Summary of Book on Foundation and Endowment Investing

Retirement Action has posted a useful summary of the book “Foundation & Endowment Investing” by Lawrence E. Kochard and Catheleen M. Rittereiser. University foundations and endowments provide ideas for investing strategy retired people since there are common characteristics and goals - a long time horizon, the need to pay expenses from income/gains/capital with possible yearly variations (increases for special events, painful decreases when capital suffers in bad markets to protect long-term viability), possibly no new capital.

Some points that I found interesting:

• a perception by the funds that asset classes are blurring or merging
• the significant proportion of equity / non-fixed income
• the importance of re-balancing
• a disbelief in market efficiency and totally passive index investing
• investment portfolio allocated to perform certain functions- e.g. real return bonds to protect against inflation, foreign equity for currency diversification and higher growth, rather than a simple division according to market value of non-correlated assets

Will be adding this book to my reading list. Reviews in Amazon seem to be very positive.

Another Estimate of the Equity Risk Premium

Canadian academics Glen Donaldson, Mark Kamstra and Lisa Kramer estimate that the equity risk premium (the amount equities should return over risk-free treasury bills) is about 3.5% on US equities (give or take 0.5%) in their November 2008 paper Estimating the Equity Premium, which is available for download at SSRN. They claim their estimate is more precise because of simultaneously considering dividend growth rates, interest rates, Sharpe ratios, price-dividend ratios, volatilities and excess returns.

As usual, in using this conclusion to plan and estimate future portfolio rates of return, one must consider the assumptions, and this study's validity is bounded by the use of data covering about the last 50 years of US experience and the presumption that the future will be like the past.

Compare these results to other estimates I've blogged about, all with higher numbers of 5% or more:

• the book review of Bradford Cornell's The Equity Risk Premium
• various others like the Canada Pension Plan Chief Actuary, Rick Ferri (author of AllAbout Asset Allocation) and the US Social Security Administration's Chief Actuary
  

Pension Issue Now on the Table at Last

One of the silver linings from the slide into oblivion of GM and Chrysler is that the issue of pensions may finally be moving to be a front and centre public policy issue. The auto unions have been agitating for a rescue of their pensions but the online comment reaction to the Toronto Star editorial of April 25 on pensions shows that there is a high level of passion and opposition to the idea of guaranteeing / bailing out auto union pensions. Everyone is yelling "what about me and my (sometimes non-existent) pension?" A simple government/taxpayer handout cannot and will not happen.

Fundamental pension reform needs to happen and the sooner the better. Governments need to lead the creation of a single national solution (in the process getting rid of one area of needless provincial duplication and variation). A good place to start are proposals like the Universal Pension Plan discussed on the Wealthy Boomer blog, the Canada Supplementary Pension Plan of Keith Ambachtsheer on the CD Howe Institute website, or Peter Benedek's Pension Reform paper on his Retirement Action website.

One thing I know for sure is that some form of pension system providing a decent minimum retirement income needs to come about. I spend a lot of time acquiring knowledge about investments, diversification, asset allocation, risk management, international investing, longevity estimation, taxes, annuities, RRSPs, LIRAs, TFSAs to plan my own retirement income and it is darn complicated to plan properly. How could everyone do that? A simple, mandatory, fair, equitable, well-managed, self-funding system that removes much of this planning burden and attains economies of scale is required. The CPP seems to be quite successful along those lines so there's no reason it cannot be done again.

Book Review: Mean Markets and Lizard Brains by Terry Burnham

This book is at once entertaining, thought-provoking, frustrating and self-contradicting in attempting to combine the research on irrational behaviour from behavioural finance (the Lizard Brains) and an assessment of current macro-economic and stock/bond/real estate market conditions (the Mean Markets) in the USA. Author Burnham, a former Harvard economics professor and an investor, sets out to show readers how to make sound investing decisions.

