Hot Off the Web- September 16, 2013

 Contents: Bonds as portfolio stabilizers, end of income investing, ‘autopilot’ withdrawal strategy, financial plan: necessary but only useful if implemented and up to date, Swedroe: don’t approach investing like lottery, careful with ‘safe’ investments, insured annuities-unlikely, advisors: need for, problems with and potential value of a professional advisory relationship, Canadian house prices up in August but moderation expected, rising mortgage rates won’t stifle US housing market, Ontario Teachers’ Pension Plan best run, Canadian public pensions models for the world? Canada’s public pensions disintermediate private-equity firms, Rosenberg: inflation coming-start hedging against it, smart beta is not indexing but an active strategy, liquidity defined and something to worry about in the bond market? top 1% income earners in US captured 19.3% of total income! baby boom coming?


Personal Finance and Investments

In the WSJ’s “Bonds still belong to your nest egg” Tom Lauricella observes that despite recent losses in bond portfolios “older savers should remember there are still good reasons to keep a hefty slug of their money in bond investments”; and this is not just because the higher interest rates will eventually translate into higher yields. So after a 30-year bull market in bonds, some are wondering if they should exit bonds completely. But that would be a mistake since the reason why retirees need bonds is their lower volatility and because they “tend to act as a stabilizer to help offset the impact of frequent short-term swings in stock prices”. Just keep in mind that not all bonds bring this benefit with them, in particular high-yield bonds don’t, while Treasury bonds and investment-grade corporates do at least if you are prepared to hold to maturity). Short-term and to a lesser extent intermediate bonds will also be less affected by interest rate increases. (Lately I’ve been settling for 1-2 year GICs earning about 1.8-2% interest, which is pretty painful after maturing 5-year 4.5-5.5% GICs or provincial bonds. But the fixed income component is the ballast of my portfolio and is acting as my stabilizer; I take most of my risk on the other half of the portfolio. Unfortunately, in the U.S. 1-2 year CDs yield even less than GICs making this even more unpleasant.)

In The Financial Post’s “The end of income investing-for now” Ted Rechtshaffen lists the three strikes against income investments (e.g. high dividend stocks): many are too expensive by historical standards, when interest rates increase income driven investments go down, and depending on the business cycle phase different sectors outperform. Rechtshaffen writes that “traditional income focused portfolio needs to be changed” to focus on the sectors that are likely to outperform, otherwise on might be in for “a long period of underperformance”. (Sounds like a challenging maneuver with uncertain outcome. I personally don’t bother with such “income investments” explicitly (see previous comments above on my fixed income approach); instead I use mostly broad index ETFs for the non-fixed income or risky part of my portfolio. If insufficient income is thrown off for my needs by interest from fixed income and dividends from the equities, I still have the option to sell some assets to make up the shortfall.)

In an interesting article on withdrawal/decumulation strategy in WSJ MarketWatch’s  “Put retirement savings withdrawals on autopilot” Henry Heebler, host of a very useful website AnalyzeNow, marries IRS’s RMD (Required Minimum Distribution, where required draw  is “last years ending balance divided by the RMD” ; the RMD table is available at page 109 of IRS Publication 590) approach which make conservative life expectancy assumption, to the “4% rule”  (in which first retirement year draw is 4% of assets; subsequent years simply adjust previous year’s dollar draw for inflation). He then defines the “autopilot method” as the average of the amounts calculated by the RMD method and the 4% rule. “To get the value for the 4% rule, we increase last year’s Autopilot withdrawal by the amount of last year’s inflation. Then we add that to the RMD amount and multiply the sum times 0.5. The formula is 0.5 x (Last year’s withdrawal amount x (1 + Inflation %) + Last year’s ending balance / RMD).” For the set of assumptions included in the article, he concludes that the “autopilot method” would have done the best not just for those who retired in the most adverse historical circumstances (1965) but in general as well. Heebler also compares the “planner’s method” whereby the draw is calculated using Pmt(return-inflation, remaining life expectancy, Last year’s ending balance). His preference for retiree calculations would be the Autopilot first, RMD second, Planner third and 4% Rule last.” Heebler also notes that the “autopilot” strategy requires no computer, just back of the envelope calculations. (I certainly agree that the inflation adjusting “4% rule” is the worst of the lot. I would like to see how residual assets look with the “autopilot” method and how it does in a Monte Carlo test rather than just historical data before I fully buy in, but instinctively it feels right.)

