Contents: Decumulation strategies, save more with Roth IRAs, retirement realities, fiduciary is a must but industry fighting it tooth and nail, soft landing for Canada’s housing? rich benefit from low interest rates, Canadian home sales up/down/flat depending on location, pension plan liability calculated with discount rate based on rate of return on pension plan assets -is this a bad joke? UK pension plan dumps gilts, watershed un-annuitization in the UK, public pension millionaires, not all ETFs created equal, reverse mortgages rear their head again, family office-like services available to ‘poor rich’, defining fund risk, inflation/deflation.

Personal Finance and Investment

As promised, I summarised in more detail a couple of recently mentioned papers on decumulation strategies in this blog. The blog post earlier this week entitled “Two very different decumulation strategies” first discusses Sexauer and Siegel’s proposal for a self-executed low-/no-risk approach to retirement planning which aims to deliver DB plan like outcome. The second paper discussed is Sheikh, Roy and Lester’s dynamic decumulation strategy which proposes an integrated quantitative black-box approach including not just the usual age, wealth, lifetime income and risk tolerance but also the utility/satisfaction that a retiree receives from a particular withdrawal strategy. The first (very conservative) one you could probably execute in some form yourself, while the second you’d have to rely on an ongoing JPMorgan implementation; I found both very interesting reading.

In WSJ’s “Can’t save? Change your plan” Carolyn Geer sings the praises of Roth IRAs, especially for people who have trouble saving. She recommends, when possible, use Roth IRAs where taxes are prepaid at contribution time. The article also notes that Roth IRAs don’t have minimum distribution requirements but “If tax rates during the distribution phase were lower, all things equal, then the Roth may not be the better option…”

In Reuters “Stern advice- Getting real about retirement” Linda Stern shines some ‘reality’ on retirement: (1) “you’ll spend less than you think, after you spend more than you think” (households headed by >75 year old spend72% of those headed by 65-74 year olds, 63% of 55-64 year olds and about 50% of 48 year olds), (2) “you won’t work until you are 70” (even though there are significant benefits associated with deferring retirement in general and starting Social Security later in particular, but it is not realistic because of health and other reasons), (3) expenses/spending won’t be stable so neither should be withdrawals (there are occasional major planned and unplanned expenses and certainly retirees don’t adjust their spending with inflation each year), (4) “you probably won’t run out of money” (because most people adjust their spending to available resources) and (5) “you’ll have fun” (according to JPMorgan survey the “amount of increased satisfaction that a retiree gets seems to flatten” around $40,000 per year. (For what it’s worth, I have seen the stats indicating that older retirees spend less than young ones, but I always wonder if that indicates correlation or causality?)

In InvestmentNews’ “Borzi counters fiduciary criticism” Mark Schoeff reports that Assistant Labor Secretary Borzi continues to protect small investors, indicating that “They are entitled to have the maximum amount of the dollars they save to be there for their retirement, not be frittered away on unreasonably high fees and other hidden sources of compensation…People who hold themselves out as experts, who have a relationship of trust with their clients, need to put their money where their mouths are,” she said. “They need to actually put their clients’ interest first by being held to a legal standard of care that puts the client’s interest first.” But the financial industry is fighting tooth and nails against best interest standards.

Real Estate

In the Globe and Mail’s “All data points to a soft landing for Canada’s housing market” Robin Wiebe makes a well reasoned argument for soft landing in Canada’s housing market based on slowly rising mortgage rates, no oversupply except possibly in Toronto’s condo market, and continuing population growth driving demand. (Only interest rate rising more rapidly could upset the apple-cart, but many argue that’s unlikely to happen given the convenient effect of low interest rates on carrying cost of government debt; instead let boomers and retirees pay the price with lower income on their savings.) In fact in another article, Bank of Canada governor Poloz warns of slow growth and continued low interest rates, which he blames on aging Boomers. (I guess the Boomers have only themselves to blame.) By the way, the Economist’s Buttonwood has a great column “The rich are different” in which he discusses who benefits from the ongoing financial repression (ultra low interest rates) in the past five years, and he concludes that the wealthy benefit extraordinarily more from the low interest rates compared to the average and poor segment of the population. “People with small pool of savings…they keep it in form of liquid assets. They have been hit hardest by the fall in interest rates. Rich people have much less use for liquidity; they can diversify into riskier assets and get access to the best financial and tax advice. They are thus likely to earn higher returns…”

While the Financial Post’s “Canadian home sales: How healthy is your housing market” reports that during February “Canadian existing home sales edged up 0.3%, breaking a five-month run of declines”, but you must look at the number with a little more granularity. “Nationally, home sales are up 1.9% from a year ago, but BMO senior economist Robert Kavcic says markets vary widely across the country with half of Canada’s largest cities reporting a sales dip from a year ago.” Calgary is firing on all cylinders with sales up 14% YoY and prices up 9.1% YoY. Toronto prices up 7.3% YoY even though sales about flat over year ago. Vancouver sales increases are an “eye-catching” 41% YoY, but “activity merely back to 10-year norms. Montreal is struggling “consistent with a weak economy” (and renewed talk of separation).

