Topics: Retirement spending declines voluntarily, disappearing inheritances? financial tuneup, retirement planning steps, fund boards ineffective, Otar: zone strategy enhanced with stress testing, lower annuities for affluent retirees, foreigners/Canadians buy up US houses, Toronto condo-craze cooling? UK GDP sustained by delayed retirements, OECD: raise retirement age, Swedish regulator adjusts for “financial repression”, rate increase a threat to Canadians, bond rates too low and might be staying there? “living wills” vs. “health-care agents”, Great Recession reduced US family wealth by 40%.
Personal Finance and Investments
Contrary to a lot of the financial planning approaches discussed in the literature over the past 10-20 years, there are persuasive arguments and evidence which indicates that spending decreases voluntarily with age. In the Financial Post’s “How spending declines with age” Fed Vettese goes to great lengths to argue that it is unnecessary for pensions to be fully protected against inflation because spending needs are actually falling with age (I guess he must be thinking of public sector DB pensions since unfortunately there are very few Canadians or Americans in the private sector who still have DB pension plans, and even fewer with fully indexed benefits. Still it is worth following Vettese’s arguments as they are applicable to retirement planning in general.) He also argues that assuming a decreasing spending profile with age, reduces the amount that one needs to save for retirement and/or allows one to spend more early in retirement. He uses a German study which indicates that saving rates decline in retirement to about age 70 and then they increase and he concludes that this is because “It appears the primary reason for saving more is that the very elderly have fewer opportunities to spend. Health can deteriorate, which inhibits traveling or even driving a car. The death of a spouse or close friends can further increase isolation and make it difficult (or just not as interesting) for them to spend money on entertainment.” He also presents the results of a U.S. study found that “With age 65 as the benchmark, the study found that household spending fell by 19% by age 75, 34% by age 85 and 52% by age 95.” Canadian data suggests the same. On the same topic there was a 2005 article which I discussed a few years ago in my How much do you need in retirement? blog, entitled “Reality Retirement Planning: A New Paradigm for an Old Science” in which Ty Bernicke in which he refers to data showing how individuals expenditures by major categories change indicating decreases with age in overall spending as well as in each category except health-care. The data is based on surveys which typically exclude people in long-term care facilities. Bernicke’s data supports Vettese’s conclusion that the spending reductions with age are voluntary based on data indicating that median net worth increases with age even as spending is decreasing. (Clearly, Bernicke 2005 article and this week’s Vettese article both argue persuasively against assuming constant real retirement expenditures i.e. continuously rising with inflation, and instead suggest that a more realistic approach to retirement planning is appropriate. Although there are some forces driving an increase of required retirement savings despite an apparent gradual voluntary decrease of real spending with age; these might be that: one of the greatest fears of retirees is that of running out of money before they die especially with continuously growing life expectancy over the years (so fear of spending may not be entirely ‘voluntary’), and that new retirees today and going forward are less likely to have workplace DB pensions thus being more reliant on covering even expenses associated with basic needs from savings; in addition Bernicke points out that those in long-term care institutions were excluded from the surveys. This would suggest that a more realistic spending profile in retirement might be more U-shaped with higher spending in the early years, followed by gradual reduction and a spike in spending during the last 2-3 years of life on health related care).
Another article on retirement expenditures is InvestmentNews’ “Reality check please: Clients way off about retirement income” in which Jeff Benjamin writes that according to advisors the top impediment to setting realistic expectations for retirement planning is the ”how much money clients expect to spend in retirement… as well as a lack of understanding about how current spending and savings patterns could affect retirement income.” (The article doesn’t mention that a very good approach for the starting point for estimating the baseline for retirement spending is categorizing pre-retirement spending and the adjusting the spending categories and their levels for things that one will stop/reduce and start/increase doing in retirement and as one ages.)
