Hot Off the Web– October 25, 2010

Personal Finance and Investments

In Tim Cestnick’s Globe and Mail article “Deducting mortgage interest takes a fortitude many lack”he explores the so called “Smith Manoeuvre” which “essentially involves slowly converting your non-deductible mortgage payments into deductible interest payments on a loan used to fund an investment portfolio” (even though in Canada there is no mortgage interest deductibility like in the U.S.). “If you’re the type of person who views market corrections as opportunities, you might be right for the Smith Manoeuvre because the math works if you have the conviction to stick with the plan…If market corrections make you nervous, you probably don’t have the fortitude required for most types of leveraged investing. In that case, skip the Smith Manoeuvre and stick with the KISS principle.”

In the Globe and Mail’s “Gain to pain ratio can help you pick a fund” Avner Mandelman looks at methods of comparing different funds. In addition to the traditional Sharpe Ratio (fund’s annual return reduced by the risk-free rate, divided by the fund volatility), he suggests a “gain to pain” ratio measured by dividing “the average rate of return by the maximum drawdown …the maximum dip from peak to through at any time during the fund’s history” and another number which is the “maximum time it has taken the fund to recover from a drawdown”. (Interesting and might be worth trying, so long as you remember that all these measures are backward looking and “past performance is not an indicator  of future performance”.)

A very short video clip addresses the Difference between income and wealth “”You can be middle class by income, but not by wealth,” Julianne Malveaux, an economist and president of Bennett College tells O’Brien in the documentary…If you’re middle class by income, anything will knock you over. If you’re middle class by wealth you can basically survive a couple of storms.”” (You might also be interested in my earlier blog on “What is wealth?” in Annuity I. Recommended by the Washington Post’s Personal Finance Letter)

In Fortune’s “Warren Buffett: Forget gold, buy stocks” Ben Stein shares some thoughts from a conversation with Buffett: buy VTIinstead of gold and that housing “recovery is still a long way off. That market got way out of equilibrium, and it’s going to take a long while for it to get fixed”.

In the Globe and Mail’s “How your loss can be your spouse’s gain? Tim Cestnick discusses a mechanism to transfer capital gains from one spouse to another who has unrealized) capital losses by taking advantage of “superficial loss” provisions of income tax laws. Spouse with loss sells, spouse with gain buys same, and then proceeds to sell; timing is critical in this tactic.

John Heinzl in the Globe and Mail’s “Stock indexes: Taking the market’s temperature” explains the differences in types of indexes: market-capitalization weighted (most common form of index), price-weighted (DJIA), equally weighted (and more recently the so called fundamental indexes).

In WSJ’s “How to accept money from your relatives” Ruth Mantell warns that before you accept loans or gifts from family or friend you should “explore and exhaust every reasonable possibility before involving personal relations,” said Ms. Gurney, a psychologist. “It’s much easier to deal with loans when you clearly know your responsibilities and transaction costs.”  Gifts and loans “can change the dynamics of a relationship” even if the loan was repaid. ”Money is transitory, and things you buy are transitory, but relationships last a lifetime.”

In the Globe and Mail’s “Hedge fund fees start to drop amid fierce competition”Shirley Won reports that “Hedge funds were once known for the fat fees they charged investors, but they are trimming those charges amid growing competition for clients.” She gives examples where the traditional 2-and-20 (annual 2% fees plus 20% of the profits) is being replaced by 2.5-and-0 (just 2.5%/yr with no profit sharing or by 0-and-20 (no annual fees just 20% of profit). (Interesting, and one ask what the impact of these changes might have on the very high Canadian mutual fund fees.)

Jonathan Chevreau in the Financial Posts “A good annuity strategy can help you beat inflation” discusses inflation indexed annuities that are starting to become available in Canada. For those who are considering annuitization because of a combination of their income needs relative to available assets, have low risk tolerance and/or have no desire to leave an estate, indexed annuities are another tool in the retirement tool-box, which of course comes at the cost of about 36% lower that the un-indexed annuity income given in the article example. (Just make sure to compare with other available annuity and non-annuity options.)

