Contents: Only “fee-for-service” in Australia and UK, factors for monitoring and dynamic adjustment of withdrawal rates: stage in retirement/asset allocation/longevity percentile/distribution period/failure probability, hedge funds place big bet on improving US housing, impact of rising condo fees, banks more receptive to short sales, flood-risk insurance, expanded-CPP, Ontario private pension shortfalls to be partly covered by letters of credit, is end of bond bubble imminent? TAG: exiting government support programs.

Personal Finance and Investments

In the Financial Times’ “Global trends in financial advice” Guo and Robinson discuss the new regulatory regimes introduced in Australia (July 2012) and UK (January 2013) which require only the use of “fee-for-service” wealth management business models as a means of “eliminating the conflict of interest inherent in the compensation paid to wealth management service providers”. European private banking has long used fee-based model, while the U.S. has 27,000 Registered Investment Advisers (RIAs). The fee-for-service model allows an adviser to take a long-term view… (but) There is no guarantee that the service is always satisfactory under any model.” (I am actually preparing (another) blog on the necessity for a fiduciary level of care for financial advisors, which is related to this topic)

In the December/January 2013 issue of MoneySense, David Aston in “Your last care package” (not available online)David Aston looks at the trade-offs between buying long-term care insurance (LTCI) and paying for those expenses from savings or home equity. The article includes reference to some of my thoughts on LTCI, based on a telephone interview David Aston conducted with me. The article also looks at a broad range of approaches to senior care ranging from in-home help, in-home care, daycare services, independent or assisted living residences and nursing homes. The article also discusses some current Canadian LTCI pricing, including the right of the insurance company to raise the future rates. Arguments by insurance company representatives that unknowns like “uncertainty about how much the government will subsidize care or how much it will actually cost…in 30 or 40 years…(make) funding for long term care becomes an insurable event” are somewhat of a red herring since due to other factors associated with LTCI mentioned in the article: high load factors, potential rate increases for policies already in force, uncertainty of if/when qualification for benefits (inability to perform 2 or 3 activities of daily living) will occur, complexities of non0standardized policies, inflationary erosion of benefits. But an equally important reason for an approach of “saving and using equity in your home to cover care costs” is that insurance is best for low probability catastrophic (high impact) risks and LTC is not low probability (according to the article “the chances that a 65-year-old will require long-term care at some point are 49% for men and 65% for women) and is mostly not catastrophic (government coverage, institutionalization displaces other “living expenses”. You might be interested in reading a couple of my earlier blogs on LTCI at “Long- term Care Insurance (LTCI- I)” and “Long-Term Care Insurance (LTCI) II- Musings on the Affordability, Need and Value: A (More) Quantitative View”)

In the Journal of Financial Planning’s “Transition through old age in a dynamic retirement distribution model” Frank, Mitchell and Blanchett look at sustainable withdrawal rates in retirement, not just from the longer distribution period perspective of younger retirees, but also from the perspective of older retirees. Some of their conclusions were that: “Equity allocations above 50 percent cause an “allocation volatility drag” on optimal withdrawal rates”, “a retiree’s actual, real-life, distribution path would be transient, crossing among simulated paths because of actual market results they experience as well as withdrawal decisions they make over time”, “higher withdrawal rates deplete portfolio values faster, which leads to lower lifetime total cash flows and lower terminal values”, sequence of return risk as reflected by probability of portfolio failure should be factored in the withdrawal rate calculation annually, retirement may be divided into two stages and in the pre-75 stage withdrawal rate is strongly influenced by consumption vs. bequest orientation while in the post-75 stage by the dynamically changing remaining distribution period (influenced by the appropriate health determined longevity percentile and the increasing longevity expectation with age), post-75 use the 1/n (where n is the appropriate remaining, longevity percentile and health adjusted, distribution period). The paper also explains that “if the probability of a 65-year-old male living to age 85 is 40 percent and the probability of a 65-year-old female living to age 85 is 50 percent, the probability that either or both would live to that age would be 1 minus the probability that both are dead, which would be 70 percent (1 – ((1 – 0.4)*(1 – 0.5))); or alternatively, a 70 percent chance that at least one of the couple outlives age 85”. (The article points out the importance of withdrawal rate flexibility and need for annual measurement and recalculation of appropriate withdrawal rate in retirement.)

