Mind of the Turtles book winner - slickvguy

The draw for the free copy of the book Inside the Mind of the Turtles has been done and the winner is slickvguy. Congratulations to you!! Contact me via the email link on the side of the blog with your mailing address and the book will be off to you right away.

RRSPs and the Government's Secret Tax Weapon

Jonathan Chevreau posted today on a BMO Retirement Institute survey finding that boomers expect to receive huge amounts of inheritance money to pay for their retirement.

A quick skim of the Passing it on study reminded me that in the case of inheritances "what you see is not what you will get". The example box on page four of the report shows how an estate worth $350,000 at death can be chopped in no time down to $223,500. That's even before lawyer and executor fees, or probate fees (taxes) get taken out. The reason is that instead of inheritance taxes Canada has a nifty little tax rule called deemed disposition, whereby upon death a person is considered to have sold all property at fair market value and to have cashed in all registered plans like RRSPs, RRIFs, LIRAs, LRIFs etc. There is an exception that a spouse can transfer the registered plans into his or her name without tax being triggered, but eventually the spouse too will die. Sooner or later there will tax to pay and since everything enters the person's income all in the same year, for almost everyone that will mean falling into a much higher, if not the highest, tax bracket.

Think about it, how many people die penniless, their registered plans depleted to nothing? You and I may withdraw RRSP money during retirement at lower marginal tax rates than while we were working but it is pretty sure that come death, our estate will be paying top rates. The government will end not only recouping its tax deductions but may well end up with more tax! That's the secret weapon. If you are dead, you may not care about paying unfairly high taxes on your estate and it is certainly difficult to complain at that point, or to vote against the government.

I've tried getting stats out of Stats Can and the Canada Revenue Agency about the extent of the issue - e.g. what is the average size of registered plans at death - but none seem to be readily available. Better it not be too well known, I guess. People might get upset. The problem may get worse over the years as the decline of defined benefit plans means RRSP-type savings become more and more important.

This issue is one reason I am using my TFSA first since that account is "tax pre-paid" for contributions and any gains are tax free, even at death. It is also a reason to take money out of the RRSP when my tax rates are low.

Finally it is a good reason to donate money to charity since the tax credit effectively would mean no tax to pay even at the top marginal rate on the donated amount. Maybe that's why significant numbers of seniors are planning to donate parts of their estate to charity, not to bequeath it all to family.

Book Review and Giveaway: Inside the Mind of the Turtles by Curtis Faith

Risk: exposure to the consequences of uncertainty.

Using the above definition, stock market trader and entrepreneur Curtis Faith describes how he thinks about and handles risk, both in the stock market and in life. The book does not deal with the technical aspects of risk like probability and correlation. Instead it focuses of the psychological and behavioural and offers seven general rules for taking on the appropriate amount of risk: 1) overcome fear; 2) remain flexible; 3) risk the right amount; 4) prepare to be wrong and to change course; 5) actively seek reality before and especially after making a decision; 6) react quickly when reality changes; 7) focus on making the correct decision, not the outcome.

Few would dispute the list and indeed, I could only agree with it despite my own reticence to engage in active trading such as that practised by Faith. Each principle is clearly and entertainingly explained through stories and examples from the author's own experience. There are many quotes from famous people that summarize the ideas with wit and charm. The book is an enjoyable and quick read at only 200 pages.

The idea "appetizers" were excellent but I would have wanted more of the "main course", meaning direct explanations of how to shape one's own mind to properly handle risk. After explaining how fear works, it is not enough to say "just do it, be brave". There is a bit of advice - start small and work up to get familiar with how the mechanics work. But the method for dealing with the biggest and hardest fear - irrational, emotional fear that is so detrimental to investors in times of markets crashes - is only described. I hate those questionnaires which assume that a person's current risk aversion level, which is often mainly based on irrational fear, is correct and appropriate. The thesis of this book that one should embrace and welcome appropriate risk, is one with which I wholeheartedly agree. I only wish Faith had gone a little further in telling us how to overcome fear and in providing more detailed practical advice on how to achieve the other principles. There is some of it, just not enough. What we need is the equivalent of Peter Block's classic step by step guide called Flawless Consulting.

Nevertheless, I found value in the book, in particular, the reminder to continually seek confirmation that an investment decision is going the way I thought. Last Fall, for instance, I much reduced my holdings in US investments on the expectation that the US market would remain muted for years and that the US dollar would weaken against the CAD. So far, that still seems to make sense but I pay attention whenever anyone comments on the subject.

