Hot Off the Web– May 30, 2011

Personal Finance and Investments

Have maximum safe withdrawal rates dropped for recent retirees from the traditional 4% to 2%? My last week’s in-depth blog reviewed Wade Pfau’s “Safe savings rates: A new approach to retirement planning over the lifecycle” in which he extends Bengen’s work on SAFEMAX (maximum safe withdrawal rates) and shows that based on historical data one needed a minimum savings rate of 16.6%/yr over 30 years of accumulation, to generate an inflation adjusted 50% final salary replacement rate for the next 30 years. For those of you who, like I, are junkies for papers on withdrawal rates (especially when they have something new to say as is case here) might be interested in some of Pfau’s other related work uncovered as a result of correspondence with him. He pointed me to another related paper of his entitled “Can we predict the sustainable withdrawal rate for new retirees”, in which extrapolating some historical data suggests (Figure 4 in the paper) that new retirees since about 2003 might be facing safe withdrawal rates as low as under 2%! (I am intrigued by his analysis and results. I find his argument that those retiring in years of (extreme) high/low market valuation might need/have lower/higher maximum sustainable withdrawal rates, but I have difficulty resonating with the suggested unprecedented sub-2% withdrawal rate (especially given the author’s own caveats). While the results are interesting in the sense that Richard Hamming indicated that the purpose of “computing is insight, not numbers”, the indicated numbers can be frightening to new retirees; I particularly can’t relate to the set-and-forget assumption of 30 years of inflation adjusted withdrawals following the initial draw of 4% of year 1 assets, irrespective of market returns and remaining assets. As readers of my blog know, my approach is to use 4% of current assets in retirement as a guideline withdrawal level, which not only won’t increase withdrawals for inflation, but even reduces nominal withdrawals in years when nominal returns are <4%. Having said that, I am very interested in exploring (if and) how one might adjust one’s allocation to risky assets when (extreme) market valuations prevail (e.g. PE <10 or >30) and whether any gains might be reaped after taxes, transaction and other  costs incurred in such market timing manoeuvres over and above a simple rebalancing to one’s strategic asset allocation.) Another paper which I came across on this interesting subject is “The impact of market valuations on safe withdrawal rates” in which Michael Kitces discusses: the criticality of the returns during first 15 years of retirement (or, perhaps better put, until one is about 75 years of age when probability of much more than (joint) 20-25 years of remaining retirement is remote), how one might adjust safe withdrawal rates and portfolio composition in response to valuation extremes (one might chose to use the 4% of current assets guideline), and while market valuation may be helpful but it is far from perfect market timing indicator. (And as you know, I am not a believer in market timing (except at the margins, at best, when some valuations really are at extremes), but one needs to keep an open mind and continue to retest one’s assumptions and dogmas.)

Ted Rechshaffen in the Globe and Mail’s “Think you’re too wealthy for Old Age Security?” has some suggestions for those who, as a result of minimum RRSP/RRIF withdrawal requirements starting at age 72, will not only push them into higher tax brackets but also may kick-in OAS claw-back. For the specific circumstances in the article, Rechtshaffen’s suggestions include using the age 65-71 interval to make some appropriate annual RRSP withdrawal to reduce size of RRSP without affecting OAS before age 72, so size of required post age 72 withdrawals will be lower. (Tax-driven investment strategies are not usually the preferred approach, but it is worth looking at if your circumstances are similar to those described and there may be some tax or OAS savings involved. But then of course tax regime may change and perhaps the government might decide that after all it is not right to force individuals to take minimum withdrawals at age 72 or even later, or might even lower the income level at which OAS clawback starts; but that is even more speculative than deciding to pay higher taxes now to save taxes in the future, assuming an unchanged tax regime. The article didn’t mention that if you want these pre-age 72 withdrawals to be eligible for pension splitting, you might have to convert the targeted withdrawals to a RRIF.) By the way coincidentally there was a second article on the same topic and day by Rob Carrick entitled “How to avoid the dreaded OAS clawback”

Preet Banerjee explains “How to create your own weighted average benchmark” in the Globe and Mail article of the same name. (You might also be interested in my earlier blog on Benchmarks. Thanks to Rob Carrick’s Personal Finance Reader for referring the article.)