Another Jonathan Chevreau article “Downside defence at a cost”discusses a leveraged equity investment product with downside protection that was a hit in Australia. The vendor, while not divulging the products exact structure assures investors that it worked great in Australia. “At the stated range of interest rates (12-18% and 3-5 year term), assuming dividend yields of 2% to 4% after tax, the annual cost would be 4% to 8% to carry such an ­investment. Of course, this assumes all loan interest is fully tax-deductible. If not, the numbers are less rosy. (Beware; costs will likely eat any upside potential…just like GMWBs.)

Real Estate

If you are interested in looking at global housing purchase and rental prices the Economist has an interesting set on interactive charts in “Clicks and mortar”.

Ted Rechtshaffen in the Globe and Mail’s “Is your house key to your retirement plan?” quotes his real estate agent mother that “if you live in a city your whole life, the only significant real estate purchase and sale decisions are the timing of your first home purchase and the sale of your last house”. If you know that you’ll need to sell your home, because the proceeds will be needed to meet your needs in retirement then the timing of that sale can be critical, and Toronto “average prices have now risen 14 straight years”. So he suggests that you consider either selling now or securing “a sizable home equity line of credit, should you need it in the future.”

In the Globe and Mail’s “Why U.S. housing faces double-dip threat”Michael Barad reports that “House prices are likely to fall steadily over the course of the next 12 months, taking them to a new cycle low. Prices may not regain their previous peak for a decade.” “In the second quarter, 23 per cent of all mortgage holders were in negative equity. Half do not have the 20 per cent of positive home equity necessary to qualify for a new mortgage … Millions of Americans simply are unable to move home or refinance.”

In the WSJ’s “Banks restart foreclosures” Silver-Greenberg, Whelan and Fitzpatrick report that U.S. banks restarted foreclosures “that were frozen by documentation concerns”. After reviewing paperwork during the recent foreclosure hiatus, they concluded that they found the paperwork in satisfactory condition.

Pensions

Shlomo Benartzi on “Behavioral finance and the post-retirement crisis” looks at employee/retiree behavioural consideration for retirement income strategies. He generates a checklist of “10 behavioural insights that should be taken into account when creating and evaluating a retirement income strategy”. Included in the list are: framing in terms of monthly income, translating financial decisions today into impact on future life, compatibility with retirees risk tolerance, making pre-cognitive-impairment decisions, appropriateness of default decisions to each individual, comprehensibility, inclusion of some inflation protection. (Thanks to Ken Kivenko of the CanadianFundWatchfor recommending.))

The Economist’s Buttonwood in “Old-age tension” concludes that “Raising the retirement age may not be popular, but it will be more popular than the alternatives. Get used to it: we are heading towards a pension age of 70.”

In the Financial Post’s “Senators call for new Canada-wide pension plan”Norma Greenaway reports that a bipartisan (7 Conservatives and 5 liberals) Senate committee report recommends that a “new Canada-wide pension plan should be created to help bolster the retirement incomes of Canadians, especially those without company pensions”. (Someday this or the next federal/provincial government will recognize that not tinkering but urgent and massive changes in Canada’s retirement income system are needed; hopefully that someday will be sooner, not later.)

Milevsky and Shao in the Pension Research Council working paper “Annuities and their derivatives: The recent Canadian experience” gives an overview of the Canadian annuity market including tax considerations and Money’s Worth ratios (MWR).

