Contents: Investment manager or financial planner? importance of liability management, comments on proposed changes in OBSI terms of reference, indexing vs. dividend-based strategy, Canada/Denmark looking to reduce mortgage related housing risk, Obama: privatize mortgage insurance, actuaries the last to discover that Canadian living longer-eh? recommendations to upgrade RRSP effectiveness to that of DB plans, US public pension crisis escalates, DFA: earnings sustainability as strong an effect as value, currencies nothing but smoke-and-mirrors.

Personal Finance and Investments

In my mid-week blog post this week I replied to a question from one of my reader. In “Q&A: What do I need: Investment manager or Financial Planner/Adviser?” blog post the reader, a DIY investor, is concerned that her husband will be incapable to manage their investments if/when she will be unable to do this on their behalf; she was also dissatisfied with the returns she was getting with her ETF based portfolio. Her question is why not hand over the assets to a professionally managed pooled fund or a discretionary manager, and where can she find them? The short answer is that she needs a financial planner not an investment manager.

In the Financial Times’ “Liability management: The case for hopelessly boring wisdom” Tom Stable discusses the growing emphasis on “liability management” in context of institutional investors (e.g. pension funds) and the importance of applying the same techniques to the average investor. What this involves for individual investors is “mapping their portfolios against “goals”. Planning around pricey items such weekend houses and retirement needs”, rather than trying to beat the market. When people finally really take stock of their liability streams, as they approach retirement and leave accumulation phase of their financial lives, they realize the importance of not just understanding but also managing/reducing their liability streams; “the cargo of people, properties, cars, pets, “toys” in addition to the “future bills for retirement, healthcare…(and) finding star money managers…was beside the point”. “Minding liabilities and pruning costs (asset management fees, taxes) may be the safest path for today’s retirees…(but) such wisdom is hopelessly boring.” (My old reliable “Control what you can!” blog post which recommends focus on controlling: savings, spending, costs and asset allocation harps on the similar theme.)

You might be interested in seeing my comments on the proposed OBSI changes in its terms of reference at the OBSI website in the RetirementAction.com (August 6, 2013) link. OBSI, the Ombudsman for Banking Services and Investments, is an “independent and impartial” free service (funded by participating institutions) which “resolves disputes between participating banking services and investment firms and their customers if they can’t solve them on their own.” My comments address concerns surrounding: proposed abandonment of the pursuit of systemic issues, proposed abandonment of one-stop shop approach by dropping segregated fund complaints, and $350,000 cap on claims.

In the Globe and Mail’s “Indexers vs. dividend lovers: How to pick a winner” Preet Banerjee discusses the arguments supporting index vs. dividend strategies. While he leans toward indexing based on theoretical arguments, in his conclusion he squarely comes down with an ambivalent conclusion, arguing that either strategy is acceptable so long as one sticks to it. (I am with indexers; it is an approach that generally gives a better diversified portfolio whereas dividend based one tends to lead to a lot of sector concentration.)

Real Estate

In the Globe and Mail’s “CMHC moves to take steam out of the housing market” Tara Perkins reports that “Canada Mortgage and Housing Corp. is limiting guarantees it offers banks and other lenders on mortgage-backed securities. The measure comes amid the federal government’s efforts to protect taxpayers from financial risks in the housing sector, further cool lending and add upward pressure to mortgage rates.” Effectively, banks will have to assume more of the mortgage lending risk which will force them to improve their due diligence in screening eligibility of borrowers, while borrowers will end up paying an estimated 0.2%-0.65% higher mortgage rate.

On a related theme, in Bloomberg’s “New crisis lurks in cure for old as Danish probe shows risks” Frances Schwartzkopff discusses the debate in Denmark “on how to wean households off cheap, yet potentially volatile, debt echoes a dilemma facing policy makers across much of the globe, where the response to over-indebtedness has been to feed demand for borrowing.” It seems that adjustable-rate mortgages now represent over two-thirds of Denmark’s residential mortgages and this leads to annual requirement for massive mortgage bond refinancing. “Danes bear the world’s highest private debt burden, at 310 percent of disposable incomes…” the government and the credit agencies worry about the need to deal with the “…the “substantial mismatch” between funding and lending maturities…” (I suspect that Canadian banks’ exposure to the risk associated with this mismatch in maturities is somewhere in-between the U.S. and Denmark , in that the predominant mortgages in Canada are 25-30 year amortization but the mortgage rate is reset every 5-years. As I mentioned the past couple of weeks there is growing discussion about whether it makes sense that government policy should encourage home ownership or whether this leads to a: misallocation of resources, drive individuals to risky/concentrated portfolios with one critic even suggesting that such policies are regressive.)

In the Washington Post’s “Obama touts housing recovery lays out strategy to build on gains” Zachary Goldfarb reports that President Obama tabled some going forward housing principles including “…any future housing system must preserve the 30-year fixed-rate mortgage, a linchpin of the American economy that requires the government to provide guarantees to the housing market because bankers are unlikely to offer such long-term loans on their own…(but) he called for an end to the federally owned mortgage giants Fannie Mae and Freddie Mac and said that any future system must place the vast majority of financial risk on private-sector lenders…”

