Contents: Yes to statutory fiduciary requirement for advisers, no TIPS for inflation protection, new Vanguard international ETF, growing ETF proliferation and complexity, fixed SPIA and stocks comprise retirement income efficient frontier, US real estate optimism might be premature, small town benefits for Canadian retirees, Toronto house prices up YoY but…, Indalex pensioners struck down by Canada’s Supreme Court, companies hurt by low interest induced increase in pension liabilities, are target date funds an appropriate 401(k) default given their loose definition? debt supercycle end may come later than expected, low interest rates imply low future stock returns, commodity indexes’ desirability decreases, Canadian banks’ ratings cut, Americans delay retirement en masse.

Personal Finance and Investments

See my Fiduciary – Response to “CSA Consultation Paper 33-403 – The Standard of Conduct for Advisers and Dealers: Exploring the Appropriateness of Introducing a Statutory Best Interest Duty When Advice is Provided to Retail Clients” blog published earlier this past week in which I responded to the CSA’s Consultation paper on whether statutory fiduciary requirement is necessary for financial advice situations involving retail clients. The answer in my mind is clear, not only is fiduciary level of care required but so is a business model conducive to delivering that level of care.

Brett Arends in WSJ’s “Looking for inflation protection? Take TIPS off your list” discusses the many reasons why it might not be a good time to buy TIPS for inflation protection, e.g. low or negative real returns, and “Logically, owning long-term TIPS will probably work out well only if the economy plunges into a multidecade deep freeze or bursts into rampant runaway inflation.” (And he didn’t even mention that if deflation hits, the value of previous upward principal adjustments could even reverse, with an ultimate floor of $100.)

And since it is RRSP season, you might want to read a couple instructive RRSP related articles in the Financial Post. In “The affluent investor’s harsh RRSP reality” Michael Nairne reminds better off investors that “With every contribution, an investor is concurrently creating a deferred tax liability that will have to be paid sometime in the future. Over time, this deferred tax liability can grow to a staggering sum, running into hundreds of thousands or even millions of dollars as the RRSP grows. The present value of the stream of future taxes associated with the RRIF withdrawals or annuity payments should be recognized today as a liability.” Ted Rechtshaffen in  “Five commandments to help boost your retirement savings” recommends that you should: maximize your savings “before children, and after they are out of the house”, don’t contribute to RRSP if income<$42,700, invest in the market when horizon is long, and pay attention to taxes (US dividends “face withholding tax in a TFSA, but do not in an RRSP”, and I assume that this is an issue only because in a TFSA it is not recoverable.).

In InvestmentNews’ “Vanguard’s International bond ETF gets a due date” Jason Kephart reports that Vanguard announced that Q2’2013 will be the launch date for its Total International Bond Index Fund which will be “a blend of investment-grade sovereign and corporate bonds in a single index. It also will be the first international bond ETF to hedge out the currency of its underlying bond holdings…. We really think the primary purpose of our bond allocation is to act as a diversifier to equities…By hedging out the currency, investors are treated to a purer exposure to the interest rate and inflation environment outside of the United States”. (This does not solve the currency exposure for international bonds for Canadians; the USD/CAD still remains unless Vanguard Canada will offer a Canadian version.)

In the WSJ’s “A simple way to invest grows more complicated” Paul Sullivan reviews the history of ETFs, this being the 20^th anniversary of the inception of the first ETF (SPY). The article notes that the industry now manages $2T in 3000 distinct ETF, about 1200 in the US and about 1700 in Europe (and some 200 even in Canada). The arrival of broadly diversified ETFs has allowed investors and adviser to focus on asset allocation. “The E.T.F. label gives the funds the veneer of simplicity, but they can produce outcomes that investors did not expect.” The growing proliferation of ETFs is further aggravated by their morphing into increasingly complex forms like leveraged, inverse, active, directional algorithmic, etc. “For the average investor who wants to be in stocks, buying the SPDR is a great thing…When you get into the more esoteric products, it requires more knowledge on the part of the person buying them. There are a lot of E.T.F.’s that are troublesome…E.T.F.’s have been so successful that people have engineered E.T.F.’s that don’t follow the same functions as the original ones…original E.T.F.’s were broad, stock-based index-traded funds that were really efficient ways to gain core exposure to core markets.” (For most people it would be best to stay away from the more esoteric ones, I tend stay with the “plain vanilla” “original” ETFs.) You might also be interested in Christian Magoon’s “So God made an ETF”.

