Hot Off the Web- February 25, 2013

Contents: Retirement scenarios, tax preparers, value investing requires patience, CCRC (Continuing Care Retirement Communities) vs. LTCI, risk based asset allocation, winner’s game, RRSP withdrawal strategy, RBC devours Ally and replace 1.8% with 1.2%, 5th monthly decline in Canada’s house index- annually still up 2.7%, CIBC endorses a voluntary expanded-CPP but others call it fantasy, communication/perspective differences in DC vs. DB, human capital considerations for advisers, trouble ahead for future retirees, stocks after retirement, fundamental indexing.

Personal Finance and Investments

With more people delaying retirement, Carolyn Geer in the WSJ’s “How to get to retirement? Practice” considers various outcomes for a 60 year old couple earning $100K/yr, saving 15%/yr and with $500K saved up for retirement. The differences in outcomes are startling for the three scenarios (factoring in the 7-8% increase each year Social Security is delayed) she considers for their retirement as measured by income/yr and cumulative income from 60-69; these would be: 1. retiring at 62- $52K/yr and $586K pre-tax income during their 60s, 2. continued working and saving through age 69 and  retired at 70- $96K/yr and $850K income during their 60s, and 3. stopped saving at 60 end retired at 70- $88K/yr but $1M total income in their 60s. All that extra income would allow the couple to “Work, but start living some of your retirement dreams at the same time.” “With that extra money they could, for example, pay off their mortgage, make some home improvements, or buy some big-ticket items, such as a new car or recreational vehicle.”

In the WSJ’s “What to look for in a tax preparer” Tom Herman warns to beware of “anyone claiming to be able to get you a larger refund than other preparers… who wants to charge you based on a percentage of your income-tax refund” and “”Use a reputable tax professional who signs the tax return and provides a copy…”

In WSJ’s “Value stocks are hot-but most investors will burn out” Jason Zweig quotes  Jean-Marie Eveillard that while recently “value investing seemed easy…(but) most people aren’t cut out for value investing, because human nature shrinks from pain…(and) superior returns can be earned only by those who know that it is hard—and stay put.” Recalling his experience when he managed a value fund which outperformed for decades, “After one bad year investors were upset…after two they were mad, and after three they were gone.” He also warns that while value outperformed growth stocks since 1926 by 4% points annually, by today’s valuations the gap between value and growth is smaller, value managers use different measures- now “cheap relative to current or expected earnings” vs. book value in the past, and today large rather than small are favored by value managers (in the past the small company returns were the source of much of the outperformance).

In WSJ’s “Beyond long-term care” Kelly Greene reports that with the rising cost of long term care insurance some families consider CCRC (Continuing Care Retirement Communities) “to hedge against the potential for late-life custodial care that can decimate decades of retirement savings in just a few years… They offer a range of care depending on medical need, from independent living that appeals to some healthy older adults seeking social activities, transportation or meals (all the way) to 24-hour skilled-nursing care.” Average CRCC admission fee and rent are $280,000 and $3,500 (a 17% increase since 2008) respectively, but the monthly fee for those offering “life care” (Type A) covers a villa when you are healthy and 24-hour skilled nursing care when that’s required. “That means the only financial unknown is how long you will live, rather than how much your future care will cost.” (From what I gather there is also the risk associated with likely increases in monthly rent.) There are other models as well: “Type B contracts, for example, typically discount the cost of additional care for a set time period. Type C facilities charge more for residents who move into assisted-living or skilled-nursing units, but also charge smaller or no entrance fees and lower monthly rates for independent living.” Greene notes that while these are worth exploring one must be aware of risk of: operator bankruptcy, staff cut-back and spending of capital to grow the business unwisely. She also mentions that “it’s OK to “bargain” and you must “do due diligence” on the community’s finances. (This sounds like an interesting model but you are putting a lot of very important eggs in one basket! But whatever concerns one might have with the CRCC model, that doesn’t mean that LTCI is the answer, as LTCI is not really a risk appropriate to be managed with insurance; insurance is appropriate to manage low probability and very high impact event. Long-term care is not a low probability event.)

