Topics: Bengen stands by 4.5% rule with refinements, parents’ future, trust your advisor? home to fund retirement? US real estate sales/prices up, CPP investment story, Euro, euro-zone and impact on Canada, ‘perfect storm’ of corporate debt, retirement risk, Value-at-Risk
Personal Finance and Investments
In the Financial Advisor’s “How much is enough?” William Bengen, “the father of the 4.5% rule”, does some fine tuning to his previous (almost 20 year old) work on sustainable withdrawal rates from retirement portfolios, to reflect current circumstances. Recall that his safe withdrawal rate work was based on specified portfolio from which a retiree draws 4.5% of starting portfolio value in year-one of retirement, then adjusts initial withdrawal dollar value annually for inflation (to maintain a constant standard of living) over the next 30 years. The good news is that he writes that he is “not ready to abandon the 4.5% rule”! However he suggests some fine tuning to the 4.5% rule by either increasing income or reducing expenses/spending. His recommendations include: (1) Spending: “Take some pre-emptive action, no matter how mild, when the current withdrawal rate first exceeds the initial (or expected) withdrawal rate by 25% “(current withdrawal rate is current year dollar withdrawal divided by current assets); if ratio continue to deteriorate take more aggressive action on spending. (2) Income: (i) consider buying “immediate fixed income (or inflation indexed) annuities” some or all of the assets preferably incrementally and at an older age (e.g. 80), (ii) reverse mortgages, (iii) change investment methods: replace buy-and-hold, avoid overvalued assets, add international assets. (I like his proposed spending flexibility and new investment methods, much less so the “reverse mortgage” suggestion unless all other options have been exhausted. Thanks to VP for recommending the article)
A couple of thought-provoking articles about children getting involved in planning or status of their parents’ retirement finances. In the WSJ’s “Plans for parents’ future” Rachel Ensign writes that since “nearly two in five adult children financially support parents 65 or older…and 86% of millennials expect to care for an aging parent or other elderly person in the future” they should consider getting involved with parents’ plans, even though it is likely a difficult topic to approach and discuss, especially finances; other areas requiring discussion are long-term care plans and location of key documents. In the Financial Post’s “Planning your parent’s retirement” Ted Rechtshaffen writes that finally Boomers may be feverishly focusing on their retirement finances, but they forgot about a potential exposure related to their parents’ finances. Cross-generational discussions are required to address four financial challenges: (1) are parents expected to leave a significant inheritance or they’ll likely run short of money? (2) child primarily responsible for providing assistance/care to parents is entitled to immediate compensation and/or larger in share of inheritance, (3) what insurance policies parents have? (life (individual, joint first- or last-to-die), critical illness long-term care insurance), (4) have parents prepared wills and powers of attorney? (Potentially very sensitive topics for discussion but at some point wise parents will bring children into their confidence, while some of the outcomes may still be influenced.)
In Morningstar’s “How well you trust your advisor” John Gabriel reconsiders his original conviction that fiduciary standard should be an explicit regulatory requirement for financial advisors. He implicitly argues that a fiduciary requirement will not necessary result in a fiduciary behaviour, and thus one couldn’t really count on it anyways without doing explicitly due diligence on the advisor. Instead of counting of regulation, he suggests: asking difficult questions until satisfied that advisor is acting in your best interest, e.g. has turnover been excessive? Do you understand the design philosophy used? Have risk tolerance and long-term goals been defined? How transparent are the fees? And most importantly one is trying to “screen for individuals with strong morals and high ethical standards, which cannot be legislated…regulatory requirements can help, but they don’t take us all the way. It is incumbent upon us as investors to be good judges of principle and character.” (Thant’s certainly true, that fiduciary standard won’t guarantee corresponding behaviour, but explicitly requiring a fiduciary standard of duty sets framework of common understanding of expectations…so I think it is absolutely a requirement. (Thanks to Dan Braniff for recommending the article.)
