Pension Income Shortfall a Problem for Only a Few - Is That So?

Some pundits and politicians like Alberta's Finance Minister Ted Morton oppose the expansion of CPP to give a bigger assured retirement income to Canadians on the basis that it isn't a big problem because it is "... limited to a small sector of the Canadian workforce ..." (as quoted in this News 95.7 report from June this year).

Perhaps he was looking at data such as that in the Retirement Income Adequacy Research Report of December 2009 which was commissioned by the federal and provincial finance ministers. Tables 2 and 3 cite research showing that retired 70-72 year old men and women in 2006 had average income replacement levels from about 70% on up across every single income level. Looks good doesn't it since 70% replacement is the common rule of thumb for maintaining a standard of living. Furthermore, that result holds whether or not the retiree had been a member of a Registered Pension Plan or not and to complete the picture, in all but the highest income quintile, the non-RPP retirees had higher incomes than the RPPs. That's true even when the employment earnings of the non-RPPs (since non-RPPs, unsurprisingly, still are working and have much higher employment earnings) are subtracted. Got that? Retirees without a pension plan had higher incomes. Shocker! What retirement income problem?

As report author Jack Mintz writes, "The results are thus quite striking but need to be interpreted with care." Enter the nit picking detail. Note the word average in the above paragraph. Consider this dumb statement - if you have one foot in the freezer and the other in the oven, then on average your feet are a comfortable temperature. The Stats Can researchers Yuri Ostrovsky and Grant Schellenberg who put together the original data in Pension Coverage, Retirement Status, and Earnings Replacement Rates Among a Cohort of Canadian Seniors realized the hidden danger of using an average and have since done a revealing follow-up in A Note on Pension Coverage and Earnings Replacement Rates of Retired Men: A Closer Look at Distributions (no, they did not look at the detail for women) of July 2010. By looking at the breakdown of replacement income percentage, they found that the non-RRPs had a much higher concentration of men at the low end of the income replacement scale. The RPPs are clumped in the middle of the replacement spectrum. The average came out the same because of an offsetting bunch of non-RPPs at the highest end of the scale. A few rich people counterbalance a bunch of poor people and the average looks the same. The graph below from the study shows this for the middle income group ($45,700 to $58,200 / quintile 3).

If one cares to look, the phenomenon is the same in all three middle income quintiles, covering income of $32,800 to $76,100. In every income group except the very lowest (where OAS and GIS ensure that the bulk of men have pretty close to or more than their pre-retirement income) about half fall below 50% replacement rate of income. 50% replacement must be about the minimum for anyone to maintain a standard of living no matter how modest and probably it isn't near enough at lower income levels. Conclusion: pretty darn close to half the Canadian retired population of men must be unable to maintain their standard of living in retirement. A small sector of the workforce indeed, Minister Morton!

Senate Weighs in With Some Useful Retirement Savings Suggestions but ...

Canada's Senate committee on Banking, Trade and Commerce announced a half-dozen recommendations on how the government could enhance retirement savings in its Oct.19 report Canadians Saving for Their Future: A Secure Retirement.

The recommendation that would likely have the most beneficial effect is the suggestion to establish a Canada-wide plan for retirement saving and investing. The new plan would entail setting up five or so professionally-managed, competitively-sourced investment funds into which savings deductions/contributions of Canadians 18 and over would go. It's a pretty good but incomplete plan. Why?

1. Auto Enrollment - the report calls the plan "voluntary" but that means an optional opt-out, which few people will do. As the famous book Nudge explains (and as the use of the word in the report slyly suggest that the Senate committee is aware of the idea), the difference between voluntary opt-in and opt-out is huge and participation rates will be as good as universal, up in the 90+% range. Goodbye to the costly sales and marketing overhead cost of retail funds because it's a captive market.
2. Fiduciary Duty Governance and Management and Competitive Sourcing - they call it a commitment to avoid "real and perceived conflicts of interest". Professional managers can add diversification, discipline and net value when the fees they charge are restrained - i.e. the gross investment return isn't sucked dry by the fees. Hello to much lower fees from the powerful negotiating position that such a massive plan will have and hello to a resulting much higher net return to investors with much higher end value retirement savings.
   
3. Optional RRSP or TFSA - it is valuable to have the flexibility of being able to contribute to the right account for one's tax situation / income level (the familiar question about whether your tax rate will be lower in retirement - RRSP better, or whether your absolute income is low - TFSA better) and retirement goal (if legacy desired, TFSA better).

