans, whereas only 23% of private sector workers have any employer-sponsored plans and those are mostly of the inferior DC type. His conclusion is “the ideal solution for most workers would be to raise private sector benefits to public sector levels, rather than reduce everyone to the lowest common denominator. Unfortunately, with the economy the way it is, that seems unlikely. The solution may lie in a happy medium instead—but one thing is clear: hiking taxes on already beleaguered private sector workers to pay for increasingly deluxe benefits for the public sector is not an option.” (This is another aspect of the “Systemic Failure” of Canada’s pension system; when are the long promised reforms coming?)

On the same topic of public vs. private pension, the Economist’s July 9^th issue in “Unsatisfactory state” discusses the coming public sector pension crisis in the UK and US. “As workers in the private sector are losing their final-salary pensions, public employees are being shielded from the true cost of provision for old age.“ The article discusses the about to blow up problem associated with unfunded and improperly valued/funded public sector plans. The authors refer to a few trillions underfunding here and a few trillions unfunded there, and before you know it we are into some serious money. They discuss the gap in participation rate and benefit levels of DB pension plans between public and private employees and they indicate that the “implied gap in benefit rates is as much as 30% of salary”. They mention my favorite example of egregious actuarial/pension system lunacy whereby the discount rate for liabilities is the expected rate of return on assets!?! “In a paper last year Robert Novy-Marx and Joshua Rauh, of the University of Chicago, found that if states put their pension assets into a highly geared S&P 500 exchange-traded fund (an extremely risky portfolio), the implied discount rate would yield a “surplus” big enough to pay off all outstanding state bonds and provide a $5,000 dividend to every American citizen. From an economic perspective, using the expected rate of return makes little sense. The liabilities will not go away if the expected rate of return fails to materialize.“ After discussing the a whole range of issues which continue to be swept under the carpet rather than being deadly with forthrightly, the article concludes that we are about to leave a huge “tax bill for future generations…it is not much of a legacy.” (What a mess!)

In Financial Times’ “Watchdog set for BT pension battle” Norma Cohen reports that the British regulator is challenging BT’s assumptions in calculating pension liabilities. Specifically they are challenging the discount rate and life expectancy of plan members. A “0.25 percentage point cut in the discount rate could add £1.2bn to the scheme’s liabilities. Adding one year to its assumptions for the life expectancy of members could add a further £1.3bn in liabilities.” (Why don’t we read about such regulator vigilance in Canada? The British regulator is also the one that successfully appears to have blocked $700M Nortel cash in the UK to insure that it goes toward Nortel’s UK pension plan shortfall! Of course in the UK, unlike in Canada, the government essentially guaranties all private pensions, so the $700M is protected to cover a part of the plan underfunding that the government is ultimately insuring. In Canada as the is no pension insurance to speak of, except for the minimal one offered by Ontario, so government doesn’t seem at all engaged to protect pensioners’ due.)

Norma Greenaway writes in the Ottawa Citizen that “Slow pace of pension reform irks critics”. She quotes CARP’s Susan Eng that “I think the federal government has been engaging in serial stalling,” She questions why so little (nothing?) has been done given the obvious inadequacies of Canada’s pension system. There are/were federal and provincial commission recommendations, research groups, and unanimous motions in the House of Commons to give priority to underfunded pension claims in case of bankruptcy. You can read this week my blog on “Outside-the-box pension options and a path to pension reform” for a better approach than currently legislated (a little technical, but if your eyes glaze over when you see numbers, you might still get value out of the narrative).

Personal Finance and Investing

In WSJ’s “Collect now, or later? Timing your social security benefits” Tara Siegel Bernard writes most experts agree that generally you should resist the temptation to take Social Security as soon as you are eligible. The longer you wait the more you built yourself a larger and larger inflation indexed annuity which will serve you well as longevity insurance. (This also applies to Canadians with respect to CPP/QPP. She also discusses when you should not wait till 70, such as poor health related lower life expectancy and others examples.)

WSJ’s Neal Templin in “Home ownership was never a road to riches”looks at home ownership from an investment perspective and he like others concludes that it is not an investment, but a place to live and you should only buy as much home as you need. He quotes Columbia’s Mayer that U.S. wide home appreciation was historically inflation + 1% (local conditions are no doubt different.) Then you ad imputed rent and subtract property taxes (and maintenance) and you end up with the overall return. Templin’s conclusion is “That’s the brutal financial reality of home ownership in today’s market. But the consolation is this: I really like our house, our neighbors and the quaint suburban town where we’re now putting down roots. In other words, I’m happy being a tenant in this building I happen to own.”

Jonathan Chevreau looks at “How to hedge your bets against rosy forecasts”in the Financial Post. Chevreau discusses one of the exposures with Real Return Bonds (RRBs) is that the issuer (the government) is also the one who “measures” the consumer price index which determines the interest that the bond pays; and surprisingly it underestimates the true inflation by 7% a year. While there is still a debate on whether short-term we’ll have inflation or deflation, the expert opinion is more convinced that in the medium/long-term inflation will be the problem. Chevreau then lists the various mechanisms to protect against inflation in your portfolio in addition to RRBs: gold (as in jewelry, bars, securitized), real estate (actual, REITs), inflation linked annuities; stock while they won’t (necessarily) do well in an inflationary environment, the equity risk premium should improve returns of the overall portfolio. In deflation regular bonds, recently issued RRBs

Mike Hogan in Barron’s “Do it yourself portfolio management” surveys a number of online investment advisory services which have recently become available. His verdict seems generally positive. He mentions MarketRiders, E*Trade, TDAmeritrade and Financial Engines; the latter has been providing these services for a number of years and “now offers optimal portfolio allocations for a million investors, mostly through 401(k) plans. Non-plan investors can use the services for about $150 a year.” “MarketRiders E.Adviser costs $100 annually and, unlike Financial Engines, recommends exchange-traded funds exclusively” after one completes an online risk-tolerance questionnaire. A suitable portfolio is then recommended based on the risk-tolerance and the investor does her own implementation at a discount broker. I haven’t evaluated any of these, but they are certainly worth exploring. (Portfolio recommendations are likely aimed at American investors, so the asset allocation may not be suitable for Canadians without significant modification.)