In addition, I liked the author's support of diversification to control risk and his exhortation that people should take control of their own fate and not leave things in the hands of supposed experts.

Faith also offers opinions on how the education system, corporations and governments should foster taking more risk in order to ensure continued prosperity for the USA. It's time for you to get into politics, Curtis!

My rating: 3.5 out of five stars.

Giveaway: The publisher McGraw Hill has graciously provided me with a copy of the book to give away to blog readers. If you want to be in the draw for the book, submit a comment below under a unique name (i.e. not Anonymous). The giveaway closes at midnight Thursday July 16th. I will then do a random draw and announce the winner on the blog, asking the winner to provide me with a name and mailing address by private email. The information will not be used for any other purpose. For those so inclined, say in the comment whether you think people tend to take on too little or too much risk investing.

Benefits of Investment Diversification for Retirees

A few weeks ago I noted in my review of Moshe Milevsky's excellent book Are You a Stock or a Bond? that further diversification beyond the US stock, bond and T-bill portfolio he used could provide more benefit. I've done a bit of research and number crunching and take a look at these benefits!

Diversification can:

1. Raise the possible safe withdrawal rate from the investment portfolio by 1.5% a year, perhaps considerably more. Safe withdrawal rate is the percentage amount that can be taken out and spent every year while minimizing the chance of running out of money before dying - a 4% rate on a $100,000 portfolio means taking out $4,000 per year and raising that 1.5% means being able to spend $5,500 per year.
   
2. Reduce the chances of running out of money by anywhere from 3 to 10%.

Most of the benefit of diversification comes from the potential large reduction in volatility, or swings in the portfolio. Diversification helps enormously to reduce the sequence of returns risk (the chance of having bad markets at the start of retirement) which can send a portfolio on a downward spiral from which it never recovers. Retirees face this damaging risk, which is quite different from investors in the accumulation phase, because they are taking money out.

The table below uses Milevsky's formulas, which incorporate the risk of dying along the way, for calculating the risk of running out of money before death. It shows a few hypothetical (but based on realistic numbers) calculations and a couple of results using historical data.

Hypothetical Calculations:

• Weak vs Strong Diversification, keeping the same 4% withdrawal rate - the slight increase in return combined with the large reduction in portfolio volatility (standard deviation from year to year) means that there is a 10% better chance that the money will last till death - which would you rather have an 87% chance of not running out or a 98% chance?
• Weak vs Strong Diversification but boosting the withdrawal rate - for the same risk of 87% chance of successfully having the money last, an extra 2.7% could be withdrawn. That's $2,700 extra for every $100,000 in the portfolio.
• both these scenarios assume a 50% chance of living 19 or more years e.g. a 65 year old getting to 84, which is about the current number according to Milevsky

Historical Data

• TSX from 1958 to 2008 (i.e. including the highly "volatile" 2008!) produced a 2% higher return than the hypothetical scenarios but the volatility is about the same. The comparison portfolio is from the conservative 50 portfolio (50% fixed income) from IFA Canada, which is quite broadly diversified with Canadian, US and international equity holdings, fixed income and real estate, though it does not include other potential asset classes such as commodities and real return bonds. There is still a huge reduction in volatility in the IFA portfolio to 8% from the 15% of the TSX alone. This would have allowed the withdrawal rate to be 1.8% higher with the exact same 97% assurance of not running out.

By playing with the numbers in the spreadsheet, it becomes evident that the longer the expected time in retirement, the stronger the effects.

Bob Clyatt's interesting book on how to semi-retire, Work Less, Live More, shows similar results using the approach of reconstructing actual data for a US investor from 1927 to 2004. He estimates that an internationally-diversified, value- and small-tilted portfolio would allow investors to increase their safe withdrawal rate by 1.5% or more per year. His analysis addresses the needs of much younger people (the semi-retirees) who essentially need their portfolio to last indefinitely, 40 years or more.

PS: Those who want to try Milevsky's formula with their own numbers should read a A Gentle Introduction to the Calculus of Sustainable Income. If you use OpenOffice instead of Excel, be aware that the GAMMADIST function parameters are in the same order as for Excel, not as the OpenOffice help documentation says (that caused me some head scratching till I "reverse-engineered" the correct way to do it).

The moral of the story - in retirement, diversification is a huge opportunity to both boost income and/or reduce the risk of running out.

Vanguard Enters UK Market. Canada Next?