In the WSJ’s “Counting on an inheritance? Count again” Anne Tergesen writes that not only will boomers get lower inheritance from parents than previously thought, but in fact they may have to pitch in to help them. This is due to a combination of Boomers living longer and they took a major hit in the 2008 market crash and 2006+ US real estate crash. And by the way, in a ranking of the top financial concerns, preserving the inheritance for children (41%) is way lower in priority of affluent investors than health-care costs (79%), European financial crisis (61%), ensuring financial assets last a lifetime (60%) and being able to afford desired lifestyle(55%).
In the NYT’s “Planning a financial tuneup?” Ron Lieber refers to an interactive checklist to consider when you are doing your personal financial tuneup. The list of 31 suggestions includes: gradual increase of your savings rate, rebalancing investments, better banks and credit cards, extra mortgage prepayment, budget analysis and paring, and finances with loved ones.
In MoneySense’s “6 steps to a wealthy retirement” Barbara Hawkins writes the steps include: separating your retirement needs into two categories- the musts and the nice-to-haves, build in the government pensions (CPP/OAS/GIS), factor in RRSPs and work-related pensions that you might have, assess the risk that you can take (e.g. 30-50% fixed-income investments) and assume that you can draw 4% of initial value of assets adjusted for inflation each year (I prefer a rule of thumb of 4% of current assets each year), alternatively consider an annuity to cover the must have portion of your expenses (though annuities are quite expensive right now).
In the WSJ’s “Is your fund’s board watching out for you?” James Sterngold writes that in the $12T fund industry investors are exposed to “the failure of an important if little-known layer of investor protection—the fund’s highly paid internal trustees. The lapses in oversight…are part of a system of governance that is almost designed to fail.” The puzzle according to experts is not why the boards fail to protect investors, but why anyone expects this mechanism to work; reasons include: being highly paid (by the funds themselves) limits their ability to challenge managers, (apparently) high workload due to sitting on too many boards, they rarely “quibble with advisory firms over fees”.
In Advisor.ca’s “Lifelong retirement income: The zone strategy” and “Stress testing your retirement plan: How big is my cushion” Jim Otar discusses decumulation strategies in terms of an investor’s financial capacity (aside of his emotional capacity to risk). In the first article he lays out the major areas of risk in retirement: longevity, market and inflation. He then takes a very prescriptive approach: for longevity recommends planning for age 95, for’ equity-percent’/’drawdown rates’ with a 90% probability of not exhausting assets (based on historical data) he recommends 50%/3.1%, 40%/3.7% and 30%/5.2% at ages of 55, 65 and 75 respectively. He then concludes that the required capital for each $1/year indexed withdrawal is $31, $27and $19 at ages 55, 65 and 75 respectively. The other reference point that Otar uses is cost of buying a 10-year guaranteed $1/year 3% indexed annuity for a M/F of ages 55, 65 and 75 respectively being $27/$30, $19/$23 and $14/$16. (Annuity quote was sourced from Equitable Life.) He then, based on the required income stream for the individual or couple, defines those with assets greater than the required capital for the indicated withdrawal rates to be in the ‘Green’ zone while those with capital less than required to purchase an annuity to be in the ‘Red’ zone, while those in-between in the ‘Grey’ zone. Otar also looks at the appropriate mix of annuities and withdrawal strategy, annuity ladders, what withdrawal rate should trigger an annuity purchase; he also mentions ‘variable annuities’ (a la GMWBs) but is (rightly) much less enthusiastic in endorsing them compared to his view when he published his PDF-book a few years ago. In the second article he adds some stress testing to his red/grey/green zone strategy. Stress conditions mentioned are: “sudden and permanent loss of assets”, “need to increase income”, “inflation higher than historical”, “living longer than planned for”, lower equity returns and/or bond yields than historical. He then calculates “stress envelopes for these various scenarios to determine how much a parameter can change and still stay in the green zone. (A very good quantitative approach to determine when one might have to annuitize, or reduce expenses, with only a few key caveats that you might have to consider and adjust for: assumes 2% fees (not acceptable level of costs- even with an advisor a 1% level would be more appropriate total cost), a withdrawal strategy whereby one starts with an initial withdrawal rate which then is adjusted for CPI each year (a ‘proportional’ approach say 4% of current assets might be a more practical long-term strategy) and calculations are based on historical data (a more forward looking approach factoring in current view of future expected returns might be more realistic).