Alicia Munnell in WSJ SmartMoney lists “4 reasons your retirement is riskier than your parents”; these are: “we’re living longer, “replacement rates are falling”, “out-of-pocket health costs are rising” and “returns have declined”.

In WSJ SmartMoney’s “How to insure a stock portfolio”Jack Hough lists some approaches to insuring a portfolio against market declines. The list includes: buying puts (option contracts) on a single stock or on the whole market, zero coupon wrap (buying a discounted zero coupon Treasury strip and  investing the remaining assets equivalent to the discount into equities, so at strip maturity date  you’ll at least have original nominal dollars), stock indexed annuities (equity index annuities whose payout varies with market performance), but the best is, the old-fashioned approach  to flood insurance, building on high ground (the investment analogy being having an appropriate base of fixed income securities i.e. bonds). The author notes that except for the old-fashioned approach, the others tend to be expensive when continually used and can seriously eat into returns.

In the Globe and Mail’s “Super rich are no happier than the rest of us” Angela Self reports that “The ideal is to come to happy place with what we have while maintaining a healthy drive for what we want. Dr. Klontz says to get to this place, we need a clear idea of why we want to build wealth in the first place.”

Real Estate

The March Teranet-National Bank House Price Indexindicates a Canadian home price advance of 0.6% in the month of March and 4.1% over previous year. Prices advanced in five of the six cities making up the index, with only Calgary showing a drop.

In the Financial Post’s “Vancouver housing testing ‘rationality’” Christine Dobby writes that according to a recent RBC report Vancouver home prices are “becoming increasingly disconnected from local demand conditions; the cost of carrying a home has become 72.1% of pre-tax income of homeowners (including mortgage, utility and property tax payments). Toronto is at 47.5%, Ottawa at 39%, Calgary at 35.9% and Montreal is at 43.1%. (Recall that according to graphs shown in “Strong housing forecast for Canada: report” the average Canadian house price is more than twice the average U.S. one, in local currency. Do trees grow to the sky? I guess we’ll find out eventually.)

In the NYT’s “As lenders hold homes in foreclosure, sales are hurt” Eric Dash reports that banks and mortgage lenders “own more than 872,000 homes as a result of the groundswell in foreclosures, almost twice as many as when the financial crisis began in 2007, according to RealtyTrac, a real estate data provider. In addition, they are in the process of foreclosing on an additional one million homes and are poised to take possession of several million more in the years ahead…economists project that it would take about three years for lenders to sell their backlog of foreclosed homes. As a result, home values nationally could fall 5 percent by the end of 2011.” (Thanks to CFA Institute NewsBriefs)

In WSJ’s “Housing headache felt all over”Kelly Evans reports that “Anyone playing down the importance of housing at this point in the business cycle is missing the point: Housing is the business cycle… It is no secret housing and consumer spending have become increasingly important to economic cycles in recent decades. Yet economists and policy makers haven’t fully understood the implications of that, especially in regard to rising debt levels—one reason the current downturn is so severe…We are stuck today, as in the 1930s, in a household recession triggered by excessive debt levels. These, unfortunately, can take many years—not months—to fix.”

In the Palm Beach Post’s “Palm Beach County property values sink, further depleting tax coffers” Howard and Playford report that PBC property appraiser indicates the total taxable property value dropped 2.8% to $127.3B from the 2007 peak of $169.4B. To some this may be an indication that property prices may be bottoming, though I am not sure how good an indicator this is, given that Florida probably has the world’s most complex and screwed up property tax system (e.g. see just passed changes going to referendum “Florida’s nonhomesteader snowbirds shafted again by new property tax Bill 381”. Not clear what that 2.8% means since (computer model generated) “improvement” value (which is supposedly market value) is not necessarily actual “market” value; in addition for the guesstimated 30-35% property value in the county which is homesteaded, in a falling market can still increase “assessed” value by up to 3% of market value, which then translates to an even higher percentage of “taxable” value since homesteaders also get a $50,000 exemption. Of course homesteaders are screaming mad about this, but not to worry, it is the non-homesteaders who are getting screwed.) The good(?) news however is that “Falling prices, low rate mortgages put record number of homes in South Florida within the grasp of average people”according to Jeff Ostrowski who writes that “77.5 percent of homes sold in the first quarter were within reach of a median-income family, according to an affordability index released this week by the National Association of Home Builders. That’s based on a median home price of $120,000 for houses and condos, and a median family income of $67,600.”