Pensions and Retirement Income

In C.D. Howe Institute’s “The real problem, with public sector pension plans”  ex-Mercer Canada (Nortel pension plan’s actuarial firm) partner and actuary Malcolm Hamilton writes that “private-sector pension accounting standards long ago rejected the premise at the heart of today’s public-sector accounting standards – that the cost of a fully guaranteed pension depends critically upon the rates of return that a pension fund can earn on risky investments even though the pension itself is totally unaffected by these returns”. Not sure what “long-ago means” and when Canadian actuarial practices made this no longer acceptable for private sector plans; but it wasn’t long enough ago since Nortel pensioners took a 40% pension cut just a couple of years ago resulting at least in part from such accounting, or was it just funding practices, under Mercer’s watchful eyes. As I noted in my October 2008 blog, where I discuss discount rate for “going concern valuation” for private sector pension plans, and note that actuarial and regulatory practices appear to allow the “use a rate related to, believe it or not, the expected return on the plan’s assets?!? This is truly amazing, or perhaps ridiculous would be more appropriate description. What this means is that the more risk you take with the plan assets (and thus might expect a higher return) the higher the discount rate that you can then use for the calculation of the present value of the liabilities. This is alchemy! Discount rates used for accounting purposes should be required to be used for regulatory going concern valuation” entitled What’s wrong with private sector defined benefit pension plans? Everything? …Problems and Solutions) What Mr. Hamilton writes about public sector pensions may be right, but what a shame that this concern about “discount rate” abuse wasn’t such high on Nortel actuaries’ list of concerns when required pension plan contributions were recommended/specifies for Nortel pension plan by Mercer? So while the use of inappropriate discount rates might misrepresent the cost of public sector pensions, at least the beneficiaries of the public plans have little to worry about their benefits, as these will be covered by the next generation of taxpayers (our children and grandchildren).

In the Financial Times’ “London pension body sells entire stock of UK gilts” Steve Johnson reports that UK pension plans are considering the sale of gilts as they some view such bonds unsuitable for an underfunded pension plan. “If our rate of return [on gilts] is 3 per cent before inflation, probably nothing after inflation, we are not going to be able to pay the pensions. Therefore we are safely guaranteeing bankruptcy by investing in gilts.”

In the Financial Times’ “UK Budget 2014: A watershed moment for pensions and savings” Ross Altmann writes that the elimination of required annuitization from DC plans at retirement indicates that the UK “government does believe in the value of saving and wants to trust people who have put money into pensions to manage their money for themselves in retirement”. This will benefit the stock market, short-term tax revenues, the economy and stop forcing individuals with “smaller pension funds buying poor-value annuities”. Those who still insist on an annuity “will receive face-to-face advice to help them understand the risks before making an irreversible purchase‎”. Altmann notes that there remains significant risk as the industry lobbying my try to undo the government’s good intentions. Some critics comment about the risk of all these oldsters being allowed to do as they please with their money, “the benefit to retirees is immediate and real”, will end badly for some poor pensioner “who blew his retirement savings on a boiler-room scam”. (Giving people more freedom and choice, can’t be all bad! The UK Chancellor of the Exchequer expects that it will “contribute to creating a new culture”. )

In WSJ’s “How to become a (public pension) millionaire” (the American Enterprise Institute scholar) Andrew Biggs writes it’s no surprise that a number of U.S. cities are in bankruptcy given that “costs of maintaining pensions for city and state employees more than doubled to nearly $84 billion in 2011 from 2002.” And while public employee association indicates that average plan member receives only about $19,000 per year, these numbers are reduced due to employees who retired many years ago with much lower benefits and short-term workers with tiny pensions. Biggs argues that a better “measure of the public pension burden is how much typical full-career state employee retiring today receives”. Excluding public safety employees whose pensions are more generous, the average 30-year career state worker pension is $36,000, rising to $51,000 when Social Security is included. Some of the more generous states have full time career employees retiring with pensions around $60,000 (plus Social Security). Stats show that “the average retired state-government employee has an income higher than 72% of full-time workers in his state”. While 70% may be the recommended income replacement rate in retirement, “30 states pay replacement rates above 85%, and in five states—Oregon, California, Texas, New Mexico and West Virginia—an average full-career employee retiring today receives a retirement income higher than his final salary.”