Douglas Appell writes in Pensions&Investments that “ProShares set to debut 130/30 ETF” This ETF is intended to track the Credit Suisse 130/30 Large-Cap index and will have an expense ratio of 0.95%. The managers of the fund opined that this vehicle is a “low-cost means of achieving 130/30 beta and, potentially, alpha superior to what a comparable long-only large-cap strategy would deliver over the long run.” (130/30 refers to a so called long-short equity strategy whereby for each $100 held in the fund $30’s worth of least desirable (most overvalued) stocks in the index are sold short and the proceeds are then added to the other $100 in order to buy $130’s worth of the most desirable (most undervalued) stocks in the index. I’ll have to reserve judgment on this.)

Jonathan Chevreau in Financial Post’s “RRSP meltdowns don’t inspire confidence” warns reader to move with great care before contemplating “leveraged RRSP meltdowns” which are schemes of taking RRSP withdrawals “while minimizing income tax. The idea is that you set up an investment loan to buy tax-efficient dividend-paying stocks, paying the interest charges from RRSP withdrawals that are equal to the interest payments. The interest on the loan is tax-deductible so in theory the taxable RRSP withdrawal is cancelled out.” Chevreau quoting McKeough does not recommend the approach due to liquidity and risk associated with the scheme.

In the Globe and Mail’s “ETFs: The way to get country diversification” Roger Nusbaum argues that while it is a good idea to get foreign equity exposure, but rather than just go with, say the highly correlated with S&P500, MSCI EAFE index exposure, with a little more work investors might be able to get better diversification (lower correlation) by selecting a number of country indexes instead. Of course, even if you are successful, it will likely come with higher volatility.

Something to Ponder

In his WSJ article, Jason Zweig asks “Does the stock-market data really go back 200 years?”  in reference to Jeremy Siegel’s assertion that since 1802 U.S. stock returns were 7% after inflation. Zweig challenges the assertion primarily on the basis of survivorship bias (i.e. not considering companies which are out of business or no longer listed.). He also raises questions about dividend yield history. Zweig the asks, since “As of June 30, U.S. stocks have underperformed long-term Treasury bonds for the past five, 10, 15, 20 and 25 years.”,  and there are questions about the  validity of the commonly used historical stock return information “What, then, are the odds that stocks will continue to lag behind bonds for the long run? The sad truth is that history can’t tell us the answer.”

Martin Wolf in the Financial Times’ “After the storm comes a hard climb” suggests that there is light at the end of the tunnel but “Those who expect a swift return to the business-as-usual of 2006 are fantasists. A slow and difficult recovery, dominated by de-leveraging and deflationary risks, is the most likely prospect. Fiscal deficits will remain huge for years. The alternatives – liquidation of excess debt via either a burst of inflation or mass bankruptcy – will not be permitted. The persistently high unemployment and low growth may even threaten globalization itself.” It an interesting article with insightful data pointing to slow 2010 improvements in the US, UK and Japan, but not Europe.

Fredrik Nerbrand writes in the Financial Times’ “De-dollarization is upon us” expresses concerns about the US dollar’s reserve status and suggests that “Treasury bonds should be viewed as ‘return free risk’ rather than ‘risk free return’…(and)… as all assets rest on the now unstable foundation of US government bond yields, valuations of riskier assets may appear less attractive….(then)… private investors need to be aware and positioned for a multi-polar world.”

Nassim Taleb and Mark Spitznagel in “Time to tackle the real evil: too much debt” have a better idea. Sounds simple and it might work by stopping the foreclosure driven forced home sales. “The only solution is to transform debt into equity across all sectors, in an organized and systematic way. Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity.” And as great minds think alike, John Dizard in “An interesting arbitrage in the property sector” proposes a similar solution. “Two processes have to play out: losses must be incurred and recognized, and debt must be replaced with equity.” Alan Weiss suggests to “float unlevered real estate investment trusts, specialized initially in multi-family rental housing, that will pay dividends to the public, not interest and principal repayments to the lenders” and “have come up with a methodology for determining the return on the public investors’ equity that, they believe, gives the investors an inflation indexed return, and leaves the property owner with an incentive to continue to actively manage and improve the underlying properties.”

And finally, something useful J

In the BirdTalk section of the latest issue of the Canadian Snowbird Association CSA Magazine (not yet posted online) there is interesting information for those who travel or winter in the U.S. and have been frustrated as they lack a U.S. Bank sourced credit cards and the requirement to enter a Zip Code to complete a gas purchase with your Canadian credit card. According to letters in the CSA Magazine, US based credit card is available for Canadians from Discovery if you provide them your temporary US address.  As far as ZIP code problem when buying gas with  Canadian credit cards, all you have to do is punch in the 3 digits from your Postal Code plus two zeroes!