Since the 2008 experience when faith in (un-)correlation based diversification was shaken to its foundation, the search for other diversification mechanisms has been on. My last week’s blog referred to an article proposing four buckets: expansion, recession, inflation, deflation. This week we have a three bucket approach. In CFA Institute’s “A risk-based asset allocation frameworks for unstable markets” Ashvin Chhabra writes that “Individual investors need to shift from trying to beat the market to creating a strategy that will enable them to achieve their important financial goals regardless of the future behavior of financial markets. The wealth allocation framework is an intuitive goals-driven framework of three portfolios: safety, investment, and aspirational.” The three portfolios “The personal risk bucket, or safety portfolio, is designed to protect the investor when the market is unstable or even goes out of existence; this bucket is designed entirely for safety. The second bucket, or market portfolio, is the most efficient way of getting return per unit of market risk… The third bucket, or aspirational risk, represents the opportunity for wealth mobility, which can arise from human capital (business ownership, concentration). Real estate (which he calls a “sensible home”) belongs in the safety bucket. Gold also in the safety bucket (usually bought gradually for dollar cost averaging) is a long-term “hedge against the world reserve currency” and like real estate is expected to have zero real long-term return. Gold would be in the aspirational bucket only for speculators. To assess your current situation place each existing asset and liability on one of the three buckets. Assume zero real return for those things which are there for safety and place them into the safety bucket. The high return high risk items are to be place in the aspirational (10x increase in value) bucket, with everything else going into the investment bucket which will provide market return. Then use scenario analysis to explore how overall portfolio meets goals under market conditions of return of: -50%, -30%, 0%, +20% and +50%. If -50% scenario results is unacceptable outcome, wealth allocation must be changed.

In a webcast, from CFA Institute’s 2012 Asset allocation for private clients conference, “The winner’s game” Adrian Cronje looks at how the financial (advice) industry can respond to accusation that “business motives of the industry have caused it lose sight of overall fiduciary duty to clients”. Cronje suggest that stewards in the industry can be recognized by four things: 1. define mission correctly (it’s not about return, return is largely determined by the starting point, 5% real draw from a 60/40 portfolio can only be achieved by erosion of real capital), 2. smoothing the ride to the destination (Soros: it’s not about whether you get it right or wrong but it’s about how much you make or lose when you get it right or wrong, important because volatility can lead to bad behaviour and since portfolios compound geometrically not arithmetically upside vs. downside capture determines returns over time), 3. managing expectations to what is possible (not promising financial magic  like asset-class based risk parity or risk factor based portfolios but perhaps managing expectations by looking at risk buckets like liquidity reserves, safe assets, market risk, manager risk and private capital), 4. Cost containment (costs are certain but expected value added is not).

In the Financial Post’s “Smoothing out your RRSP withdrawals” Jason Heath looks at one particular couple’s situation (retiring at age 57) who are seeking advice whether it makes sense for them to start taking money out of their RRSPs before government pension kick in and OAS claw-back might hit them, or wait to age 71 before tapping the RRSP. In this specific situation the choice would be neutral from an age 90 net worth perspective and OAS claw-back would not kick in. But Heath leans to making some early RRSP withdrawals for some generic reasons which may be applicable to others as well: (1) if one or both of the couple die(s) young the surviving spouse and/or beneficiaries of the estate will have higher tax rates on the RRSP, and (2) he tables the possibility of potentially higher future tax rates in general given increasing pressure on government budget due to aging population. He also make the point that real advice is about retirement/financial planning, not investment advice!

In the Financial Post’s “RBC to close consumer savings accounts at recently acquired Ally Financial” David Friend reports on the collateral damage of RBC’s recent purchase of Ally Financial is the demise of the 1.8% interest associated with Ally’s HISA (high interest savings account) which is to be leveled with Royal Banks 1.2% interest on their ‘high’-savings accounts. (If Canada’s big banks don’t like to explain the high rates paid by one of their smaller competitors, Canada’s big banks can just buy them and shut ‘them’ up/down.)