Things to Ponder

In ETF.com’s “Structure matters: Moriarty on ETF nuts & bolts” Dan Weiskopf interviews ETF thought  leader Kathleen Moriarty and discusses with her a range of important ETF topics:  ETF is an industry not a low-cost index product that started this industry, the importance of the specifics of the underlying index for index ETFs, active strategies masquerading under the ETF label, “smarter” people created smart beta, differences between ETF vs. ETNs (ETF assets are segregated whereas ETNs are unsecured notes of the issuer, with issuer’s creditworthiness key in ETNs which are without any specific securities backing them), There are two flavors of ETFs: UIT (e.g. SPY) vs. open-investment trust (UITs are more restricted in that they can’t lend the underlying securities to earn extra income. By the way, in InvestmentNews’ “SEC to take another look at ETF regulation”  Mark Schoeff reports that the SEC is relooking at ETF related issues that were not addressed in 2008 such as “the distinctions between active and index funds, transparency surrounding indirect and underlying instruments, flexibility in the creativity the funds could exercise, and inverse leverage.”

In Reuters’ “U.S. retirees return to reverse mortgages, big banks stay away” Rudegeair and Conlin report that U.S. retirees desperate for income have again started using reverse mortgages to cover for insufficient retirement savings. $15B was borrowed in 2013, up 20% from previous year, but still significantly below the $30B peak in 2009. Some of the big banks are not participating in the business indicating “factors including unpredictable home values and the level of delinquencies”; FHA which  guarantees these mortgages is also at risk, as it needed last year $1.7B taxpayer bailout to cover losses. FHA now limits borrowing to 60% of home value and charge over 5% for a lump sum loan. Lenders’ fees are high and margins can be 3-5 times as high as regular mortgages. Property values are unpredictable and they are driven down by the reluctance of elderly owners with reverse mortgages from “undertaking repairs and maintenance that someone else might do proactively”.

In Reuters’ “Family focused advisers offer personal touch” Deborah Cohen discusses how family office type services previously limited to the ultra-rich, are now accessible to those with investable assets over $2M (the “poor rich”). Financial advisors are offering “Personal CFO” services like investment management, tax services, bill paying, estate planning as well as long-term strategic planning, “education of and communication with family members, the administration of trusts and family foundations, and general hand-holding where needed”. Fees range from $6,000 to $30,000 depending on the complexity of the client’s financial situation.

I don’t usually address mutual fund issues in this blog, as I don’t believe in mutual funds. However, in response to the CSA’s request for comment on proposed mutual fund risk classification Morningstar Canada’s submission on Mutual fund risk classification methodology is worth mentioning due to the risk-related educational value of their submission. Specifically they argue that SD (standard deviation) or any other single risk measure is inadequate, and they recommend CVaR as measure of total loss and “holdings-based” measures. The risk associated with a particular fund can only be understood in context of the investor’s rest of holdings; often including a risky/concentrated fund which contains a risk factor otherwise absent from the investor’s portfolio might actually reduce overall risk. They recommend Conditional Value at Risk (CVaR) as a better measure of risk, because “instead of measuring the dispersion of returns around the average (like SD)… it focuses entirely on possible losses”. “A 5% VaR means that there is a 5% chance of losing a certain dollar amount or more in 12 months…(so if) the fifth percentile of the monthly return distribution of a fund is -6%, then 5% VaR is 6%”. But CVaR is the expected average loss of capital that would occur should VaR be breached…(so) CVaR is a measure of tail-risk, focusing entirely on possible losses. For example, a one-month 5%CVaR of 10% means that the average one-month loss in the 5% of worst cases is 10%.”  CVaR is always greater than VaR. (Thanks to Ken Kivenko for recommending. There is no question that “downside risk is an essential element defining risk. In very gross terms I think of downside risk of a broadly diversified equity portion of a portfolio as capable of 50% loss in 3-6 months; if I can’t deal with the impact of that on my portfolio then I might need to reduce my equity allocation. You might be interested to also read some risk perspectives I cobbled together in the following earlier blog posts  Risk perspectives: What is risk? Its measurement, dimensions, modeling (asset classes, risk factors and regimes) and  The Pursuit of Risk Management.)

And finally, in the Financial Times’ “Inflation and deflation: The asymmetry of risk” Andrew Smithers writes that when people discuss the risk of inflation vs. deflation they usually interpret that as meaning which one is more likely to occur, rather than which one is the greater risk. Smithers notes that “inflation is a much greater risk- not because it is more likely but because of its consequences are far worse”. Inflation can occur purely as a result of a rise in inflationary expectation which then drive prices and wages higher in a vicious circle. To tame inflation, a shock is the needed, like Paul Volker’s dramatic interest rate increase in 1982; however the current economy would be much less able to handle such a shock should it be required.