Real Estate

The Economist’s “A new generation f investors is betting on America’s housing market” looks at how the “big short” when pre-2007 hedge funds bet against the housing market, in 2012 hedge funds are investing in the “big long” betting on “a full blown housing recovery”. One example mentioned is where hedge funds and private equity investors “…finding, buying and managing thousands of homes scattered around the country. This is not easily done from a skyscraper in Manhattan. A property-management company is helping Blackstone buy some 100 houses a day in selected markets… The plan is to fix up the houses and rent them, generating yields of around 7%. Jonathan Gray, the head of real estate at Blackstone, says that part of the investment case is that house-price increases will create fat capital gains.”

In the Financial Post’s “Condo buyers unfazed by rising fees” Garry Marr discusses the importance of considering condo fees (and the possibility that they’ll rise, especially in older buildings), not just condo prices and mortgage fees before buying a Toronto condo (average condo fee $0.59/SF/mo on resale $0.49/SF/mo on new condos). The article notes that maintenance is of course also part of home ownership costs.

In the Miami Herald’s “Short sales outpacing sales of bank-owned homes” Alex Vega reports that “Sales of U.S. homes facing foreclosure are on the rise and outpacing sales of bank-owned homes, a reflection of stepped up efforts this year by lenders to avoid foreclosing on homes with mortgages gone unpaid… sales of homes already in the foreclosure process jumped 22 percent”, two-thirds of which were short-sales. Banks found that they are ahead accepting less then borrower outstanding mortgage is cheaper than completing the foreclosure process. “The average price of a foreclosure sale in the third quarter was 32 percent below the average sale price of non-foreclosure homes.”

Many Florida condo owners with ocean front properties live with some fear (at least in the back of their minds) worrying about hurricanes, beach erosion and rising sea-levels. In the Financial Times’ “The high risk of living on low floodplain” Tim Hartford explores the problem of insurance protection in the UK from private insurance companies or the government in areas where there is a high probability (say 20%) of having a flood in any one year. He argues that unaffordability or unavailability of insurance amounts to the same thing; “the government needs to decide whether it wants to pay people thousands of pounds a year to live in high-risk areas or not”. If not, the author argues that that the price of homes in flood-risk areas would drop steeply (or even go to zero). So he argues that the government could decide to stop providing/enabling flood insurance in high risk areas “while simultaneously making a one-off payment of hundreds of thousands of pounds to anyone who owns a home in a high-risk area”; then people could choose to stay without insurance or go with the cash. While he calls this extreme example ‘utopian’ and a solution which won’t happen, he argues that other types of social protection aimed at protecting people from unpleasantness might also be “providing incentive to seek unpleasantness out”. He also correctly concludes that while people have explicitly chosen to live (though many unwittingly so) in high flood risk areas, planning authorities were complicit in approving buildings in such areas and certainly have a choice to approve or not further new construction. (These are sobering thoughts not just for all those affected this year by hurricane Sandy and a couple of years ago by Katrina, but by all those living along the coast lines all over the world. No doubt the subject will have to be dealt with head on by those affected, with or without government assistance.)