Real Estate

Canada’s January 2013 Teranet-National Bank House Price Index indicates that house prices were “…up 2.7% from a year earlier, the smallest 12-month gain since November 2009.” Year-on-year prices were up in Toronto (5.3%), Calgary (4.3%) and Winnipeg (3.4%). Ottawa-Gatineau matched the average (2.7%), Montreal (2.6%) and Victoria (1.1%). For Victoria it was the first 12-month gain in 13 months, while Vancouver was down 2.5% from previous year. “The January composite index was down 0.3% from December, a fifth straight monthly decline. Prices were down from the month before in seven markets. For Calgary (−0.1%) it was the second consecutive monthly decline, for Vancouver (−0.8%) and Edmonton (−0.7%) it was the third, for Toronto (−0.4%) and Winnipeg (-0.3%) the fourth, for Montreal (−0.2%) the fifth.”

In the National Post’s “Canada’s home sales rise in January, easing correction fears” the Canadian Press is quoted that “Sales were up 1.3% in January from December, the Canadian Real Estate Association said on Friday. The trade group for the country’s real estate agents said that compared with a year earlier actual sales for January, not seasonally adjusted, were down 5.2%.” (As one of my economist friends indicated, the seasonally adjusted average Ottawa temperature in January is 20C/68F.)

Pensions and Retirement Income

In the Financial Post’s “Canadians should be allowed to contribute more to CPP to ‘reignite a culture of savings’ urges CIBC chief” Melissa Leong quotes CIBC CEO that “I believe that a reasonable starting point, benefitting the greatest number of individuals, would be to allow Canadians to increase their contributions to the CPP,” he said. “We need to provide Canadians with further choice — choice that gives them date certainty and real dollar amount certainty. A choice that will help Canadians as individuals, and Canada as a nation, reignite a culture of savings.” (An endorsement for some form of expanded CPP is refreshing coming from a bank CEO, and there was no mention of the PRPP.) However Terence Corcoran strikes back with “The new savings fantasy” in which he argues “With this plan, however, Mr. McCaughey is reintroducing the defined benefit pension concept on a national scale, a concept that seems beyond the ability of any pension system to deliver. There is no way to provide individual investors with guaranteed pension benefits 35 or 40 years into the future, because there is no way to guarantee investment returns. .. A new era of saving and investment dawns, one based on realistic assumptions about risk, changing demographics, greater longevity. But new eras require new thinking on the part of individuals, business and government as to who should carry the risks… Trying to create a new national substitute for a fantasy seems like the wrong way to prepare for the new era.” (Of course, both are half right. Allowing additional voluntary contributions within a CPP context as proposed by CIBC CEO would be very sensible, however Mr. Corcoran’s point about “real dollar amount certainty” via a federally operated DB plan being fantasy also has some merit, after all the CPP is really a target benefit plan (e.g. contribution rates increase at least a couple of time in the past 20 years). You might also be interested in my blog on this subject Expanded-CPP Plus where I discuss how the CPP infrastructure could be used to create a national savings scheme with attributes that have a significantly improved chance for a superior outcome for Canadians, without creating unrealistic expectations or placing unsupportable risk burden on the government.)

In Benefit Canada’s ‘Give DC the attention it deserves” Jean-Daniel Coté discusses the differences in perspectives, needs and communication for DC plans vs. DB plans. The article has an interesting table looking at the differences. (DC plan communication should also include some feedback mechanism indicating required plan contribution to meet a certain retirement income and/or age goal, and expected retirement income assuming current year contribution rate continues.