In the Financial Post’s “Overcoming condophobia”William Hanley discusses some of the challenges and patience required to condo living. Hanley concurs that “condo life is not for everyone. Vertical villages can, like the non-vertical kind, have idiots. And sometimes it can seem as though they’re actually running the place. Indeed, in a way it is a great leap of faith to commit yourself to entering an agreement whereby you are to be financial and social partners with a couple of hundred strangers for the foreseeable future. You will deal with them at the closest of quarters, trusting them to do the right thing so that your property and your wellbeing are secure.” He suggests that before committing to condo living, consider: a test-drive of a condo rental for a year, take careful look at the building-its common areas-financial statements including reserve funds, and beside a walk through the neighbourhood “you may want to sit in the lobby and read a newspaper or magazine while observing the comings and goings of the occupants and getting a sense of what the villagers are like”. The Hanleys love the peace of mind which allows them to escape in winter for months without having to worry about their Toronto home.

Pensions

In the Financial Times’ “Risks in regulating pensions further”Pauline Skypala writes that DB pension schemes were wonderful for employers so long as they “appeared to cost little or nothing” and “sponsors often took long contribution holidays”, but the “surpluses turned out to be temporary, if not illusory” (Though she is speaking of the UK, this sounds awfully familiar; the difference is that in the UK, unlike in Canada, the pensioners are actually protected by government run pension insurance). This is now leading to the demise of DB pension in the private sector. Skypala explains that sponsors are now concerned that they’ll become subject to the same capital requirements as insurers in the UK. There is even talk about Europe-wide regulatory approach to pensions. “People cannot rely on the state to provide pensions in future, “so we need private pensions with a framework people trust and that gives assurance the regulatory system can cope with risks out there”” and this applies to both DB and DC plans to which the private sector has rapidly moved to “without any discussion of the required regulatory framework for it”.

Things to Ponder

So are ETFs about to collapse? (This is a question I seem to get occasionally as well.)In the FT.com/alphaville blog by Izabella Kaminska she refers to “Terry Smith doesn’t like ETFs” where mutual fund manager Smith argues that the mass shorting of ETF might somehow lead the collapse of an ETF when “the assets of the ETF may become significantly less than the outstanding cumulative buy orders would suggest” and “ETF holdings are not backed by assets of the sort investors expect”. There was another article, Financial Times’ “Raciest ETFs are an accident waiting to happen”  in which Jonathan Guthrie elaborates that “Bear raids pose another threat, writes Mr Smith. Shorts could sell heavy volumes of ETF equity, expecting to cover the transaction with shares created for the purpose. But funds might struggle to neutralise liabilities created for them in this way, particularly if their mission was to track indices on illiquid small-cap stocks… The majority are conservatively run and provide useful diversification to investors. But the raciest ETFs, which are most prevalent in the lightly regulated EU market, pose a mis-selling risk to consumers and a stability risk to financial businesses.” (I have contacted Vanguard and Barclays two of the largest ETF originators asking for a comment. I haven’t heard back from Barclays as yet, but Vanguard reply indicated that “We feel that the concepts described in the article are not supported by the rules inherent in the securities marketplace. The scenarios presented by the author are normal functions of the securities lending process and would not result in an exchange-traded fund (ETF) being over-sold.”  Vanguard then referred to their own October 2010 article on this subject entitled “Can  an ETF collapse?- Vanguard sheds light on this recent headline” which answers the articulated concerns, and to the IndexUniverse article by Matt Hougan “Can an ETF collapse? No”. The Vanguard article explains how “short interest in an ETF beyond shares outstanding is not a function of naked short selling. Instead, it is a function of the securities lending process and subsequent sale of borrowed ETF shares… ETF issuers have a basic restriction in place on redemptions that require the ETF shares to be in a deliverable state. If your shares have been loaned out, you do not have the shares to deliver for settlement of redemption”. So while there may be multiple owners of multiple ETFs on same underlying securities, only one of those owners, the one who did not lend his ETF is in a sellable state. Gluttons for punishment can also read John Heinzl’s Globe and Mail article “Assessing the risk of an ETF ‘blow-up’” addressing ETF concerns. (The bottom line is that the issue raised cannot happen given current trading practices, but if you are still concerned, you‘ll want to always stick with the largest and most broadly diversified ETFs representing passive indexes which implement creation of units by purchasing the underlying equities (rather than derivatives, e.g. swaps). As I have said before, risks are everywhere and I cannot say unequivocally “nothing can go wrong” (i.e. there may be unknown unknowns in ETFs as in other investments) but while ETFs are a different construct than mutual funds, they are also more transparent and it’s not apparent why they would be riskier than a mutual fund investing in the same asset class. I think the open discussion of potential issues with ETFs, real, imagined or just maligned to undermine confidence, is healthy as it will strengthen the ETF product characteristics; this would be true even if the sources of the attacks on ETFs are managers of mutual funds who have an axe to grind in their quest to stunt the ETF onslaught. While not all ETFs are created equal, they do have one thing in common, they are a rapidly growing threat to the mutual fund industry’s gravy train. You can expect to see growing hysteria from mutual fund managers who are trying to protect their turf. You might also be interested in my earlier blog on ETF risks entitled ETF Concerns: There are risks, but thanks I’ll stay with ETFs for my money in which I discuss how, used as originally intended, passive index based ETFs on broad/diversified asset classes, with low-cost, high liquidity, and limiting trading with appropriate order types, ETFs are still my preferred portfolio implementation.)