Vanguard will begin selling eight equity index funds and three fixed income funds in the UK as of tomorrow June 23rd (announcement here). This will bring the lowest cost fund competitor to the British public. Vanguard's annual Total Expense Ratios of the various funds vary from 0.15 to 0.55%, less even than the range of iShares ETFs - list on Stock Encyclopedia - (e.g. the Japan Vanguard fund will have a TER of 0.3% while the iShares ETF has a TER of 0.59%) or OEIC tracker funds like the M&G UK All-Share Equity Index Tracker (TER of 0.49% compared to Vanguard's 0.15%) which also serve the passive index investor. It will be interesting to see how much sales commission, if any, gets charged against a purchase of the new Vanguard funds in the fund supermarkets such as Hargreaves & Lansdown, Fidelity UK and FundsDirect where the DIY investor will be able to buy the funds. The M&G Tracker funds have no sales charge.

Admittedly Canada is not as large a market as the UK, but with the expense ratios of Canadian mutual funds being even higher, is it not time for Vanguard to enter the Canadian market? Vanguard's comment today when I asked: "At this time, Vanguard does not have plans to launch funds in Canada."

Acknowledgements to the Telegraph where I found this item.

Gail Bebee asks: Has the death knell sounded for mutual funds?

Author Gail Bebee sent me the following message with the above dramatic title:

"New exchange-traded funds from a Big Five Canadian bank will compete with mutual funds

Toronto, June 17 – The Bank of Montreal (BMO) is getting into the exchange-traded funds (ETFs) business with an offering of seven funds which largely mimic existing products from ETF industry leader, iShares. Says independent investor and personal finance author Gail P. Bebee “ETFs, the low cost alternative to Canada’s high fee mutual funds, are making major inroads into the mutual fund business and BMO wants to profit from this trend. The good news is that a major bank is offering ETFs to clients, so more Canadians will learn about the benefits of investing using ETFs instead of mutual funds. Hopefully, BMO’s decision will motivate other Canadian banks to launch their own ETFs. Canadian consumers will be the winners.”

According to Bebee, ETFs offer several advantages over mutual funds:

1. Better returns than most equivalent funds

2. Lower management fees

3. Greater tax efficiency

4. Ability to buy and sell throughout the trading day.

For more information or to arrange an interview, please contact:

Gail Bebee

Personal finance speaker and author of No Hype - The Straight Goods on Investing Your Money

All the investing basics for Canadians from a savvy financial industry outsider

Tel: 416-733-0221

gbebee@nohypeinvesting.com

www.nohypeinvesting.com"

To which I would comment, I hope not a death knell since there is nothing inherently wrong with the concept and structure of mutual funds. It's just that the current fees are so darn high, they do not provide good value to investors. However, the ability of mutual funds to take small amounts of new money efficiently and to automatically reinvest distributions and keep track of tax info such as Adjusted Cost Base are worthwhile attributes. Some fund company in Canada needs to go the route of Vanguard in the USA by providing ultra-low cost index funds.

The flight from mutual funds that Bebee refers to may just be a good thing. It reminds me of the situation many years ago when Canada's wine industry (which was more aptly described as the whine industry) contentedly produced horrible stuff in high volume until free trade opened up competition and the industry successfully shifted to high-value, high-quality niche wines. I hope the surge of ETFs is a wake-up call to mutual fund providers.

A Good Thing: Assuris Guarantee of Annuities and Insurance Payouts

The failure last year of major financial players like Lehman reminds us that a promise to pay is only as good as the ability of that organization to actually pay. In the case of a life annuity or some form of insurance, one must naturally ask what guarantee there is that a financial company will be around for the twenty or thirty years that an annuity may last, or who will step in if it is not.

The answer in Canada is Assuris, a not-for-profit organization to which all insurance companies are obliged by law to belong. On the failure of any company, it promises to either pay up, or more often, simply have another company take over and continue the coverage or payments. It has its own small "Liquidity" fund of $100 million and can levy up to $900 million more from its members, which it says would more than cover any failure that has occurred in the past.

Whether that would be enough to handle a failure the size of a Great-West which has obligations over $100 billion per its Q1-2009 financial report is debatable. A series of failures in a systemic and cascading crisis could happen, as very nearly happened with banks last autumn. However, as was observed then, some companies and industries are too big and critical to the economy to allow them to fail. The government steps in to provide guarantees and that is the ultimate level of protection for annuities and insurance though it is not formalized as a promise to backstop Assuris.

Assuris does only guarantee 100% of payments up to $2000 per month per insurance company, or 85% of the payment, whichever is higher (example shown here), so it is wise to split up annuities amongst different companies.