Irrational Thinking or Misleading Language?
Burnham argues the Lizard Brains parts by analogy and by stories, and therein arises both the pleasure and the frustration I had in reading this book. The stories are amusing but rigour and precision (though sources are duly cited) go by the wayside. Ultimately, that undermines confidence that his advice is correct. Our supposed irrational thinking may not actually be so at all.

For example, on pages 248-249, Burnham relates the famous "conjunction fallacy" (see Wikipedia's entry on conjunction fallacy for a brief explanation) using the Linda problem first tested by Tversky and Kahneman in 1983. The failure of most people to get the right answer is the conjunction fallacy and the cause is supposedly an inability to cope with probability and a mistaken use of the representativeness heuristic. Burnham goes on to cite research by a professor Gerd Gigerenzer who found that people got the correct answer if he simply re-phrased the question in terms of frequency instead of probability. We must think in terms of frequency or get it wrong. Instead of concluding that humans cannot cope with financial markets, maybe the simpler conclusion is that we should closely examine statements and thoughts, reformulating them to see if that changes our perspective. We need to beware of the wording of statements since others may deliberately or accidentally mislead. Therefore we don't need to assume that people cannot think straight. The Lizard Brain works just fine.

Lizard Brain Out of Sync with Modern Financial Markets or Perfectly In Sync?
A few pages on (p.254-55), Burnham says that our ancestrally-wired Lizard Brains are not built to cope with the stock market since the situation is so very different and as a result gives this advice: "For investing, the only rule is to predict what everyone else is doing, and move to profit from their behaviour." But did ancient food hunts not require anticipating actions of animals, or did ancient battle success not depend on out-manoeuvring enemies? Is it a wrong-thinking problem we have today, or just an information overload and filtering challenge (for instance, what will be the impact of the swine flu on markets, can anyone really tell?). Some explanations of stock market bubbles suggest that trying to predict what everyone else will do is a rational source of bubbles. If you are trying to maximize short-term profit at the expense of greater fools, it does not matter what the true value of an Internet bubble stock is.

Time Keeps Moving On
Another problem of the book is that it presents a picture and assessment as of a moment in time - mid 2008 - and things have changed mightily since then. The discussion of the US economy and what would likely happen to markets is well argued and quite insightful given events of the 9 months since the publication. But would Burnham's advice on the relative value of stocks, bonds and real estate still be the same?

Assessments and Recommendations to Chew Upon:

• Bonds - won't give attractive returns since interest rates are likely to rise, including real interest rates, so we are exhorted to borrow at fixed rates, invest in short-term bonds and borrow less overall
• Stocks - we've been lucky for a long time and it won't continue (pretty good assessment for last summer)
• Real Estate - prices will keep falling as there is 60 years of excess to undo (is that still the case in his view?); get a fixed rate, not variable, mortgage
  

Burnham's Signs to Decide If the Time is Right to Buy Risky Investments:

• equity dividends are higher than bond yields
• for stocks, when broad population ownership of equities is low
• for real estate, when cash flow (rent etc) alone makes a profit without counting price appreciation
• when household savings rates are high, debt levels are low and home equity to debt is high
• when press and analyst investment scorn is directed at either stocks or bonds or real estate

A Piece of Trading Advice from Burnham:

• Preserve options to either increase or decrease risk (i.e. keep the flexibility to do what Warren Buffett did by investing a huge amount in Goldman Sachs, which now seems to be doing very well ... though I doubt he quickly exited the "loser" when GS went down considerably after his investment at c. $110)

The last point dovetails with the statement on page 270: "... there is a systematic difference between great players and good players [of poker] related precisely to the decision of when to be fully committed. The great players tend to go all in with hands where they have a good chance to win." Yes indeed, therein lies the difference between those who state the theory of how to win at investing and the actual winners like Warren Buffett. Of course, there are not many great players. It is not so much a matter of irrationality and ill-adapted brains as good judgement and nerve. Maybe buy and hold index investing makes sense after all, Lizard Brain or not.