The report does not address a few key issues related to this idea:

• Savings Deduction Rate? - how much should it be? Maybe 9% would do, the same as for CPP, which aims to replace about 25% of pre-retirement income, so such a contribution rate in this plan would provide another 25%. A less desirable method would be to allow the contribution rate to be chosen by the contributor but then the new plan should have a default rate with option to change it (another nudge).
  
• Sequence of Returns Risk - the danger of a market plunge, such as happened in 2008, at the intended time of retirement is that the total available to purchase an annuity is vastly reduced and permanently low retirement income would result. The alternative of withdrawals from a RRIF would see much lower sustainable withdrawals. Of course, nobody would retire after a market crash if they possibly could and they would deal with the market returns risk by continuing to work however long it took for market and retirement savings recovery. That's not the only way to deal with this risk though. The method of the CPP is to have a defined benefit payment coming no matter what the state of the market - did the CPP announce a reduction of payments in 2008 even though its investment portfolio dropped about 20%? The reason the CPP can maintain payments is that it can, as a fund with a very long term investment horizon, smooth out market humps and bumps, knowing that savers continue to provide cash inflow. There is time risk sharing going on within CPP that the Senate's proposal lacks, which to my mind is a very important feature of making retirement saving feel secure and actually be so.
• Conversion to Retirement Income, Inflation Risk, Longevity Risk and Annuities - a retirement savings plan, such as the one proposed, must be converted into an income stream and the report does not consider how this will be done, except for brief off-hand references to buying an annuity. Yet the income conversion vehicle, its cost and its effectiveness in countering inflation and longevity risks determine the success of the whole retirement income exercise. This cannot be considered apart from the savings phase method with the assumption that all will be well. Choose an annuity and even low, normal 2% inflation eats away a huge portion of the value of a fixed payment annuity over the longer and longer retirement periods of today. Real constant-value CPI-adjusted annuities are almost absent from the Canadian marketplace. Most annuities on the market in effect provide income for life at a fast (high inflation) or slow declining standard of living. I bet that's not what people want or need. There is also the problem that the market is lop-sided - the people who want to buy annuities are those who figure they will live longer and not those who will die off sooner and whose cash helps maintain a higher standard of living for the survivors. (Those who believe this is unfair could be reminded that sharing the risk means everyone gets higher payments than if no one shares) The annuity-selling insurance companies know about likely-to-live longer annuity buyers of course, and so annuity payouts are even lower. Contrast that with CPP where everyone, early and late deceased, automatically and without choice to opt out, gets into the annuity payment stream. Choose the other option to generate income, a RRIF from which withdrawals are taken, people have the very hard job to figure out how much to withdraw given their uncertainty how long they will live and need income. Live too long and you run out of money. There is no longevity risk sharing. People can either be very cautious, withdrawing slowly, and perhaps live a much more restrained lifestyle than they might have liked, or they can live high, perhaps to discover that they must drastically reduce their spending later on. Pooled assets with no opt out (i.e. with longevity risk sharing) during withdrawal means higher payments for everyone and much less worry along the way. The prime example of a successful end-to-end solution is the CPP - you pay in a certain amount per year and you are guaranteed (by the most stable provider around, the Federal government) a certain inflation-adjusted amount for however long you live.

The report includes several other worthwhile but less significant suggestions:

• Set a TFSA lifetime contribution limit of $100,000, which could be used immediately in full any time e.g. for an inheritance; helps present-day retirees with taxable accounts
  
• Remove the effect of RRSP withdrawals on means-tested benefits; makes things less complicated and less punitive
  
• Defer RRSP conversion age to 75; helps those who work longer
  
• Have the Financial and Consumer Agency of Canada do financial education and monitor investment advisors (I think they mean financial advisors, which is much broader than investment advisors) - pretty wimpy, they could and should have recommended that fiduciary duty for financial advisors be put into law with some body given policing powers
  

Cap-Weight vs Fundamental Portfolios: Q3 Update after DRIP

The live updated spreadsheet at the bottom of this blog, which shows the on-going contest between a cap-weight portfolio and its fundamental weight counterpart, has now been updated to include the automatic reinvestment of dividends where the ETFs offer that feature.

The DRIP purchases included the following:

Fundamental Portfolio

• CRQ - Claymore Canadian Fundamental Index Equity large cap - 6 extra shares
• ZRE - BMO Equal Weight REIT - 2 shares
• ZRR - BMO Real Return Bond - 6 shares

Cap-Weight Portfolio

• ZRR - BMO Real Return Bond - 6 shares

The leftover cash is now sitting in each account. The Cap-Weight portfolio is starting to pile up the extra idle cash while the Fundamental Weight portfolio is putting it to good use by reinvesting.