Things to Ponder

Investment News’ “Why advisers won’t talk about clients’ careers-but should” based on Moshe Milevsky’s work on the importance of human capital (career, earning capacity) and its source, asks why financial planners don’t spend more time factoring it into their advice. Specifically, the article mentions that factoring in human capital (with the financial capital) and the risk accompanying it (the old argument being that stockbrokers’ and college professors, all else being the same, should have different portfolios) could change the asset allocation. The point of the article is to suggest that financial planners should but don’t factor in human capital into a financial plan because it is not a source of income to them; the suggestion is that an hourly fee for service compensation structure for young people with minimal financial capital but lots of human capital, and as assets build up a switch to percent of assets model could fix the problem. (The article fails to mention that one typically doesn’t get a “financial plan” from broker-advisor who may be compensated already with commission/trailers or asset based fees; in the US there RIAs who do provide fee only advice and typically deliver a financial plan as the core element of the advice, and I’d be surprised if the RIA wouldn’t factor in elements of human capital into the plan, when appropriate.) The article also raises the question of ROE (Return-on-Education), indicating that research shows that ROE is different depending on the degree pursued. For example A degree in engineering or medicine has a 12% annual return whereas anthropology 3%. Of course what one studies is not necessarily an investment decision, but may be a consumption decision.

In the Washington Post’s “Fiscal trouble ahead for most future retirees” Michael Fletcher reports that “For the first time since the New Deal, a majority of Americans are headed toward a retirement in which they will be financially worse off than their parents… The economic downturn exacerbated long-term factors that were already eroding the financial standing of aging Americans: an inexorable rise in health-care costs, growing debt among older Americans and a shift in responsibility from employers to workers to plan for retirement.”  According to Fed data 53% of American workers over 30 are “on a path that will leave them unprepared for retirement” compared with38% in 2001 and 30% in 1989. And of course with Social Security and Medicare under pressure due to government deficit, this potentially further aggravates the situation.

In the Financial Post’s “Why you should buy stocks after retirement” Andrew Allentuck challenges the conventional wisdom that retired people’s “portfolios should be mostly or entirely bonds”. He argues that in the current low interest environment when 10-year government of Canada bonds pay 2%, this might not be a formula for a successful retirement. He quotes advisers: one suggesting that “If you do not have an indexed defined-benefit pension plan, then you must have a hefty allocation of stocks that pay dependable historically rising dividends.” And another is more extreme “…we think 100% equity is OK for someone even in his or her 70s.” Of course fixed income allocation is still needed for capital protection and reserves for each individual. (There is no question that the very low interest rate environment has serious impact on retirees, but as mentioned elsewhere 3-4 times in this week’s blog, retirement planning is not about investment returns, but about preparing a financial plan which will take one to the desired destination. Therefore it is one’s goals/objectives and risk tolerance (a combination of willingness and ability to take on risk) not investment returns that will be the determinant of one’s asset allocation.)

And finally, in Index Universe’s “Siracusano: Fundamental indexing not niche” Cinthia Murphy interviews Wisdom Tree’s CIO Siracusano about fundamental indexing. Siracusano, whose firm has the largest (?) base of fundamental indexed ETFs in the market and he argues that “the days of market-cap dominance are over”. He dismisses critics who call fundamental investing “just another form of active management” given 40 years of back-tested data and five years or so of “real-time” data “fundamental indexes have consistently outperformed the comparable capitalization-weighted index”. For example, he counters those critics who argue that it is just a value tilt, by pointing out that fundamental indexing outperformed in an environment when growth indexes beat value indexes; their approach is to “own equity markets and reweight once a year based on income. He similarly argues against those who say it’s just a small-cap bias approach or that it cannot be scaled up. He further argues that such fundamental strategies belong in the core of the portfolio and just like investors like to diversify among different active managers, the same way they should diversify among “passive” indexes. (Wisdom Tree’s case sounds persuasive, but I haven’t taken the leap as yet for all the reasons that he counters in the article, plus others like higher (management/transaction/tax) costs. So there you have Wisdom Tree’s fundamental investing story and I’ll let you be the judge of whether you are ready for a leap.)

P.S. KeatsConnelly has started a Cross-Border blog addressing topics of special interest to those of you who might be living on both sides of the Canada-US border. For example the February 20, 2013 blog is entitled “How long do I have to stay outside the US before I can return as a visitor”

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