In the Globe and Mail’s “Don’t count on your home to fund your retirement” Ben Rabidoux writes that the future in Canada’s housing market will be different than the past decade because: housing prices will not be able to continue increased growth given the inevitability of rising interest rates, lose credit requirements will be replaced to stricter ones and demographic headwinds are blowing against rising house prices “demographics alone will have a 1% annual drag on house prices”. His conclusions are that: downsizing will affect negatively higher end homes but will put a floor under smaller age-friendly homes and condos.
In the Globe and Mail’s “OECD urges Canada to raise rates” Kevin Carmichael writes that a new OECD report urges Canada to start raising interest rates to “cool housing prices and contain inflation”.
Based on data from the National Association of Realtors, U.S.-wide sales of previously owned homes were up 3.4% in month of April and the median home price was up 10.1% over April 2011. The price increase was primarily due to a smaller proportion of reported sales were associated with foreclosed homes. “Housing inventories have shrunk in some areas, as real estate agents report increasing demand. Some lenders have shown a willingness to loosen up on the strict credit standards put into place after the financial crisis. (See “The rise in home sales points to rebound” “Existing home sales and prices ticked up in April”.) Palm Beach County saw a 67.9% increase in sales over previous year, while median single-family home prices increased 6.6% year-on-year according to the Palm Beach Post article “Palm Beach County home sales surge”: “April single-family home inventory declined 55.5 percent to 5.7 months from 12.8 months a year ago. It was the same story for townhomes and condos, which fell 53.8 percent to 5.5 months from 11.9 a year ago.” Banks, apparently, have not been releasing much shadow inventory and there has been very limited construction of new homes in the past six years. (Some good news, perhaps some light at the end of the tunnel?)
A somewhat strange Globe and Mail article “Inside the Canada Pension Plan’s $153-billion portfolio” where Doug Steiner has an inside look at how management of CPP investments has evolved. Not sure whether the author intended that this article put Canadians’ minds at ease or get them worried about the future of the plan, but I am sure that there will be some each camp. Current assets at about $160B forecast to be $500B in 20 years and Steiner writes that “we’d better hope that they make the target”. Referring to the CPPIB as “adventurous investor”, “run by investment professionals…who, for some mysterious reason, think it’s more rewarding to invest on behalf of the Canadian public than make far more dough on the other side of the Street….I want to know what makes these guys tick”. The answer from one of “these guys” is “No restrictions on where to look and what to put money into. No cap-in-hand looking for money for a new fund every five years or so. Equities, fixed income, commodities, short-horizon trading, strategic stakes in public companies, they’re all good.” “And what happens if the CPPIB team turn out to be the worst investors the world has ever seen, and lose most or all of the money? Notwithstanding all of the checks and balances in place, Wiseman cracks a smile and says, “If they raise the amount taken off your paycheque by 50%, in less than five years we’re right back where we are now.” (The contribution rate history indicated that it started with 3.6% in 1966 and has risen to the current 9.9% level by 1998 from the just over 6% at that time, in order to make up for accumulated past shortfalls; according to actuarial estimates I recall that not 9.9% but only about 6.5% should be required for current level of benefits and the CPPIB assumed real 4.2% return). The funding strategy is described as having evolved from a pay-as-you-go strategy (but it still is partial pay-as-you-go). Investment strategy has evolved from Canadian federal and provincial government bonds only approach, to a “broad-based index portfolio” which was then extended to permit it to “buy anything that is legal in Canada”; strategy was further extended to allow a shift from index to active management, including bringing some of the management in-house because “it is cheaper to do it that way”. More recently private equity (and real estate) was also added to the list of permissible investments. Steiner observes that buying securities, “writing a cheque”, is much easier than converting them to cash later on (that would be especially true for the real estate and private equity investments now part of the portfolio; in fact it is even very difficult to value such assets now a growing part of the portfolio). And the CPPIB now uses a new “risk budgeting” approach to asset allocation (hopefully not the same approach as used by the foremost risk managers at JPMorgan. (Perhaps I shouldn’t be, but I am in the camp of those more worried after than before reading the article. Not sure if it was the tone of the article, or its content, or perhaps that we’ll just have a lot of eggs in one basket. )
Things to Ponder
Jeremy Siegel in the Financial Times’ “Devaluation- Last option to save the Euro” enumerates the euro zone problems and opines that austerity will not solve them. He argues that the “least disruptive route” is devaluation of the Euro; the current path of austerity being pursued will only lead to the “disintegration of the monetary union”. However the WSJ’s “Europe girds for Greek exit” discusses how Europeans are exploring contingency plans for Greece’s exit. The real concerns are not really with Greece’s exit, but that should it do so, that opens the possibility of Spain and Italy’s exit which are much larger economies with much more difficult to manage fallout, and might trigger a financial crisis. The Globe and Mail’s “Canada vulnerable to recession if euro zone worsens” looks at a TD Bank report on the potential impact on Canada, which suggests that there would be a significant risk of economic downturn due to global commodity prices, and corresponding impact on Canadian housing prices, dollar and TSX.