Hamilton and Leondis in Bloomberg’s “Finra’s Ketchum says structured products are ‘Areas of Concern’”write that there is a requirement for selling brokers to fully understand the “structured products, which are securities created by banks that package debt with derivatives as customized investment bets…(and ) Brokers can’t rely on firm approval alone to satisfy their suitability obligations…This is particularly important with the proliferation of increasingly complex financial products, and at a time when certain investors are tempted to chase yield in today’s lower interest rate environment.” (Good luck with this…I tend to run the other way when hear structured products.)

As an introduction to the next few articles on some economic and market forecasts, in the Financial Times’ “The follies and fallacies of our forecasters” Samuel Brittan addresses forecasting. He writes that “What do the Arab uprisings and the world financial crisis have in common? They seem very different subjects and are written about by different “experts”. What they have in common is the complete failure of almost all these experts to predict them.” He refers to a recent article by Taleb and Blyth that governments should stop trying to suppress volatility by various interventions trying to bring about stability. “They argue that political and economic “tail events” (ones that are unlikely in terms of conventional statistics) are inherently unpredictable “no matter how many dollars are spent on research”. They illustrate this by the now familiar analogy of the tipping point. Imagine someone who keeps adding sand to a pile until it crumbles. The foolish and common error is to blame the collapse on the last grain rather than on the structure of the pile.” Further on the subject of forecasting he brings the comments of Nobel economics winner “Ronald Coase, (who) discusses this in Essays on Economics and Economists. He remarks that when he edited a technical journal many of the quantitative articles published could not be said “to test a theory at all. They were measurements of an effect, the nature of which was already well established but of which the magnitude was unknown.”” Brittan concludes with “The moral is to try to understand a bit more and compute a bit less.” And now, some forecasts on which we can build some sand-castles or sand-piles…

In the Financial Times’ “Keynesians are complacent about the dollar”Steil and Hinds discusses concerns associated with what is perceived as an abuse by the US of the reserve currency privilege of the US dollar, and the gradual steps that are being taken by some countries. “America’s exorbitant privilege had produced an unstable international monetary system. The country had reneged on its commitment to keep its currency redeemable in gold and, predictably, had made its domestic priorities paramount over international ones. (This must have been a surprise…) China began initiatives to pave the way for what it hoped would be an eventual orderly departure from this system – such as bilateral agreements with Russia, Brazil and Turkey to conduct trade without dollars, and a slow build-up of gold reserves, which would be at least as useful in a crisis as dollars had been.”