In the Globe and Mail’s “Canadians ignoring the likelihood of ill health in old age” Noreen Rasbach writes that when working with a financial advisor you should also factor in the required saving should as a result of illness one might incur extra costs due to long-term care. She discusses the difference between life expectancy at birth of 81.4 years and DFLE (disability-free life expectancy) of 68.6 years and concludes that “Canadians can expect to live more than a decade with a significant physical or mental disability before they die”. Then the article jumps right into a suggestion from a firm specializing in “so-called living benefits such a disability insurance, critical illness and long-term care” that “We always thought we’d be happy, healthy, then dead. Who thought I might have seven to 10 years when I require care?” (I am not familiar with the DFLE metric, how it is arrived at and whether it has any relationship with how insurance company might evaluate one’s eligibility for benefits under an LTCI policy. But even if we understood the relationship between the two, if any, one might still want to question the value of an insurance where benefit payouts only account for about 50% of premiums. Having had my rant about the LTCI and critical illness insurance, it is fair to say that retirement planning should factor in at some level the potential need for additional care in one’s later years even though as one is increasingly disabled, other lifestyle cost might be significantly lower at the same time.)
For those contemplating the use annuities might find interesting an emerging trend reported in the “UK annuity pension rates fall again” where Adrian Holliday reports that annuity rates have been falling for the past decade and keep on falling due to a combination “of falling bond yields, Solvency 2, the European gender directive, increasing use of individualised underwriting and improving longevity could all yet push rates down lower.” The article points to stark differences between the annuity rates offered by different insurance companies. But what is more interesting is that “insurers are increasingly using post codes to evaluate rates – which means middle class pension savers in better off areas will see their pensions shaved further, while pensioners in poorer areas will be boosted.” i.e. insurance companies have started set annuity pricing based differences in longevity between more and less affluent retirees. (Many thanks to DA for bringing the article to my attention.)
In the WSJ’s “Foreign buyers snap up U.S. homes” Nick Timiraos reports that in the past 12 months foreign buyers bought 8.9% or $82B of residential real estate in the US. In Florida foreign buyers represented 26% of the sales. Canadians were the largest foreign buyers in the US at 24%. The forces driving the purchases by foreign buyers include: redeploying into depressed US market money pulled out of high priced real estate markets at home, stashing into perceived safe US trophy properties to protect money from political uncertainty at home, relative strength of home currency seen as opportunity to buy US property, US property perceived as cheap compared to prices at home.
In the Globe and Mail’s “Signs of sanity in Toronto’s condo craze” Perkins and Nelson report that “Ottawa’s efforts to cool off Toronto’s red-hot condominium market appear to be having an impact, as prices begin to ease and developers pull back on projects and bidding for land.” According to experts quoted this “…will prepare us for the eventual increase in interest rates. Builders are sensing this already, and we see more and more builders downscaling future purchases of land.”
In the Financial Times’ “The number of pension aged workers soars” Cohen and Groom report that the “UK contemplates further rise in state pension age since the pace of improving life expectancy outstrips even optimistic projections of a few years ago”. This is necessary as without the recent changes (forcing people to work longer) Britain’s GDP would be 6% lower.
A new OECD report entitled “OECD Pensions Outlook 2012” was released this week indicating the necessity of increases in retirement age in OECD countries. (I haven’t read it as yet, but it seems to be full of comparative pension data among countries which would be of interest to pension data junkies, one of which I confess to be.) In a review of the OECD report BenefitsCanada’s“Raise retirement ages, says OECD” indicates that the report urges governments to “gradually increase their retirement ages in order to keep their pension systems sustainable, as life expectancy at birth is expected to increase by seven years over the next 50 years. This will necessitate “Breaking down the barriers that stop older people from working beyond traditional retirement ages will be a necessity to ensure that our children and grandchildren can enjoy an adequate pension at the end of their working life”. The Economist’s “Fun with pensions” has an interesting graphic comparing 1970 and 2010 male “Official retirement age” vs. “Actual retirement age” and “Life expectancy” in 22 countries, showing that “Official retirement age” has not only not kept up with increases in life expectancy, but often the gap has increased dramatically as in France, Italy, Canada and Ireland.