In the Globe and Mail’s “The financial plan: Why do so many clients file it and forget” Rob Carrick discusses the growing realization among financial advisors and their clients about the importance of a financial plan as part of the advice package. However, even when a financial plan is provided, the statistics indicate that clients follow only 20% of the recommendations. In fact in a recent case where plaintiffs sued their advisor who prepared their financial plan because they were on track to run out of money. The court on appeal ruled against them because they didn’t follow the plan indicating: “Either follow it, or contact your advisor when you want to change it.” In addition, it is advisable to review your plan once a year or so to make sure it still ‘reflects your needs” and “you are on track to the objectives”. The article even suggests that as part of selecting an advisor you should request a sample plan to evaluate its accessibility/usefulness.

Larry Swedroe in InvestmentUniverse’s “Swedroe: Avoid the investment lottery” discusses how some people approach investments like lotteries. “People who buy lottery tickets know that those are poor investments…(because) they have negative expected returns (about 50% of sales) and returns are not normally distributed. He defines high/low kurtosis when exceptional values, much larger or smaller than the average, occur more/less frequently than in a normal distribution. (“High kurtosis results in exceptional values called “fat tails”.) He also defines skewness as” a measure of the asymmetry of a distribution”; negative/positive skewness occurs when the “values to the left/right of (less/more than) the mean are fewer but farther from the mean than are the values to the right/left of the mean. Their fat tail (high kurtosis) and positive skewness, makes lottery tickets attractive to buyers despite the negative expected return. i.e. “Even though the likelihood of winning is small, if you win you win a very large amount.” Investors have a preference toward lottery-like investments. But this is not the way to succeed in investments, yet human behaviour drives us toward high kurtosis and positive skewness which tends to lead to low returns. High kurtosis but negative skewness leads high returns.

In the NYT’s “Be wary of even safe investments” Carl Richards reminds investors that when somebody offers you ‘safe’ investments earning 7% when prevailing rates are 2% you should start running the other way! Similarly stay away from stuff that you don’t understand, and things that appear too good to be true. Ultimately we must all take responsibility for our own decisions and “If we want to protect ourselves from individuals and institutions alike, we need to ask questions that help us uncover the real motives and whether it’s in our best interest to trust what we’re being sold.” And in InvestmentNews’ “Financial fraud is rampant but most people can’t spot it” Michael Shagrin reports that a “survey found that more than 80% of respondents had been solicited to participate in potentially fraudulent financial schemes, while 40% could not identify some classic red flags of fraud.” Under-admitting to fraud rate is estimated to be 60% while “Of those who admitted to being defrauded, (only) 45% reported the fraud to someone”.

In the Globe and Mail’s “How to get more from your retirement nest egg” Tim Cestnick tables “an idea” to get more retirement income; he writes, how about a prescribed insured annuity for a 65 year old male as compared to a 3.5% fixed income investments in a 45% marginal tax rate. (I don’t wish to quibble about the specifics of the article but as I opined before, while annuities might be suitable for some, but likely better solution are available elsewhere, especially for 65 year olds with little in mortality credits and much to worry about on the corrosive effect of inflation during a long retirement. I am not sold on annuities as a general retirement income strategy for most people as I discussed in the Annuity I: What is wealth?, Annuities II: (Almost) Everything you wanted to know about annuities, but were afraid to ask, Annuities III and Annuities IV . By the way you can also look at current annuity rates available at GlobeInvestor from Cannex showing male, female and joint annuity rates.)