The writing is informal and free-flowing and thus enjoyable. The diversity of examples makes one think and provides much entertainment. It's a good fast read. But it is not destined to be a classic. Three out of five stars.

Time for Canada to Offer Auto Trade-in Incentives

Germany did it months ago and it has been a huge success. Yesterday's budget in the UK announced a similar plan offering car owners with vehicles more than 10 years old a £2000 discount for trading in their car. Obama himself in the USA has backed such an idea too. The same idea was suggested for Canada in early March according to this Globe and Mail article but seems to have gone nowhere so far.

Consumers can feel they are helping the economy and their favorite car-maker while the manufacturers get a large boost in sales. Maybe they could even bias the incentive towards environmentally-friendly cars. Everyone wins. I'd much rather see incentives than those huge loans which will never be repaid. Get with it, Messrs Harper and Flaherty.

Finding Cheap Travel Destinations by Exchange Rate Shifts

In the past few years, I've several times thought of visiting Iceland for its scenic outdoor beauty but found it impossibly expensive so did not not go. Today a GlobeAdvisor article notes that tourists are flocking to Iceland because it has become very affordable as a result of the plummeting Icelandic kronur.

Though the Canadian dollar (CAD) has dropped significantly in the past year against the US dollar, other countries like Iceland have done so much worse that they have become much cheaper travel destinations. Iceland is not at all alone. Other countries whose currency have dropped significantly vs the CAD in the last year: Sweden (-17%), Poland (-25%), Ukraine (-33%) Hungary (-17%), the UK (-10%), Thailand (-9%) and South Korea (-9%). To quickly look at changes over any period from the last 3 months to 3 years check out the RatesFX CAD Visualization chart - the brighter the red the more the CAD has appreciated. Yahoo Finance has historical rates for more countries but it requires doing one at a time searches against individual currencies.

Of course, a drastically falling currency is often associated with inflation so it's necessary to check out actual prices before booking.

Even in places like Europe where the exchange rate has not changed much, the recession is causing good hotel, airline and restuarant deals to appear.

Out of the financial crisis comes opportunity. Instead of not travelling at all, this may be a fine time to get a bargain holiday.

Tax Credit for Student Loans

In the process of helping some students in my family with their finances, I came across the fact that certain types of student loans benefit from a tax break on the loan interest.

The benefit is in the form of a tax credit, meaning that it is a straight reduction of tax. Other key features and conditions (see CRA's page on tax matters for students) include:

• the credit is non-refundable, meaning that if the student has no tax to pay before applying the credit, the credit is not refunded and the credit goes to waste; in other words, apply for the credit only when there is tax to pay.
• the credit does not have to be used in the same year as the interest on the loan was paid, it can be carried forward and used up to five years later
• the credit is not transferable to another person, like a parent or spouse, only the student him or herself can use it, even if someone else actually paid the interest
  
• the credit is calculated at the lowest Federal tax rate (currently 15%) plus the lowest Provincial tax rate (e.g. Ontario is 6.05% so $100 interest would get the student $21.05 in tax credit/reduction); Québec as usual does its own thing and gives 20% flat credit; the credit does not change or increase if the student is in a higher tax bracket and since it is a tax credit not a deduction that reduces taxable income it cannot help to bring someone down into a lower tax bracket; in other words, there is no advantage in waiting - as soon as the student starts earning enough income to have tax to pay, he/she should claim the credit.
• the credit only applies to loans issued under the Canada Student Loans Act, the Canada Student Financial Assistance Act, or similar provincial or territorial government laws for post-secondary education (to check if a loan qualifies, ask the national student loans service center or see the list of provincial student loan contacts here on Canlearn.ca); loans from banks or private lenders don't qualify, nor does a qualifying loan if it has been combined with or refinanced as a private loan
• the claim is made on line 319 of Schedule 1 Federal Tax of the T1 and on the corresponding line in the provincial tax form - e.g. line 5852 on ON428 Ontario Tax
  

Friday Fun - Green Shoots of Recovery

A few shorts months ago, UK minister Baroness Vadera received a verbal pummelling for daring to suggest that she could see a few "green shoots of economic recovery".