In the WSJ’s  “Return of stagflation” Ronald McKinnon writes that the US is “facing an ugly combination of inflation and high unemployment, usually called ‘stagflation’ that the US has last experienced in the 70s. “April’s producer price index for finished goods, which excludes services and falling home prices, rose 6.8%. The Bureau of Labor Statistics reports that intermediate goods prices for April were rising at a 9.4% annual clip. Meanwhile the official nationwide unemployment rate is mired close to 9%, without counting a large backlog of discouraged workers who are no longer officially in the labor force.” The responsibility for this is pinned on the Fed’s “near-zero interest rate policy”.

In Bloomberg’s “Savers lose as yields on long-term CDs below inflation rate’Elizabeth Ody writes that “Savers who put their cash in longer- term certificates of deposit are losing out to inflation…The annual inflation rate of 3.16 percent in April topped the best 5-year CD rate of 2.4 percent…Right now, people are more concerned about the return of their deposits rather than a return on their deposits…People are looking for this one island of safety and security, and insured deposits provides it…The average 5-year CD yielded 1.7 percent and the average 1-year certificate yielded 0.45 percent on May 18”.

Steve Johnson in the Financial Times’ “Angus Murray: Believer in real assets” reports that Murray is investing in real assets (commodities and emerging market equities) to protect against not inflation but the deliberate currency devaluation now under way (running the money printing machines overtime). He is “convinced published inflation data significantly understate the reality” (sure feels like it to me as well, at least for purchasing basket.) He argues that government like to understate CPI (by various devious schemes like supposed changes over time in baskets purchased, substitution and hedonic adjustments) to minimize the cost of indexed pensions and public sector salaries. ““Over the next six to 10 years, the huge increase in the money supply that we have seen will lead to an acceleration in the devaluation of money.” To protect against this inflationary threat, Mr Murray argues independent financial advisers should be ushering their clients into portfolios that are 40 per cent emerging market equities (as developed market equity returns are “going to suck”) and 60 per cent precious metals.” But Sonali Verma in the Globe and Mail’s “Dump some U.S., emerging market equities: Coxe” reports that Donald Coxe says dump US and emerging market stocks but hold on to commodities and gold. (There you have it: a consensus of two on commodities and gold, and disagreement on stocks. But I am sure, that you wouldn’t have to search for long to find somebody who will argue that if stocks take a significant hit (due to low or zero economic growth rate), commodities must soften as well. Now we know what to do. J) If you really want to get a view of all the possible outcomes that economists can think of, read “Will QE2 end in fire or ice?”). By the way in the Financial Post’s “Metals a safe padding for portfolios” Jonathan Chevreau also reports on concerns about flexible basket approach of measuring inflation vs. the pre-1990 fixed basket approach, and the heavy- metal (up to 90% gold bullion) approaches used by some to protect against hyper-inflation; others quoted use less concentrated but somewhat esoteric approaches like 20% gold, 25% short-term bonds, 10% preferred shares, 20% CAD-hedged international stocks  and 25% RRBs.

A contrary view on the US dollar from a Fidelity fund manager in “Fidelity counters Pimco, Goldman with bullish dollar view”in which Wes Goodman reports that the USD is near its bottom and will strengthen over next 18-36 months due to “competitive advantages in the U.S. including the rule of law, a strong education system and labor mobility…(and because) The dollar has dropped 13 percent in the past year against a trade-weighted basket of six currencies…(and) The difference between yields on 10-year notes and Treasury Inflation Protected Securities, a gauge of trader expectations for consumer prices over the life of the debt, has narrowed to 2.32 percentage points from 2.67 percentage points in April. (As the saying goes, forecasting is difficult especially about the future.)

And finally, in “Older workers have much to offer, experts say” “The question is how best to engage that talent.”Companies have to realize that intellectually curious people are ageless, and that diversity goes beyond women and people of colour and includes people who are older,” says executive recruiter Susannah Kelly, executive-vice president of DHR International in Toronto…”The really enlightened companies don’t care about age. They want the best talent. In fact, we had one candidate who was 66 and didn’t want to retire, and he’s changing jobs and going to a company that really wants him. I’m seeing more of this.””