Ken Kivenko in’s  “Do Financial Advisors add value after costs?” posted a great overview of the need for, the problems with and the potential value of a professional advisory relationship. He sums it all up with the difficulty of picking the right advisor (“if you know enough how to pick an advisor, you probably don’t need one”) and that despite “all the potential benefits, given the prevailing compensation models, proficiency standards, conflicts of interest and low suitability standard in place, advisor risk is very real.” (You could also add the lack of fiduciary standards of care to the list of concerns.) He concludes that “with Canadian age demographics rapidly changing, this is a critical point of time for regulators to provide leadership.) And by the way, the SEC-NASAA Investor Bulletin Making Sense of Financial Professional Titles is intended to improve individual’s understanding of the financial professionals’ titles, differences between titles (marketing) and licenses (usually granted by a government agency), differences between broker-dealers, advisers (Registered Investment Advisers), insurance agents and financial planners. Guidance on finding and assessing the financial professionals’ titles and useful information in assessing financial professional qualification are also included. (Thanks to Ken Kivenko for recommending.)


Real Estate

The August 2013 Teranet-National Bank House Price Index is at an all time high increasing 0.6% during the month of August (MoM) and 2.3% over August 2012 (YoY). Toronto and Ottawa were also at all time highs. MoM/YoY changes in Toronto were 1.2%/3.8%, Ottawa 0.2%/0.3%, Montreal -0.3%/0.7%, Vancouver 0.7%/-0.1% and Calgary 1.0%/6.5%. (So, prices were still increasing in Canada but at a much slower annual pace; September and October data may give a better indication of trends.)

In Bloomberg’s “Wells Fargo says rate rise won’t stall housing rebound” Dakin Campbell reports that rising US mortgage rates, up 1.2% since May low of 3.35% for a 30 year mortgage, won’t become an obstacle to the housing recovery “because new families are being created and homes are still affordable” according to Wells Fargo. However refinancing volume is being affected by rising interest rates.

Pensions and Retirement Income

In Walrus’s “Pension envy: Ontario teachers have the world’s best performing retirement fund. Is it a model for the rest of us?”  John Lorinc looks at Ontario Teachers’ Pension Plan (OTPP) and concludes that Ontario’s teachers “appear to exist in a parallel economic universe” still having not just a DB pension plan but a well funded one. With a mandatory 12% of salary contribution the teachers receive on average a $48,000 annuity upon retirement as early as age 55. While many taxpayers who do not have pension plans of their own resent having to pay for the teachers’, but OTPP ex-CEO Leach argues that 77% of the plan’s $130B assets were generated by returns in its 23 year existence and its low 0.5% cost. Leach further argues that mandatory contributions are required and that the next election will be fought on retirement security (It would be about time). The article mentions that OTPP is not immune to the demographic changes taking place: more years in retirement and lower worker-to-retiree ratio, but again proactively flexibility points being looked at is increasing minimum retirement age and amending the indexation benefits. The article also discusses the need for pension reform in Canada and some of the available options.(Recommended by CARP Action) Coincidentally, Ellen Kelleher in the Financial Times article “New York’s CIO points to pensions ‘travesty’” quotes outgoing New York City pension funds’ CIO as singing the praises of the in-sourced approach of Canada’s large public sector pension plans with OTPP and CPPIB being mentioned as models to emulate.  The low wages paid to NYC pension managers makes it impossible to hire the qualified staff necessary for in-sourcing the investment management function.

In the Financial Times “Pension plans: Flying solo” Anne-Sylvaine Chassany discusses how Canada’s pension giants (OMERS and CPPIB specifically) are aggressively ‘moving into dealmaking” bypassing private equity firms historically used as intermediaries. A recent study indicates that this disintermediation, cutting out the high 2/20 fees charged by private equity firms has been beneficial, but skeptics argue that: they can’t compete on compensation to attract the talent, don’t have the wherewithal to “find and analyze deals” and it is not in their culture…to take control of companies and make tough business decisions” or “face the political repercussions of cutting jobs” or bankruptcy. (I guess time will tell. I don’t believe that p-e firms have exclusivity on brains. However I am concerned by the growing proportion of non-publicly traded assets in large public pension plans because of the impact of the opacity of the valuation of such assets on the plans’ overall valuation and thus funding status. There is just too much room manipulation should someone unscrupulous feel the need to massage the numbers.)