Pensions

The Susan Harada hosted webcast on an expanded-CPP “Expanding the Canada Pension Plan: A Modest Proposal” on November 19^th featured a panel of pension experts composed of Michael Wolfson, Bernard Dussault and Keith Horner. The close to one hour video will be available for 30 days at the indicated link and whether you support this option or not, it well worth watching because of the thoughtful proposals tabled by each of the experts. While there were some differences in opinion among the three experts on the purpose of pensions (maintain consumption or prevent poverty, hold CPP baseline age at 65 or push it out to reflect increasing longevity, how implement an “expanded-CPP”) there was unanimity that expanded-CPP is the way to long-promised pension reform. One of the more interesting questions from the audience what related to how long will the current 9.9% contribution rate will continue to deliver benefits equivalent to a 6% contribution rate? Ex-Chief CPP Actuary Dussault opined that it will likely continue forever to compensate for the excess benefits paid to the early beneficiaries of the CPP who haven’t made the contributions long enough to justify their benefits. (No doubt, this is a very disconcerting thought to those still making current contributions.) As I have indicated often, I have no doubt that an expanded-CPP is superior to the currently proposed PRPP, but I am concerned that nobody has provided answers to how one would deal with: (1) valid concerns about “too many eggs in one (CPP) basket”? (Dussault in an expanded-CPP paper suggested incremental CPP contribution could be fragmented and managed by province) (2) solving the retirement income issues for those near or already in retirement? (Wolfson suggested an accelerated phase-in of the expanded-CPP benefits so long as done on a fully funded basis) and (3) provision of protection of the private sector pensioners when their employer goes bankrupt with an underfunded pension plan? Not addressing these questions makes the expanded-CPP the answer to Canada’s pension reform inadequate.

In Benefits Canada’s “New letters of credit regulation explained” Jana Steele explains Ontario’s PBA changes on the use of letters of credit (LC) to cover a portion of an employer’s solvency payments into a DBpension plan. .. the new rules will allow an employer that is required to make solvency payments into a DB plan because of a solvency deficiency to provide an LC in lieu of a portion of the payments, provided that certain requirements are met. LCs may secure up to 15% of a pension plan’s solvency liabilities. “ (To what degree does this new LC regulation address the much needed protection of pensioners when their employer seeks bankruptcy protection with an underfunded pension plan? Could an expanded-LC approach be the complete solution to Canada’s flawed private sector pension system with no priority in bankruptcy and no (and only minimal in Ontario) pension guarantee funds?)

In NYT’s “A 401(k) that promises never to run dry” Tara Siegel Bernard reports that some US companies started to offer within their (defined contribution) 401(k) plan not just target-date funds but they also add variable annuities which offer some guaranteed monthly retirement payout to take out the volatility risk of the equity portion of the portfolio. The plan is built so that there is diversification over time (i.e. money is added during the accumulation phase and annuity units are purchased at different benefit rates), there are three different insurance companies which provide the guarantees annuities to certain levels are also guaranteed by the various states.

Things to Ponder

In InvestmentNews’ “Another red flag as veteran fund managers raises white flag” Jason Kephart reports that “A major bond-fund manager has thrown in the towel on long-only investing. The move is the latest warning to fixed-income investors, who have doubled the assets in long-only bond funds since the financial crisis, to more than $2 trillion.”  Bond manager Stewart Cowley say that “It’s become impossible to guarantee that, given we are all fallible human beings and not magical prodigies, we can put a positive return on the table for our clients for anything more than a passing moment in time. And even if we do, it might just be because we got lucky.” (That should be taken as a warning to all to re-examine the potential impact of their bond, preferred and high-yield portions of portfolios should interest rate move up in a significant way.) Also in InvestmentNews’ “Next big move in bonds? Down, warns Abby Cohen” Kephart writes that“With most fixed-income assets trading at or near record-low yields, there would be little buffer should the Federal Reserve start raising the overnight rate…A resolution to the fiscal cliff could pump up the economy, however. That, in turn, could force the Fed to raise rates earlier.”

And finally, in the Financial Times’ “Watch out for the second US cliffhanger” Gillian Tett points out looming end of the TAG (Transaction Account Guarantee) program of the FDIC introduced during the 2008 financial panic which insures unlimited deposits “if deposited in a non-interest bearing account” above the $250,000 limit insured by the FDIC. There are about $1.5T of corporate and private funds in such accounts, and expiration of TAG on December 31 could lead at least of this moneys to flow into US T-bills/bonds driving interest rates down further and into negative territory next year. (Or, perhaps banks might raise rates enough in an attempt to prevent the outflows?) The article concludes with the lesson that seemingly useful and apparently harmless “government support measures” (as in the case of government provided flood insurance in the Real Estate section above) come with potential collateral damage when there is an attempt to exit from it.