Hot Off the Web- December 19, 2011

Personal Finance and Investments

In the WSJ’s “How to pay your financial adviser”Daisy Maxey writes that the good news is that: “You have more options than ever for paying your financial adviser. The bad news? It’s even tougher to figure out if you’re getting the best deal for your money.” She then enumerates some of the more common ones and corresponding disadvantages: asset based fee (Potential conflict of interest: advisor might take too much risk to increase assets, discourage purchase of insurance products which reduce managed assets, is advisor earning his fee?), hybrid or fee plus commission (Potential for even more conflict of interest, at times advisor wears both fiduciary RIA and non-fiduciary broker hat; the fee might be for a financial plan), flat fee (Expensive for individuals with limited assets and/or limited need for advice), net worth and income based, and hourly fee (Potential conflict is advisor incentivized to run up the clock). (Perhaps if the advisor had fiduciary responsibility toward the client, then a hybrid of asset-based fee and hourly fee (for special services like a financial plan) might work even better than the above list?)

In the Financial Times’ “Hedgies’ average return is ‘zero’”Steve Johnson reports that while previous studies suggested that hedge funds delivered excess returns of 3-5%/year after fees, a new study indicates that 0% is closer to the truth. Previously reported returns appear to have been boosted by (poor performing) funds not reporting, by “persistent” claims that that returns contained “inherent biases” and by absence of “dead” funds.

In the WSJ’s “Baby boomers are targeted by investment scams”Kelly Greene reports that boomers are under attack by investment fraud. State and federal regulatory action has increased >100%   and >50% respectively from 2009 to 2010 involving investors over age 50. High runner investment frauds included: Ponzi schemes, self-directed IRA invested in “bogus real estate, gold and oil wells, and promissory notes”. High runner enforcement actions mentioned include: variable annuities, free-lunch seminars and misuse of professional credentials.

Now that there is a GMWB/GLWB (I will use them interchangeably since a lifetime GMWB is a GLWB) product (Vanguard GLWB) priced so that the promised upside might actually have some value, a very timely article I just came across is Morningstar’s “Allocation to deferred variable annuities with GMWB for life”. In the article Xiong, Idzorek and Chen tackle some important questions associated with GLWBs: how much of one’s assets to allocate to GLWBs, how a GLWB allocation affects the risk level in the rest of the portfolio (i.e. what is the effective asset allocation of the VA+GMWB), what’s the value (basis points) of the GLWB as a function of the asset allocation in the VA (i.e. the volatility of the portfolio whose income stream is protected), the value added of the GLWB as a function of age, life expectancy, wealth-to-required income from wealth, desire to leave a bequest, guaranteed income step up frequency and withdrawal rate. The paper is well worth reading for the for some of the “numbers”, but qualitatively they conclude that: “ (1) The higher the risk tolerance, the lower the VA+GMWB allocation; (2) The higher the age, the lower the VA+GMWB allocation; (3) The higher the subjective life expectancy, the higher the VA+GMWB allocation; (4) The higher the ratio between wealth and income gap, the lower the VA+GMWB allocation; and, (5) The preference for bequest has almost no impact on the VA+GMWB allocation”…and that “Hedging longevity risk is a crucial task. Implementing a target asset allocation with a mixture of traditional investment products and variable annuities with guaranteed minimum withdrawal benefits for life creates a powerful retirement income solution that enables investors to participate in the potential upside of good markets and providing them with income for life in bad markets.” (This is all very sensible indeed and paper is well worth reading.)

In AvisorPerspectives’ “GLWBs: retiree protection or money illusion?” Wade Pfau looks at GLWBs in general and Vanguard’s new GLWB parameters in particular. He compares the Vanguard GLWB with a “nominal dollar” guarantee which actually erodes significantly of a 30 year retirement (this is the same problem with fixed annuities), as compared to an initial dollar value withdrawal of 5% of asset not adjusted and adjusted annually for inflation. While I am not a fan of using actual historical data due to its very limited sample size of 56 between 1926-1981 (I prefer a Monte Carlo approach which has its own deficiencies), but he shows that over his limited sample size only the 1929 retiree runs out of assets with a constant 5% of original assets nominal withdrawal rate. Therefore, he asks the interesting question: what’s the value of the insurance in this case? Of course the sample size of 56 is very small and we know for certain that the future will be different than the past. (A few retirees with very low risk tolerance may choose annuities (but they not only give up control over their assets, but also leave themselves exposed to potential ravages of inflation over a 30 year retirement), others will opt for a low cost GLWB like Vanguard’s which gives them the comfort of the downside protection of a lifetime income while reaping any upside that becomes available (and they don’t have to relinquish control over their assets). The Vanguard product is the lowest total cost VA+GLWB available by about a factor of two, and it is priced so that there is a good chance of an upside (see Vanguard GLWB). For a little more risk tolerant retirees, a proportional withdrawal strategy with a floor and ceiling on withdrawals provides potentially with higher income, more flexibility (but without GLWB’s downside protection). The low-cost GLWB may be a good compromise between and annuity and flying without the safety-net of longevity protection; you just must make sure that the total GLWB+VA cost is under 1.5% for a 50-60% equity allocation in the underlying VA assets.)