In the Journal of Financial Planning’s “A broader framework for determining an efficient frontier for retirement income” Wade Pfau has an interesting paper exploring the efficient frontier for a 65 year old couple whose lifestyle spending need are equal to 6% of their assets at retirement but they have annual Social Security income equal to 2% of starting retirement assets; he searches for the best solution envelope considering stocks, bonds, fixed and inflation adjusted SPIAs or VA/GLWBs SPIAs, and GLWBs. His conclusion is that given his assumptions for capital market expectations the and efficient frontier in the space of “median value of remaining financial assets at death shown on the y-axis, and the 10th percentile bad-luck outcome of spending needs that could be satisfied shown on the x-axis”, the best outcomes are obtained with fixed SPIAs and stocks (without the need for bonds, inflation indexed SPIAs or VA/GLWBs). The capital market expectations used for simulations assumed very low real bond returns (0.3%/0.1% arithmetic/geometric) and fairly tame inflation (2.1%/2.0) for the joint life of the 65 year old couple. The joint SPIA rate was 5.84% for fixed and 3.875% for the inflation adjusted annuity. (This shows the power of fixed SPIAs especially in an environment where we assume such low bond returns for 30 or so years of remaining joint lifespan. Pfau always has very interesting results for various retirement income approaches, but I struggle with the assumption that people set a spending and decumulation strategy, in this case constant real lifetime income starting at 4% of assets at retirement, and will leave it unchanged for 30 years independent of changes around them; for that matter personally I’d be leery of locking into a fixed SPIA at current interest rates or the long-term inflation assumption of about 2%. But of course, as the saying goes, predictions are difficult especially about the future. My personal preference is always toward more rather than less flexibility to be able to respond to the unknowns that the future will bring- good or bad. Of course there might be a point when one’s spend rate relative to assets will force one into a fixed annuity, but hopefully at a later age of much shorter life expectancy.)

Real Estate

In The Market Oracle’s “Is buying U.S. real estate now, insanely brilliant or moronic?” Lew Rockwell writes that he is very skeptical of all the encouragement he is receiving from friends pilling into investment homes to rent, rather than flip as it was hot to do in 2006. He argues that US “Real estate is still extremely dangerous, and only people with a solid financial cushion and who are willing to take gargantuan risk should be moving into it.” He supports his case arguing that: increases in property taxes (near bankrupt municipalities will find “owners of visible and immovable wealth easy targets” to extract extra revenue from) , increases in interest rates (even if you have a low interest 30 year mortgage, mortgage rates will increase substantially over the next 30 years which will drive down house prices that you might still be holding), higher inflation (even with low fixed rate mortgages banks will find ways to pass on their increased cost by various fees) coupled lower future rental prices than built into the financial projections (“due to the “extraordinary” number of vacant homes all around the country. The artificial restriction of supply that has occurred by having these homes sitting vacant simply cannot last.”), will all conspire to aggravate the situation on top of the usual rental property issues like finding reliable renters and high maintenance costs of cheaply built houses.  (Thanks to MF for referring. Even though I haven’t thought about the “property tax” angle, I do resonate with the concerns about expectations of rapidly appreciating US property values. Some wonder if real estate associations are cooking the numbers. According to one recent report Palm Beach County house prices are up 35% since last year, which is certainly neither my experience nor sustainable even if true. With (visible) inventory levels in South Florida now quoted at historically normal level of about 6 months, everyone is getting excited; but this week there was mention in the papers of 29 months worth of inventory in the foreclosure pipeline and who knows how much more is already on the banks’ books but are still being held off the market). Stephen Foley in his Financial Times article “House price rebound cruising for a fall” also has concerns about US house prices “When flipping property is a big topic of conversation, we should have learnt by now to be nervous that a housing market is cruising for a fall…(and) flippers represent an overhang of inventory that will keep a lid on prices, as they trickle their properties out into the market, potentially for years to come.”