From being politically incorrect it is now fast becoming the fad phrase, being uttered by Mr. Big himself Barack Obama and Fed Chairman Ben Bernanke. In the UK Gordon Brown recently still considered the phrase verbotten, rebuking another minister in March for having the temerity to utter it. However, with the UK press, the Chinese and the Koreans apparently "green shooting" now too, will it be long before Brown starts seeing the world in green-coloured glasses? In Canada the Financial Post is on board shooting off its mouth in green but Canada's politicians, whether out of deference to language or ignorance of the sprouting, have so far refrained from spouting green.

The more traditional "green" movement is loathe to lose its favorite word and is trying to drag it back by suggesting the economic situation is an opportunity to fix climate change and poverty. The panda bear federation, er the WWF, seems to resent that green shoots could appear economically without the "real" green being made to happen as well.

Not to be outdone, I too am detecting a little green here and there in my brokerage accounts (real return bonds, corporate bonds and emerging markets). Long live the cliché! May the green shoots become bountiful "hay" along with a few long-lasting Douglas fir.

... if I may be so bold, here's the next cliché we should look out for - the "choking weeds of inflation". As any Canadian knows, dandelions and other weeds follow quickly after the appearance of the real green shoots of spring and so shall inflation almost surely follow the massive stimulus and monetary expansion governments have deployed to combat the recession.

Optimizing Tuition/Education Tax Credit Transfers: TaxChopper Wins Again

It's time to throw another test at the web tax software contenders. The challenge this time: transfer of Tuition and Education amounts. I refer to the calculation of the "just-enough" amount of tuition and education tax credits (see CRA IT-516R2 or TaxTips.ca simpler explanation here) to transfer from a student to another eligible person like a spouse or parent. If a student has no or low taxes to pay, which is often the case, the education credits can be transferred to reduce or eliminate taxes of the other person. But you want to transfer and claim only as much as needed to eliminate taxes since the students can carry unused amounts forward to future years to reduce their own taxes when they start earning.

Scenario: this scenario was constructed so that the various programs would completely eliminate taxes of the parent but the optimal amount to transfer is less than the full amount of credits.

Student: $0 income, Tuition $3000, 6 months full-time study = 6x$400 = $2400 giving $5400 in total credits but $5000 is the max in credits that can be transferred (with the equivalent indexed provincial amount being $6003).

Parent: $18,500 income (T4 box 14), $742.50 CPP paid (T4 box 16), $320 EI paid (T4 box 18), $3000 tax paid (T4 box 22), $2300 LSIF purchase (LSIF box 4). Low income and an LSIF tax credit will ensure that less than $5000 is the optimal transfer.

Packages: only the top 5 in my first ratings review are included - UFile & H&R Block (not tested separately since H&R Block is a re-branded clone of UFile), TaxChopper, WebTax4U and QuickTax

Results:
WebTax4U and QuickTax have no optimization routine built in the program itself. They require you to enter the transferred amount manually. You are on your own plugging in numbers by trial and error until the right amount to reduce the parent's tax to zero is found. When the maximum transferable of $5000 federally and $6003 provincially (Ontario) is entered manually neither program rejects the excessive amount so the credits would be wasted.

WebTax4U allowed a transfer of more than the maximum permissible and available (I entered $6500) though it restricted the federal amount claimed to $5000 (I tried entering $5400). Not very impressive error prevention. QuickTax at least signals an error and prevents it being saved.

TaxChopper and UFile both have an optimization routine where you click a box to have the program find the best amount to transfer. Only TaxChopper figures it out correctly as $4518.50 federal claim on line 324 of Schedule 1 and $2582.95 provincially on line 5860 of ON428. UFile gets the same amount for the provincial claim but evidently screws up the federal claim and enters $5000, evidently because it miscalculates the LSIF tax credit as only $272.77 (line 414). Both QuickTax and WebTax4U get the same $345 LSIF credit as TaxChopper.