In Canadian Money Saver’s “Hiding the truth about UL”Robert Barney shines some light on Universal Life policies and insurance companies’ tendencies to take special efforts to obfuscate what actually happens in these policies, which he says often “can become a huge mess”. In a typical whole life policy two components (the insurance component and a reserve component which is available as cash surrender value at any time but are ultimately part of the policy payout in case of death) are used by the insurance company to determine the payable premium to insure that the constant premium paid at all time covers both the growing mortality cost with age and the asset build up required to make up for the smaller insurance component that can be bought with the insurance component. In a universal life policy, he indicates that “it is no longer the company that determines how much premium you pay, it is you. That means you will determine the relationship between the insurance and the reserve… While the company sets a minimum premium that you must pay, and the government specifies a maximum (to keep the policy tax deferred), there is no guarantee that the product will deliver a lifetime benefit if you only pay the minimum premium. And that is the danger of UL. (Of course the problem with UL policies is the high cost of investment management.)If you don’t pump enough money into the policy, it may not build enough reserves to support the ongoing and rising costs of the term insurance component.” In that case you would be called upon to increase your payments or policy would collapse. Barney writes that insurance companies don’t provide explicit break out of the insurance cost to the customer since they are “hiding the critical information because life companies are putting off giving consumers the bad news. Most of these UL policies are going to collapse”, since the “original investment projections…never materialized”.

In the Globe and Mail’s “Bond ETFs confuse you? Here is a simple guide”Rob Carrick explains some of the subtleties associated with bond funds like: types, taxes, costs/fees, differences from owning a bond, return (YTM less costs/fees). The article also includes a list of bond ETF on the TSX.

Real Estate

In the  Atlantic Cities’ “The world’s housing bubble” Richard Florida writes that “America has suffered through a housing crisis for the past several years, with the average price falling 30 percent, and much more than that in some areas. So it may come as a surprise to many Americans that much of the world still appears to be in the throes of its own housing bubble.” The article contains some very interesting IMF sourced charts on real estate price trends throughout the world, as well as measures of house prices’ two key “anchors”, “price-to-income” and “price-to-rent” ratios relative to historical average (represented by 100). By the way, Canada has the highest price-to-rent ratio at 170 of all the countries indicated, and its price-to-income ratio at 130+ is the 5thhighest not far behind Netherland at 140+ which is the highest.

The NAR (National Association of Realtors) is revising downward the last five years of U.S. existing home sales “Existing home sales to be revised lower”. The amount of the drop has not as yet been specified, but reasons included double counting some home sales. NAR’s chief economists indicated that “the revisions will have no impact on consumers because median home price data will not be revised “. (Cynics might be forgiven for thinking about “lies, damned lies and statistics”. When the sales were dropping like a rock, sales were being overestimated. Now with the expectation of sales volumes may finally hitting bottom, revising previous sales level downward should improve the looks of future sales volume increases from a ‘lower’ base. J)