In the Financial Post’s “Small towns can offer big savings for retirees” Melissa Leong discusses some of the advantages of trading one’s Toronto home for one in Peterborough, Fredericton, Stratford or Halifax.

In the Financial Post’s “Toronto home prices jump even as sales decline” Garry Marr writes that “While January sales all but collapsed in (Vancouver) the country’s most expensive housing market, Canada’s largest resale market held its own last month with a relatively small decline in activity and a jump in prices. The Toronto Real Estate Board reported there were 4,375 sales through the region last month, a 1.3% decline from a year ago. The average sales price reached $482,648 last month, a 4.3% increase from a year ago.” (But the article makes no mention of the more recent month-on-month and quarter-on-quarter sales volume and price changes. Looking on the last page of the January 2013 TREB report (not in seasonally adjusted terms) which appears to have some monthly granularity of Toronto prices appear to have peaked in April 2012 around $515K and have been in the $475-$500K range between July-Dec 2012 with January 2013 at $482K, so as the saying goes: if you torture the numbers enough, they’ll confess to what whatever you want to hear.)

Pensions and Retirement Income

Much ink has been spilt in Canadian papers over the past week as a result of the Supreme Court ruling in the Indalex case. For example in the Globe and Mail’s  “Top court deals blow to pensioners in insolvency cases”  Jeff Dray reports that the court ruled that  “DIP lenders rank first… (but) the court also surprised observers by ruling the full amount of a pension shortfall at a plan’s windup should be considered a “deemed trust” under Ontario’s pension law” in some situations. In Financial Post article “Supreme Court ranks DIP lenders ahead of pension funds in Indalex case” Drew Hasselback  reports that “The Supreme Court said that it’s up to Parliament, and not the courts, to decide where pensions should rank in restructurings. “There are good reasons for giving special protection to members of pension plans in insolvency proceedings. Parliament considered doing so before enacting the most recent amendments to the CCAA, but chose not to…” Hasselback notes that “While the decision clarifies that pension plan members rank beneath DIP lenders, the decision does not put pensions at the bottom of the payout pile. Rather, the ruling seems to suggest that in a restructuring under the CCAA, a pension fund deficit would rank ahead of creditors who lent money before the company filed for court protection.” (It’s a complex ruling involving deemed trusts, constructive trusts, fiduciary responsibility, DIP loans, etc. Time will tell if and how some strands of this ruling might be used to enhance the case of the Nortel pensioners. Given the scraps that Nortel pensioners were thrown by the court so far, I wouldn’t count on any breakthroughs.)   

In the WSJ’s “Low rates force companies to pour cash into pensions” Ramsey and Monga report that in the past year Ford and Verizon made $5B and $1.7B pension plan contributions respectively; “pension plan funding fell $79B last year at about large companies” largely due to the low discount rates driven by the fed’s financial repression. Ford spent on damage control on pensions “almost as much as the auto maker spent last year building plants, buying equipment and developing new cars”.  “While pensions may be an anchor on capital for many companies, for hundreds of thousands of workers, they represent deferred pay and a commitment that kept them working at a particular company when other offers were dangled.” (The “financial repression” continues and so do pension plan underfunding issues and retirees’ income problems. No change seems to be visible in the near-term.) In Canada, the Globe and Mail’s “Firms turn to employees for pension relief” Keenan and McFarland report that Canadian companies “have asked their employees to let them take advantage of a special Ontario government rule that allows companies to stretch contributions to underfunded defined-benefit pension funds to 10 years from five”. (There is no question that the ultra-low interest rate environment is driving DB pension liabilities to new highs, but the same low interest rates also have driven up the stock markets, so the asset side of the pension plan ledger has been affected positively. At least according to these two articles US companies are making major pension plan contributions while the Canadian companies are asking for relief; and by the way in bankruptcy US pension are protected up to about $55K/yr by PBGC. Let’s face it, private sector DB plans are gradually disappearing; but existing earned pension benefits should be sacred even if Canada’s pension system is in systemic failure and future pension benefits will stop accruing. The BIA/CCAA must be amended ASAP to protect already earned benefits by raising priority of pension deficit if sponsoring company declares bankruptcy; not doing this or pension guarantee funds in a civilized country is a disgrace. )