Pensions and Retirement Income

The CBCNews’ “The pension downside of living longer” reports that the Canadian Institute of Actuaries (CIA) new draft mortality tables the average 60 year old male and female will live and additional 27.3 and 29.4 years, or 2.7 and 2.9 years longer respectively that their ‘old’ (i.e. current) mortality tables indicate. The impact of such a change (while it would vary with the age/occupational demography of each plan) could be as much as 5%-10% increase in DB pension plan liabilities. This also means that individuals with DC plans would have to save more to cover the lifetime expenses as measured by the cost of buying an immediate annuity upon retirement.  In the Globe and Mail’s “Growing lifespans the latest worries for pension plans” Tara Perking reports that Teachers’ pension plan wasn’t waiting for the latest CIA pronouncement on increasing longevity but has proactively adjusted mortality tables in 2007, 2010 and 2012 based on its own data. Teachers’ CEO Leach recommended that “…pension plans and sponsors need to address longer lifespans by changing the rules around pensions…” i.e. later retirement, and making various guaranteed benefits contingent. Perkins also quotes the President of the CIA that “What the new table is showing is that we were somewhat wrong with our prediction, that it was not conservative enough, and that in fact people are living even longer than we expected…”   (Now, this longevity increase of close to 3(!)-years didn’t happen overnight and it’s not a surprise to anyone involved in pensions; this recognition gap (rather than information gap) developed over decades of aggressive actuarial practices which I mentioned as just one of the many contributory elements to the systemic failure of Canada’s private sector pension system. Another aggressive actuarial practice (which I have previously called actuarial insanity) further contributing to pension plan underfunding (and the delight of employers/sponsors) was the use of expected plan asset return based discount rates for liabilities. Still it was convenient for too many actuaries to condone/encourage such aggressive practices by hiding behind CIA endorsed practices which I believe were but smoke-and-mirrors used to minimize pension plan contributions and even take contribution holidays. A good example is Nortel pension plan which pensioners suddenly were surprised to find to be only 59% funded after for years being quoted funding level between 86%-103%. Actuaries can’t take all the credit for this fiasco; they had active and passive accomplices in executives/boards, accountants, trustees, investment managers, regulators and government regulations. There is lots of blame to go around but the consequences are being borne by pensioner alone.)

In the BNN video “Living longer: The implications for pensions” Money Talk’s Kim Parlee interviews James Pierlot on the impact of differences between DB pension plans and RRSPs on the potential retirement savings over one’s working life. Mr Pierlot argues that typical private sector DB plans allow you to accumulate 2x more and public sector DB plans 4-5x more than the RRSP limit constrained plans. This is due to a combination of contribution constraints, DB plans being managed professionally, DB plans attract much lower
costs and thus end up with much higher returns than individuals get in their RRSP. Then to top it off, DB plan sponsors are allowed to make up for plan losses contrary to RRSPs which are individuals are not allowed to fund deficits. Public sector DB plans (like Teacher’s) are world class and achieve returns triple what typical individuals get. During one’s working life DB plans allow accumulation of up to $2-$2.5M. Pierlot advocates for political action of “I want to have a better pension as well” and he has primarily two recommendations: increase RRSP lifetime accumulation limits including ability to make up for losses (I haven’t seen this proposal before), and allow individuals to access the world class public sector pension plans (like Teachers’). (Yes, there is no question that DB plans are better than RRSPs, at least until the employer/sponsor declares bankruptcy to escape payment of pension plan shortfall. Thanks to DT for bringing video to my attention.)

In Canada, at least public sector pensioners appear to be in very good shape; but not so in the U.S.  According to CNBC’s “Pandemic of pension woes is plaguing the nation” John Schoen reports that in a study of 120 of the largest state and city pension plans “Thanks to a patchwork of accounting practices and rosy investment assumptions, it’s not even clear just how big a financial hole many states and cities have dug for themselves. That may soon change, thanks to a new set of government accounting standards that could serve as a nasty wake-up call to states and cities relying on rosy scenarios and head-in-the-sand accounting… One of the thorniest questions that conversation will need to address: who will pay to clean up these financial messes? Will it be the millions of retirees owed trillions of dollars in benefits, the bondholders who lent states and cities trillions more, or local taxpayers who may have to pay more to cover the shortfalls or see deeper cuts in public services?” (In the U.S. and U.K. private, but not public, sector pension plans are insured up to about $50,000, unlike in Canada where there is no pension insurance if employer/sponsor becomes bankrupt.)

Things to Ponder

In InvestmentNews’ “Sweeping changes under way at DFA” Jason Kephart reports that Dimensional Advisers “is adding a third layer of screening to its equity portfolios, which already tilt toward small and value stocks. The new layer… (considers the company’s) ability to earn a profit consistently… The breakthrough came late last year when DFA began looking at companies’ earnings-to-assets and earnings-to-book, rather than cash flow or earnings-to-price (price being too volatile)… Using a company’s assets or book value, by contrast, provides a more reliable look at how profitable a company is and how likely it is to continue to be profitable.” DFA indicated that this adds a similar kicker to performance as value.

And finally, in the Financial times’ “A currency is anything that two people agree is a currency” John Kay writes that in Ecuador and Montenegro you will “learn that money is what you choose to make it”. Ecuador is “dollarized” i.e. “the government made a unilateral decision to adopt the currency of another country”; but they not only started using the USD but they even started minting their own (US) 50 cent coin which doesn’t even exist in the US. Montenegro uses the Euro without the permission of the ECB; they don’t mint their own Euros. Other unusual constructs mentioned in the article include the Isle of Man, Jersey and Guernsey which print their own currency and which local banks “will, but need not” convert to British pounds, and Scottish notes printed by the Bank of Scotland are backed by Bank of England notes. Kay concludes with the comment that “Money is a confidence game; its value depends entirely on the willingness of other people to accept it. Money is what you choose to make it.” (All this should make us uncomfortable, but an ostrich policy should allow us to march on, as there is not much we can do about it.)