In a bizarre posting at the NRPC website entitled “Nortel pension funds NOT mismanaged” a letter by CAW legal counsel Barry Wadsworth tries to argue that Nortel’s pension funds were not mismanaged. Arguments in support of the thesis included that the plan could not have been mismanaged since neither the FSCO nor the government brought charges against Nortel. (Sorry, I don’t buy the arguments. The plan is claimed to be 64% funded (yet to be confirmed by the new administrator) didn’t get there without the mismanagement of any of those responsible for insuring proper running of the plan, like: Nortel, its Board/Officers, actuaries (Mercer), investment manager and custodian (Northern Trust), regulator (FSCO), government (federal and provincial), etc….Not only don’t I buy the arguments, but it is strange that such a letter would be posted without comments from the pensioners’ representatives. It’s nobody’s fault; everybody was just following orders!?! (The following section was added on November 19, 2010) In the interest of helping to engage in a more serious discussion on the subject of mismanagement of the Nortel plan, on November 19, 2010 I replaced the ‘monkeys’ comment with the following reference to an earlier blog discussing the failure of some or all of those who were responsible for and/or benefited from having been involved in the management or oversight of the plan, and who as part of their involvement as fiduciaries, professionals, and regulators, could have prevented the disastrous outcome, but obviously didn’t, at least so far; since the bankruptcy, one could have added others to the list of those who had the opportunity, but so far failed the pension plan beneficiaries like the lawyers, judges and the federal/provincial governments and politicians now in power. If interested, you might wish to read one of my old blogs on this subject entitled Systemic Failure in Canada’s Private Pensions: Who could have prevented it? What could be done now? ; it gives a hint why the Nortel pension plan didn’t become accidentally underfunded by about 40%.

Things to Ponder

In CARP Action Online’s Advocacy section, yours truly writes in “Ideas for an investor friendly financial industry in Canada”that “There is now consensus that Canada needs a major overhaul of its retirement income system. One of the key enablers of this overhaul is a more investor friendly financial industry. Let’s look at three changes which would go a long way to a achieve this: fiduciary responsibility, low-cost asset management with decoupled fee-only advice, and mutual rather than public financial corporate organizations driven by customers’ best interests.” (The article includes recommendations for action by investors and government/industry.)

Deflation? In the Financial Post’s “Inflation continues to rise in September” Derek Abma reports Canadian inflation at 1.9% in September (up from 1.7% (the previous month). “Much of the gain came from energy prices, which were up 5.6% higher than year earlier….Core inflation, which strips out volatile items such as energy and certain food- and even the new HST in B.C. and Ontario- was 1.5% last month.”

Andrea Coombes in the WSJ’s “Expenses rise, Social Security doesn’t” reports that Americans are not getting any Social Security cost of living adjustments in 2011 (for the second year in a row). The “benefit adjustments are tied to increases in the consumer-price index for urban workers, or CPI-W — and that measure doesn’t include any retirees, who, for instance, average higher health-care costs than workers do” But some experts argue, that this is fair due to the large (5.8%) energy related cost of living adjustment in 2009. In fact some even question why indexing of Social Security is appropriate at all, since most wage earners don’t get such an adjustment.

In the NYT’s “The financial time bomb of longer lives” Natasha Singer  recounts (again) that developed countries are not taking the necessary steps to avoid financial disaster as a result of the elderly population explosion. But then the reporter shifts her attention to opportunities for “profound and transformational” changes in the “public arena, innovation that is driven by industry”. Examples include: take up aging as a cause (like the environment), education (“greater longevity may entail personal sacrifices, like increased savings and a willingness to pay higher shares of their medical and long-term care costs “), incentives so “Rather than uniformly extending the retirement age, she says, governments and the private sector could develop incentives that motivate older people to remain in the work force” and “governments and companies may need attitude adjustments so they can view aging populations not as debt loads but as valuable wells of expertise”.( Now there  are some refreshingly positive ideas  for policy makers and activists. Thanks to SI for suggesting the article.)

And finally, in the Financial Times’ “Mandelbrot tips off the markets” Christopher Caldwel, triggered by Benoit Mandelbrot’s passing last week, writes that some of his criticism of economists and the financial modeling was taken by many as an accurate reflection of market behaviour. “Economics is a science of fashions – Keynes and ‘pump-priming’ at one time, Friedman and monetarism at another”. ““I agree with the orthodox economists that stock prices are probably not predictable in any useful sense of the term,” he wrote. His gripe, rather, was with the system. All algorithms tended to underestimate the risks of investing. Mandelbrot distinguished between “Joseph” effects (seven lean followed by seven fat years, where effect “depends on the precise order of events”) and “Noah” effects (cataclysmic events whose “effect depends on the relative size of each event”).” But it is Noah effects make and unmake investors. “Wild price swings, business failures, windfall trading profits – these are key phenomena.” (You might also care to re-read my earlier blog on Mandelbrot’s book “The (Mis)behavior of Markets”.)