Things to Ponder

In the Financial Times’ “Don’t bet against Bernanke’s inflation quest” David Rosenberg argues that Ben Bernanke’s legacy, in addition to saving the world from financial collapse, will also include stagflation which is a natural consequence holding  negative real interest rates in place for years. Inflation and higher rates are inevitable; and a 2.5% inflation objective will be achieved which will lead to 30% price increase over the next decade. This will devalue in real terms the” still huge liabilities” and “it is more bad news for pensioners and those who live on fixed income investments, and good news for Uncle Sam and other debtors”. Rosenberg argues inflation is coming, so start hedging against it.

In IndexUniverse’s “Ferri vs. Arnott: Is smart Beta real?”  Cinthia Murphy discusses various perspectives on so called “smart or alternative beta” (e.g. “fundamental indexing” vs. traditional “cap-weighted indexing”). For Sharpe who originated the concept of beta, beta is just “a portfolio’s sensitivity to movements in the overall market”. For Arnott, the originator of “fundamental indexing” the argument is just semantics. But Ferri argues that it is just another active strategy and “It’s not better it’s just taking more risk in your portfolio to get a higher return…. I (Ferri) have a problem with the marketing. These providers are confusing investors.” (I am with Ferri; there is nothing wrong with ‘smart’ beta as an active strategy, but don’t call it indexing.)

The Bloomberg’s “What’s liquidity and why do we need it?” explains that “liquidity is the ease with which something can be traded for something else”. Cash is very liquid, a troubled company bond is not, but stocks can be sold quickly on stock markets if cash is needed. The more trading there is the easier/cheaper it is to sell an asset. But there is such a thing as “too much liquidity”, which in turn can lead to too much trading (“noise trading”) which doesn’t lead to better “price discovery” and “can even make markets more volatile”. So banks’ concerns that new rules might constrain liquidity are likely irrelevant and self-serving. However Tracy Alloway is not so sure, and writes in the Financial Times article “The debt penalty”  that the impact of banks having to hold more capital means that they are less able to hold (corporate) bonds and provide liquidity in the now much larger corporate bond market (up 42% since 2008). The article explores the concerns with bond market liquidity when rates finally start rising and investors might” find the exit crowded” given that “The risk embedded in corporate bonds has now been shifted from the banks to investors.” The lack of an electronic bond market place, analogous to that for stocks, at least in part due to lack of bond standardization makes it even more difficult to mach buyers with sellers. Lack of liquidity in the secondary bond market is expected to be a problem when interest rates will be rising and bondholders might be looking to exit.

According to the USAToday’s “Top 1% take biggest income slice on record” Matt Krantz reports that “The top 1% of earners in the U.S. pulled in 19.3% of total household income in 2012, which is their biggest slice of total income in more than 100 years… The richest Americans haven’t claimed this large of a slice of total wealth since 1927, when the group claimed 18.7%.” Furthermore “…the top 1% of earnings posted 86% real income growth between 1993 and 2000. Meanwhile, the real income growth of the bottom 99% of earnings rose 6.6%.”

And finally, in the Economist’s “The coming baby boom?” Buttonwood shares a BCA Research report’s forecast that “Developed economies are about to experience a baby boom that will be bigger and longer-lasting than even the one that followed the Second World War….Faster population growth implies stronger aggregate demand in the near term and more rapid supply growth over the longer haul. Equities, housing and commodities should all benefit.” Buttonwood notes the interesting argument “that goes against the consensus”. In the IndexUniverse’s “Demographics and the new normal” Robert Arnott also discusses changing demographics and its impact on the economy, by comes to a different conclusions.


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