According to a new C.D. Howe report “Ottawa’s Public-Sector pension bubble grows to $227Billion” its authors Laurin and Robson write that using fair-value accounting which value assets at market prices and liabilities based on current interest rates the federal government of Canada has an $80B unfunded liability exposure. Furthermore “These colossal numbers reflect a gross unfairness in Canada’s pension system, say the authors. The fair value of the typical federal employee’s pension entitlement is growing at more than 40 percent of pay annually- much faster than the contributions to fund it, and faster than tax rules permit other Canadians to contribute to RRSPs or defined-contribution pension plans. “Unhappily, those Canadians who must prepare for retirement in a much less congenial environment are also on the hook for the growing unfunded liability in the federal plans,” say the authors.” (By the way if your Canadian private sector pension plan sponsor (employer) goes into bankruptcy protection with an underfunded pension plan, not only are pensioners placed among the lowest priority creditors, and with no (or in Ontario very low) pension guarantee schemes, the best that pensioners can expect after having been prevented from making RRSP contributions is PAR (pension adjustment reversal) credits; so when they are 75 or 80 year old and they run out of money and they have to go back to work, then they’ll have extra RRSP room to save for their retirement. And by the way Mercer, Nortel’s pension actuaries until bankruptcy, assigns Canada 5th highest place among 16 countries ranked according to Mercer’s pension index; Of course, as children, we were told not to believe everything we read, even if prepared by Mercer under whose actuarial watch Nortel’s DB pension plans ended up 41% underfunded DB. In the Financial Times’ “Rating the not-so-perfect pensions” Pauline Skypala discusses the origins of the Mercer Pension Index and says that the index was launched “to promote Melbourne as a fund management centre, and attract international fund managers to help diversify Australian pension fund portfolios. But if it creates more debate over how to achieve that elusive perfect pension system, it will be a better publicity stunt than many.” No doubt one could have a vigorous debate about what factors to include on or exclude and how to assign weights to those factor in a pension index, but that’s more work than a ‘publicity stunt’ is worth. If Canada and Australia are near the top of the list of pension schemes despite their corrosive private sector DC or RRSP-like fees which erode over 50% of individuals’ savings over their working lives, then either the index is wrong or all pension systems are deeply flawed.) For a somewhat different perspective you might want to read Leo Kolivakis’s “The great pension divide”in which he argues that the problem is not public sector vs. private sector, but Wall Street vs. Main Street. He suggests that the solution for Canada is not the massive shift to DC plans run in the private sector (PRPP), but an expanded CPP. (I guess we’ll find out later on this week if the finance ministers agree.)

In the C.D. Howe Institute’s “Saving Pooled Registered Pension Plans: It’s up to the provinces” Ambachtsheer and Waitzer argue that while the PRPP in its current form falls short of  ensuring that Canadians without workplace pension will have access to ”a well regulated, low-cost, private sector capital accumulation plan”, they argue that the provinces can still  save the day by  addressing three of the major shortfall areas: (1) maximizing participation (require employer to offer  and require employer to contribute, but allow opt-out  for both employer/employee), (2) well designed default option (a logical  contribution and investment management  model during accumulation/decumulation phases including annuity options, and (3) fiduciary oversight (““How to fix the flaws  in Ottawa’s design for pooled registered pension plans”Effective oversight can best be delivered by an independent, expert PRPP licensing body with ongoing “value for money” monitoring responsibilities). (I guess so; if the federal PRPP proposal is the bucket (which is still empty), and may be filled by the provinces with content (the Ambachsheer/Waitzer proposal addresses three out of my four criteria for pension reform: savings rate, low-cost, longevity insurance and secure existing commitments to private sector DB plans) that would be progress compared to the current empty shell.)

Benefits Canada’s “Pension experts call on finance ministers to expand CPP” reports that” a group of pension experts, including a former chief actuary of the Canada Pension Plan, is calling on Canada’s finance ministers to commit to expanding the CPP”.  Their open letter is intended to influence (for the better) the current path of pension reform based on the PRPP, in preparation for the upcoming finance ministers’ meeting on the subject.  (Not a perfect solution, but far superior than the current path the PRPP!)

In the Financial Post’s “Sun Life limits life policies, annuities” Barbara Shecter writes that Sun Life is “opting to pursue a strategy that doesn’t involve the sale of new individual life insurance policies and variable annuities in the United States.” One analyst is quoted as saying “The variable annuity product in particular “is one that can seemingly never simultaneously satisfy the needs of shareholders, regulators and customers…”” (I suspect, the variable annuity product is not alone among insurance products about which you could make that latter comment. In fact it may be a good time to look whether mutual rather than the public shareholder based model is more appropriate for most insurance products; perhaps we need a re-mutualization debate.) And by the way in the Globe and Mail’s “Ottawa closes door on banks selling annuities” Perkin, Torobin and Robertson report that “Ottawa is wading into a high-stakes battle between banks and life insurers, ordering the banks to stop selling products that resemble annuities… The decision is a win for the country’s life insurers and a blow to Bank of Montreal which kicked off this battle in January when it began selling a product called BMO Lifetime Cash Flow, which provided buyers 55 and older with guaranteed payments for life.” (The BMO product will be no loss to investors as I indicated in my earlier blog reviewing this product BMO Life Stage retirement Income Portfolioswith the conclusion that such structured products are complex, opaque, come with high-fees and are usually not good for your wealth. Better get independent professional advice if you are considering them. It appears what the government is doing is protecting insurance companies by not allowing increased competition in the financial industry; that’s too bad since there isn’t any competition in Canada to speak of and guess who is paying for that? The right thing for insurance is to start the move to re-mutualization of insurance. The insurance industry lost its way when it transformed itself into public companies. They transformed themselves from acting as fiduciaries to their customers to fiduciaries of their public shareholders and shifted from their role as risk redistributors among their customers to financial market gamblers, with their customers ending up as losers on both accounts. )