All the programs calculate the same maximum refund of $3000 - all of the tax paid - for the parent but saying that means they all give an equally good result for the family ignores future tax that will have to be paid because those tuition and education credits are no longer available.

CRA Comments on "Accuracy" of NETFILE Certified Web Tax Software

The folks at CRA called me back last Friday after checking the huge differences in taxes owing that I found after testing the eleven web tax preparation software packages which have been NETFILE certified by the CRA.

CRA says this is entirely possible and acceptable to them! How so?

1. CRA only tests that all the income is correctly transferred and summed - that lines 150 Total Income and line 236 Net Income are correct. In my test line 150 was identical across all packages. All but one package - TaxChopper - had the same line 236 and the CRA confirmed that TaxChopper's application of foreign tax credits to line 232, which had the effect of reducing my taxes owing by about $35, is legitimate.
   
2. CRA does NOT test whether deductions and tax credits are claimed, nor whether taxes could be reduced by allowable transfers, such as tuition costs from student to parent or spouse, pension income between spouses or other optimizations. It is not CRA's job to lower anyone's income tax. Thus, the fact that a number of programs neglected to claim foreign or provincial tax credits, causing the big differences in my tax owing, is not a concern to CRA.
3. CRA has itself noticed differences amongst the programs in the course of their testing, though it is not their job to recommend any program as being worse or better than others. But for those taxpayers like me who want to legally pay the least amount, it is significant to receive confirmation the differences I found are not erroneous, anomalous or rare. CRA is considering adding words to its disclaimer on the various NETFILE packages to say that taxpayers should shop around.
   

What's to do now?

• Everyone should shop around and enter their data into several of the programs to see which gives the least tax owing or biggest refund for them. After all, most of the work of doing taxes is gathering the slips and data, so re-entering it a couple of extra times isn't a lot of extra effort. Is that effort worth the possible hundreds of dollars or more difference? With the web programs, there's nothing to download and install, nor is it necessary to pay before seeing what the bottom line is. Based on my own test, I'd suggest TaxChopper is worth a try - if they have incorporated a fairly subtle deduction that no one else does, chances are that they might be more thorough in claiming other advantages.
• More testing - I think it's time to go back and try a couple of other optimization scenarios such as pension splitting and tuition transfers to see which package performs best. I'd be curious what other people may have found for their own case.

The words "most accurate" are not the best way to describe the differences among the bottom line tax amounts calculated by the web packages. There isn't only one correct, CRA-acceptable, number. It is better to think of the lowest tax result.

Students and Low Income People - for TFSA's Sake, Make Sure You File a Tax Return

The new Tax Free Savings Account allows any Canadian over 18 to contribute up to $5000 per year into an account whose earnings are completely exempt from tax. The $5000 contribution room accumulates with every year, whether you use it or not, so even if you are not able to contribute this year, down the road when your income increases or your expenses drop and that becomes possible it is very worthwhile to have those yearly $5k amounts built up.

But how do the government tax people at the Canada Revenue Agency monitor and police who has the contribution room each year? The answer is provided by D&H Group Chartered Accountants in their 2008 Year End Tax Planning Tips:
"With the new TFSAs, it is important that all individuals who are 18 or older file income tax returns even if they do not have any income because the Canada Revenue Agency is tracking TFSA contribution room only for individuals who file income tax returns."

iShares Sale Bad News for ETF Investors?

GlobeInvestors' story today Barclays in talks to sell iShares to CVC makes me worry about the future of iShares. It's not that they won't continue, merely that such a sale may herald an attempt by new owners to milk the ETFs by raising the MERs they charge investors. In the US, there are cheap alternatives, notably those of Vanguard, but in Canada, iShares Canada really has a lock on passive, market cap weighted index ETFs and it would be more tempting and easier to raise fees. We'll have to wait and watch to see how this unfolds.