I'm going to substitute the new Horizons BetaPro TSX 60 tracker ETF (symbol HXT) in the cap-weight portfolio since its total return swap construction reflects implicit automatic DRIPing and I want to find out about the difference in weighting strategy not the effects of DRIP, which will always be beneficial to the ETFs that do it in rising market.

The net difference between the two strategies is pretty slim, with each one ahead in 3 holdings (I ignore the RWX since they both hold it and the Cap-weight is ahead merely and always because it holds one more share) and the Fundamental Weight portfolio is in the lead overall by only 0.1% or so ($171 on a $111,000 portfolio). It's a tie so far.

Crown Currency Exchange Collapse a Reminder of Need for Segregated Accounts

The plight of clients who stand to lose large amounts of money given over to the collapsed Crown Currency Exchange provides a harsh reminder that a key baseline requirement for considering any foreign exchange transfer company must be that customer funds be held in segregated accounts that are separate from the funds of the FX company itself. That way, client funds are protected from creditors of the FX company, which means you the client can get your money back instead of suffering the fate of some of the people in the BBC news account, who seem to be destined to lose an amount large enough to buy a house.

A perusal of the websites of various FX dealers reviewed in my initial post on the subject shows that many do claim they segregate client funds but some seem to make no mention of the subject, which probably means they do not. Here is what I found:

• CustomHouse - no information on how client funds are held
  
• XE Trade - no info
• Canadian/UK/NZ/Oz Forex - funds in segregated accounts; Barclays, Bank of Montreal, TDCanada Trust
• HiFX - segregated in Barclays, Bank of Montreal
• TorFX - funds in Barclays
• MoneyCorp - funds in account of clearing banks HSBC, Barclays or RBS
• WorldFirst - funds segregated, bank not specified
• CurrenciesDirect - no info
• Currency Solutions - funds held in “major UK banks”
• Interchange - use of own solicitor's account optional
• FirstRateFX - “specially designated” Barclays account

If you are transferring large amounts of money, don't take my word for it. Check that they actually do it e.g. by verifying with the regulatory body the FSA in the UK, or asking for a contact at the bank where the funds go.

Stein & DeMuth's Market Signals Go Green Across the Board

Almost a year ago when I reviewed (here) Ben Stein and Phil DeMuth's book Yes, You Can Time the Market, only a couple of indicators / buy signals were green, indicating a good time to buy the S&P 500. Now all four indicators for which they can still get data - Price, P/E Ratio, Dividend Yield and Earnings Yield vs AAA Bonds - are Green. Thought you'd like to know. Let's note that the S&P 500 as I write this is at 1165.47.

TD Bank Introduces Clever and Beneficial Savings Tool

When a bank launches a good product, it's worth noting and patting them on the back. Part of TD Bank's Get Saving campaign is a clever new tool to help people save. The 1-minute video Tools to help you save explains: each time you make a purchase using your debit card or take money from a cash machine, a pre-set amount (which you set between $0.50 to $5.00 per transaction and can change) is transferred to a savings account. It's the psychological aspect I find most intriguing and promising. First, it's automatic so it's easy. Second, you make the decision to save in advance - people have a much easier time deciding to save more in the future than now. It could actually work!

There is a third aspect, whose effect I could see being good or bad. There is a feedback link to spending - as you spend more, you save more. Will that reduce people's spending by making the money run out sooner or making them think it will, or raise their awareness of how often they are spending? Or will it cause people to think that spending more matters less since they are simultaneously saving more, (with the possible result that they end up being over-drawn - "borrowing to save" would not be good!)?

As an enhancement, TD could offer a pre-set percentage transfer e.g. 1 up to 10% (the latter is an often-recommended amount one should be saving out of income for retirement). That way, people would especially think about bigger purchases and they would save a lot more.

Credit Suisse on Inflation - How It Happens, What to Do

Credit Suisse's Global Investor 1.10 report has a lot of worthwhile content on inflation:

• How Inflation Comes About, a one-page Sim City like picture that shows how the financial system and key bits of the economy interact to create the beast we abhor - from Central banks, through commercial banks, the labour market, the capital market, the goods market. Brilliant communication! There's even a helicopter hovering over the stylized city - a sly reference to Helicopter Ben?
  
• an assessment of Inflation as the escape route for high-debt countries - they say it is "unlikely" because many countries have "... experienced the painful consequences and destabilizing effects of runaway inflation," and won't want to experience it again; but it's much more likely in emerging market countries and commodity exporters and those least affected by the real estate crisis ... hmmm, sounds a fair bit like Canada
  
• a sidebar on who is best at inflation forecasting - surprise, it is not that implied by subtracting the yield on real return bonds from the nominal return of government bonds - they were the least reliable! Best at the one-year ahead inflation forecasts were ... drum roll ... the central banks. Note how they all slightly under-estimate actual inflation. Based on the expectations on this Bank of Canada page, which does NOT seem to include a forecast by the Bank itself, 2011 looks like it will be in the 2.5-3% range in Canada.
  