In the Globe and Mail’s “Corporate debt a ‘perfect storm’ in the making, S&P warns” David Parkinson writes that in a new S&P report they warn that “the world faces a mountain of roughly $46-trillion (U.S.) in corporate debt needs between now and the end of 2016. In addition to a $30-trillion “wall” of corporate debt that will come due and require refinancing, S&P estimated that corporations worldwide will need between $13-trillion and $16-trillion of new debt to meet their capital spending and working-capital needs – essentially, to finance growth… Such a “perfect storm” is, essentially, another credit crunch. As you recall from the last one, those pesky things have a knack for choking off growth, fuelling liquidation of financial assets and generally making everyone very nervous – all bad news for the markets and the economy.”
In the NYT’s “Getting to retirement with minimal financial risk” Tara Siegel Bernard discusses management of risk as one approaches retirement. She points out that “investors can try to limit their risks by holding down their stock investments…(while others) are still dependent on the market’s engine” to reach their goals. High stock market exposure could lead to massive portfolio losses just before retirement. “Whatever approach you take is going to cost you something, even if you avoid the stock market altogether.” She suggests approaches such as: much higher savings required for more conservative investment, perhaps “risk-free” investments to cover bare-essentials in retirement, Zvi Bodie suggests TIPS ladder for essentials and riskier assets for discretionary spending”, most people can’t accumulate enough investing in safe assets only, put-option contracts, buying an annuity. (For more in-depth look at risk management you can read my recent The Pursuit of Risk Management blog.)
And finally, for those of you who want to learn more about Value-at-Risk approach to measuring/managing risk, allegedly originated at and the source of JPMorgan’s problems now, you can read the NYT’s Joe Nocera article “Risk mismanagement” (Referenced in an InvestNews article “Hardy har VaR: How JPMorgan is like Enron”) in which he explains (in January 2009) some of the problems with VaR (value-at-risk) approach (a flavour of which was apparently used by JPMorgan to monitor it risk exposure and ended up with a $2B+ loss). “In its most common form, it measures the boundaries of risk in a portfolio over short durations, assuming a “normal” market… the risks that VaR measured did not include the biggest risk of all: the possibility of a financial meltdown” “Taleb says that Wall Street risk models, no matter how mathematically sophisticated, are bogus… the essential reason for this is that the greatest risks are never the ones you can see and measure, but the ones you can’t see and therefore can never measure… huge financial catastrophes happen. Catastrophes that risk models somehow always manage to miss… he referred to what he called future-blindness. People tend not to be able to anticipate a future they have never personally experienced… The fact that you are not likely to lose more than a certain amount 99 percent of the time tells you absolutely nothing about what could happen the other 1 percent of the time.” SO VaR didn’t measure “Black Swan events”, but it didn’t even measure the 1% events, and didn’t include: liquidity risk, implicit leverage risk built into derivates. (Taleb) “says that 1 percent will dominate your outcomes. I think the other 99 percent does matter. There are things you can do to control your risk. To not use VaR is to say that I won’t care about the 99 percent, in which case you won’t have a business. That is true even though you know the fate of the firm is going to be determined by some huge event.” “as John Maynard Keynes once wrote, a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”” “Which didn’t mean you couldn’t use risk models to sniff out risks. You just had to know that there were risks they didn’t sniff out — and be ever vigilant for the dragons. When Wall Street stopped looking for dragons, nothing was going to save it. Not even VaR.”