Things to Ponder

In the Investment News’ “Fidelity target date funds draw fire from consulting firm” Darla Mercado reports that according to the Center for Due Diligence Fidelity’s target-date funds (and target date funds are some of the most prominent among current 401(k) defaults) have amassed almost $150B of assets but have significantly lagged peers in 1, 3 and 5 year performance. Various commentators suggested that this may be at least in part due to their more conservative glide-path (lower equity allocation). (The substantial differences from various other target-date funds should make those responsible to consider whether such a loosely defined construct as a target-date fund is appropriate as a 401(k) default.) 

In the Financial Times’ “The end may be nigh but don’t bet on it” Edward Chancellor discusses the “debt supercycle” with some even suggesting that we are in its “final phase”. However he writes that so far authorities have been successful in delaying a disaster by in effect “setting the scene for even greater excesses down the road”. He suggests that we may be further from the end than we may think and “In the investment world, to be early is to be wrong.”

The Economist’s Buttonwood in his “Impact of low interest rates” quotes some disturbing data which suggests that “Low real rates are associated with low future returns on equities; high real rates are associated with high future returns.” (Let’s hope this time will be different.)

In WSJ’s “Pension funds cut back on commodity indexes” Ianthe Dugan decreasing enthusiasm for commodity index funds. The large inflow of funds into commodity indexes not only produced lesser returns than expected but “…turned the market on its head. Many commodities seesawed beyond traditional supply-and-demand patterns, and some economists blamed these new “index speculators,” who had no stake in the underlying commodities. Farmers, airlines, oil companies and other producers and users found it more difficult to use futures contracts for their original purpose—to protect themselves against price swings. The government has been wrestling with limiting investments by speculators.” Expected regulatory changes will also further hinder success of such investments. (That sounds good; perhaps commodity related allocation will be redirected to companies involved in their production.)

In the Financial Times Lex’s “Canadian banks: mortgaging the future” indicates that household debt to personal disposable income reached an all time high of 165%. The article indicates that about 25% of Canadian banks’ assets are residential mortgages of which 65% are insured by government supported insurance companies. Canadian banks trade at much more generous multiples of tangible book values compared to their US counterparts, credit agencies cut Canadian banks down one notch due to fears that the government is rethinking its mortgage insurance policy.

And finally, in the WSJ’s “Americans rip up retirement plans” Lauren Weber reports that in the past two years the number of Americans between 45-60 who plan to delay their retirement increased from 42% to 62%, due to “financial losses, layoffs and income stagnation sustained during the last few years of recession and recovery”. The article indicates that while improvements have been noted in the stock and housing markets as well as unemployment has decreased, much of this age group has encroached into their savings over the past five years. However, more people staying in the workforce longer is good news for those worry about the “The vanishing worker”. In this article the Economist’s Buttonwood reports that a 1% change in the “net labour workforce (the number of workers minus the retirees) as a proportion of the population… leads to a change in GDP growth of 0.27% per year”.  If this “relationship holds good, (a four point decline in the ratio knocks 1% a year off the GDP growth rate), then most Western economies won’t be growing at all by 2030”.