• an inflation history graph going back to 1500 - inflation was a lot lower and more stable between 1800 and 1900!
• people almost always feel inflation is worse than the official CPI numbers say. Most people are not inflation-conspiracy believers, they simply notice and feel the pain a lot more on the purchases they rely on most. It's a new area of behavioural finance, an extension of the "you feel losses twice as much as gains" idea. Hmmm, maybe that's why I think life is cheap here in the UK compared to Canada because wine is definitely a lot less expensive (lots of good table wine at the equivalent of $6.50 per bottle)
• asset inflation caused by lax monetary policy and boosted by leveraging is very dangerous - no kidding - but take away the leveraging, as in the tech bubble, and the lasting real economy effects are not nearly as bad
• an Adjusting to Inflation article shows different asset classes performed differently in different high-inflation periods . In the 1970s, gold, oil and commodities did best, but between 1986 and 1990 commodities did really well, oil was ok but very up and down and gold did very poorly, much worse than CPI. They then go on with the table below to identify which kinds of assets they think will do well in different economic environments. Their conclusion is one with which I cannot but agree - since you cannot know exactly when and in what form inflation will arise, the best investment strategy is to maintain a balanced diversified portfolio but to be sure to include things like gold, commodities, real return bonds and other hard assets.
  
• 
• there are personal accounts from three individuals who have lived through either hyper-inflation (Zimbabwe and Argentina), or deflation (Japan) - a strong reminder that we do not want to go there, diversified portfolio or not.
  

Cap-Weight vs Fundamental Portfolios: Q3 Update, Guess Who Leads

Regular readers may recall that a few months ago I started a contest to see whether a portfolio based on Fundamentally-weighted ETFs would do better than the traditional standard Cap-weighted index ETFs. This contest is meant to be as realistic as possible using actual funds, including trading commissions, currency effects, distributions, DRIPs etc.

The quarterly distributions have all been announced, though not all received as BMO only pays out on October 7th and Claymore on the 6th (so their DRIP calculation will have to wait till then).

However, the quarter end was yesterday so it's opportune to take a snapshot look at how the contest is going (in order to do the comparison I've assumed a bit precociously that the dividends owing by BMO and Claymore are in the cash account now until the DRIP happens, which skews the numbers by $111 in favour of the Fundamental portfolio). With or without that cash, the two portfolios are neck and neck - with the cash, the Fundamental leads and without it, Cap-weight would be ahead. It is less than $100 difference in total either way, or less than 0.1% of the $100,000+ portfolios.

Other observations:

• Strong portfolio gains: both portfolios up almost 10% since June!
• Correlated asset classes can be good: every single ETF / asset class in both portfolios has gone up since June. That's highly unusual and sure not to continue for very long. The value of having a diversified portfolio is still evident in the large disparity between the gains amongst the ETFs. If one had only been invested in Canadian large cap equity with a 4% gain and bonds with a 2% gain, the overall portfolio gain would have been somewhere in that low range. Emerging markets, Developed markets ex-US, international real estate, commodities and Canadian small cap and REITs all contributed percentage advances of triple or more Canadian large cap's. Another way to look at it is that not having a diversified portfolio means having to pick which asset class will go on a tear next in order to get good gains. Diversification = not as good as the best but better than the worst.
  
• Fundamental winning in most asset classes vs Cap-weight - leading by 5 to 2. It is still early days in our contest but this is going in the direction I would expect. ... However, where Cap-weight is winning (Canada large equity and Emerging markets equity), it is by enough to more or less balance things at the portfolio total. As I wrote about here, in the Canada equity case, I believe the difference is due to the ongoing Potash Corp takeover bid.
  
• No re-balancing required: in neither portfolio is the actual value of any asset class anywhere near to going beyond the 1/4 away from target that we said would be our rule for re-balancing; the Cap-weight percentages are slightly more out of whack compared to target, which is what we would expect from indices that rely on market prices - fundamental accounting weights should evolve more slowly. That will be interesting to watch as we go along. (in the updated spreadsheet that appears live at the bottom of this blog, I've inserted a new column in the individual portfolio spreadsheets that shows the ratio of each asset class' actual to target)
  
• Currency has reduced returns: the Canadian dollar has risen about 1.4% vs the USD since our launch, reducing our net returns on US denominated holdings and that is the same for both portfolios.
  

The contest continues ...