Things to Ponder

In the WSJ “All countries must help Europe” IMF’s Christine Lagarde is quoted as saying “”It’s not a crisis that will be resolved by one group of countries taking action,” Ms. Lagarde said in remarks at a State Department conference. “It’s going to be hopefully resolved by all countries, all regions, all categories of countries actually taking action.” She said if the issues are not dealt with decisively, the global economy could confront the same threats that pushed the world into the Great Depression of the 1930s.”  To further add to concerns about shifting winds, Gillian Tett in the Financial Times’ “Crisis fears fuel debate on capital controls” discusses a new Bank of England report that asks whether the world is sliding toward capital controls. (It’s all quite depressing and destabilizing, and points to the most significant deficit that the world is currently suffering through, i.e. the leadership deficit.)

In an insightful article in WSJ’s “The Euro zone’s German crisis” Alan Blinder discusses the “gigantic problems” that resulted from: (1) “17 sovereign nations signed up for a currency union without first homogenizing their budget policies, their tax systems, their bank regulations or much else…or without creating a central government strong enough to…impose cross-border discipline or finance large cross-country transfers.”  Euro zone members have only one tool (fiscal policy) of the usually available three tools to fight a weak economy (monetary policy, fiscal policy and currency depreciation). (2) Euro based countries lost the productivity race with Germany; this might be fixed by increasing German inflation relative to others, have the other countries raise their productivity levels to that of Germany, and other countries have prolonged deflation (i.e. lower wages and prices); but only the latter option is available realistically; and Blinder says “wish them well”.

In the Financial Post’s “Books to get you out of this financial mess”Jonathan Chevreau provides a good reading list for those wanting to get themselves educated in personal finance and investments. Among the books mentioned are: Charles Ellis’s “Winning the loser’s game”, Larry Swedroe’s “What Wall Street doesn’t want you to know”, and others.

In the Globe and Mail’s “Record high household debt in Canada triggers alarm” Tavia Grant reports that “Canadians have set a new record for household debt, a sign that many families are leaving themselves vulnerable to an economic shock. The debt burden of Canadian households has surpassed levels of both the United States and the United Kingdom and, by at least one measure, they are hurtling toward those countries’ peak levels of 2007, new Statistics Canada data show… The ratio of debt to personal disposable income hit a high of 152.98 per cent in the third quarter…” Canadian household are at significant risk not just due uncontrolled spending but also since much of the debt is at floating rates (especially mortgages, which even when they are ‘fixed’ are only for up to 5 years) which exposes them to higher debt service levels than they are able carry. Bank of Canada’s Mr. Carney is quoted as suggesting that problems start when debt service consumes >40% of income.

In the NYT’s “A risk once unthinkable”  searches for mechanisms of how MF Global missing $1.2B of customer funds in segregated account could have disappeared and he comes up with no answers. The closest hints are that there may have been some unauthorized trades in customer accounts and the industry is essentially self regulated with very minimal independent regulatory oversight.

In WSJ’s “Gold experiences an identity crisis” Liam Pleven asks whether gold is an “Insurance play or bold bet? Defensive asset or risk chaser? For the yellow metal, it depends on the day”.

While gold is still up over 10% since the start of the year, it is well down from its all time high earlier this year and it’s been quite volatile lately. Gold’s correlation has been increasing with stocks, meaning that when stocks fall, often so does gold. Last year when the Greek crisis flared investors were dumping stocks, gold was a safe haven. This year instead of buying gold when crisis hits often investor seem to run to the U.S. Treasuries and dollar. Some argue that often gold sell-off is due to its liquidity investors are able to raise cash to cover losses on other assets. In Bloomberg’s “Death of Gold bull market seen by Gartman” Nicholas Larkin reports that Gartman predicts a fall in gold price to the $1475 area after 11 year price increases, including this year’s 17% (though 13% off the record $1921).

And finally however, in the Barron’s “Next: “Face-ripping” inflation” Doherty and Barry report that QB Asset Management predicts global hyperinflation since soon “central bankers will start printing money to pay off public debts and keep banking system solvent. They expect a managed global devaluation of major currencies in six months to a year.” Their recommendation is to “buy gold and unlevered assets. The losers in this scenario are holders of cash and “risk-free” Treasuries”.


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