The Financial Times Lex’s “Financial repression: Sweden makes a stand” reports that Sweden’s financial regulator proposed a temporary floor under discount rates used for calculating liabilities of insurers and pension funds. The reason for the proposal is that the financial repression coupled with various regulatory effects (Basel III and Solvency II) are cascading to insurers and pension plans to reduce their equity allocations forcing them to buy more government debt (in fact more bonds than are even available), further driving up bond prices. The combination of resulting lower portfolio returns and falling discount rates have aggravated the asset liability mismatch.
Things to Ponder
In the Financial Post’s “Why no Canadian is safe from interest rate increases” Jason Heat reports that according to the latest Bank of Canada bi-annual Financial System Review warns that unless the European policymakers can resolve the unsustainable fiscal situations the impacts could be “significant”. A combination of high Canadian debt-to-income ratios (153%), 31% of mortgages at carried at variable rates, vulnerability to mortgage rate increase at renewal time for the 5 year term mortgages, extremely low current rates (better described perhaps as artificially low current rates due to governments’ “financial repression”). A significant proportion of increase in household debt was driven by “home-equity extraction” to be used “to finance both consumption and home renovation”.
In the Financial Times’ “Bond buyers should be mindful of history” Burton Malkiel argues that investors are making a mistake when fleeing to the perceived “safety” of bonds when in fact they are settling for negative real returns. He gives 1946 as a historical example when Treasury bond yields were last at 1.5%, and investors ended up losing purchasing power; both negative real returns and when interest rates started rising they also were hit by capital losses. These rates are all as a result of the financial repression inflicted by central banks in an effort to handle the massive developed countries’ debt. He further argues that developed and emerging market equities are cheap compared to bonds and concludes that “equity investments in today’s market environment entail less risk than the “safe haven” bond investments favoured by so many investors.” In the WSJ’s “Are bond rates on a road to nowhere?” Jason Zweig explores potential reasons why bond rates may be going nowhere longer than we might have imagined, like who hold U.S. Treasury debt and for what reason(s): a significant proportion of is held by “uneconomic” buyers like foreign central banks (34%) and the Fed (11%), Dodd-Frank will drive most of complex derivative (e.g. swaps) trading to exchanges/clearinghouses which require collateral (typically Treasurys). So “recognize that if rates stay low for years on end, inflation will eat your cash alive”, so minimize your cash component as much as possible.
In WSJ’s “A new look at living wills” Laura Johannes discusses the need for increased flexibility than that offered by current living wills, which are simplistic documents which might typically express one’s desire in some “black-and-white situations” like not wanting to be kept alive in a vegetative state. The article suggests that perhaps “a health-care agent- a trusted family member, for instance- could supplant the need for a living will… Under the legal doctrine of “substituted judgment,” health-care agents must try to make the decision you would if you could”. (An interesting approach which might have merit in many cases.)
And finally, Don Lee in the LATimes’ “Great Recession erased nearly 40% of family wealth” reports that according to a new Fed report median family wealth dropped 39% from $126,400 in 2007 to $77,300 in 2010, but for families headed by 35-44 year olds the drop was an even steeper 54%! “More recent quarterly data from the Fed shows Americans’ net worth has increased since 2010 as the stock market has rebounded, more people have found work and housing prices have stabilized in many parts of the country. In the first quarter of this year, net worth saw its biggest gain in seven years.” “For all families, the median income fell to $45,800 in 2010 from $49,600 in 2007 and $49,800 in 2004, after adjusting for inflation.” Families lost 18 years of wealth increase between 2007 and 2010.