CD Howe and Pension Study - The Proper Choice of Reno Tools

Head of the CD Howe Institute William Robson told us in the Globe and Mail last Friday to Fix pensions with screwdrivers, not sledgehammers based on the results of the Institute's newly-published study Sizing Up the Retirement Challenge: How Well are Canadians Preparing for Retirement?. With all due respect, since the study, of which Robson is an author along with Kevin Moore and Alexandra Laurin, is an interesting and worthwhile piece of work, after reading through it, I think we should be saying "Don't patch pensions with the wrong colour paint, cover the whole wall over ".

Through its reasonable, for the most part at least, assumptions the study projects that the likely pension income shortfalls cover such a broad spectrum and such a large and steadily growing number of future retirees that spot fixes like the proposed PRPPs won't do the job.

The study summarizes the future problems thus (my highlighting):

"The principal finding of this study, however – that is, a projected gradual increase in the proportion of future retirees likely to experience a significant decline in their standard of living upon retirement – persists even with differing assumptions for future real wage growth, inflation, rates of return, RPP coverage, and future saving rates." (page 2)

"... the proportion of newly retired individuals unable to replace at least three-quarters of their average pre-retirement consumption from the sources we model is projected to nearly triple over the next 40 years (see Figure 9). If current trends persist, by the 2046-50 period, about 45 percent of workers currently aged between 25 and 30 years would not meet our 75-percent threshold ... " (page 20)

"This decline in potential consumption replacement would be felt across the entire earnings distribution ... " (page 20)

We are just at the start of a long-term uptrend in inadequate pensions that is little affected by such things as increased saving in RPPs, which is essentially what the new PRPPs would offer to people working for small companies and the self-employed. Look at this chart from the study. Other charts in the study have similar inexorably upwards trends based on "business-as-usual" in pensions savings methods/plans.


All this looks like a pretty substantial problem to me.

Ironically, the following quote suggests an alternative:

"... the public pension system, which is mandatory and has nearly universal coverage, provides high levels of consumption replacement to individuals with low pre-retirement earnings. The higher a person’s earnings, the more voluntary saving by the individual (and/or his or her employer) through RPPs, RRSPs, home equity, or other instruments is needed to replace consumption in retirement." (page 13)

In other words, the combination of OAS/GIS and CPP have been doing a great job. When higher income income earners have to rely on the various other means, they fall short.

There is one problem with the public pension option, however. The beneficial influence of OAS will progressively wane. By being indexed to CPI inflation, it only maintains the standard of living at the moment of retirement. The standard of living slowly rises i.e. real wages increase and real consumption does too, faster than CPI does. Since the pension objective assumed in the study is to maintain a level of consumption, anything that goes up only by CPI will produce less and less consumption relative to new retirees. Here is the relevant study chart.

A couple of assumptions probably understate the future pension challenge.
1) Home equity drawdown - the study assumes as base case that 50% of equity in a home would contribute to retirement income. The methods for accessing home equity, like high-fee reverse mortgages, or downsizing, seem unlikely to happen for most people except under forced circumstances. To the authors' credit they run the model excluding that assumption and the difference is another 5% or so today, rising to about 8% in 2050, of the population with less than the target 75% consumption replacement rate.
2) Consumption replacement at age 70 - this number derives from actual government data based on what is used from various sources, including investment return sensitive limited capital RRSPs and RRPs from defined contribution plans. The study does not, that it says anyhow, model consumption to track adequacy all through the retirement years. What happens to the income at age 75, 80 and 85? Chances are it won't go up. Age 70 is likely the maximum income / consumption. One of my relatives has been using a RRIF to supplement her income but it will run out in a few years so she is facing a significant drop in income/ consumption. The model thus does not seem to attempt to evaluate the effect of longevity risk sharing, or not, (running out of money before you die).

One telling point founded on the actual past statistics is the fact that " ... the net real rate of return received by individuals in the future is roughly 1 percent for RRSPs and 2.5 percent for defined-contribution RPPs." That's a shockingly low return compared to the actual historical asset class returns of 4% averaged for a portfolio. The combination of fees and poor investment decisions by individuals trying to manage on their own really cuts deep. If the real return for investors could magically be 1.5% higher, it looks from figure 13 as though another 5% of Canadian retirees in 2050 would escape the inadequate income threshold of the study.

People need to assess the problem properly before deciding on how to fix it. Like a bad paint job, if you don't do it right the first time, you will soon be doing it again.

Green Investing - Returns Performance Evidence Inconclusive

The EDHEC Risk Institute's November 2010 Adoption of Green Investing by Institutional Investors: a European Survey contains the chart below that conveniently summarizes available research on the financial performance of green investing. Some studies say green investing provides worse performance, some say it does better and some say it does the same.


In their survey of European institutional investors, authors Noel Amenc, Felix Goltz and Lin Tang found that almost 90% already pursue Green investing as an investment theme and 90% intend to do more. Not surprisingly to anyone who has looked beyond the mere phrase to try understanding what Green investing entails, the biggest obstacle is the lack of credible standards in the field.

One finding that may surprise those who have an unwavering negative view of the institutions of society: the motive for doing Green investing by these institutional investors in more than 80% of cases is simply a sense of responsibility to the planet and society.

A surprise for me is that equity/ buying stocks is not the only way to go. Bonds are a Green investing option too as the table below shows. At least they are for European investors. Canadian investors do not have such a choice available. Maybe an option for our federal government to consider?

Flaherty Decides to Build Wading Pool for Pensions

Federal Finance Minister Flaherty's proposal today to set up something called Pooled Registered Pension Plans is a disappointing timid response to calls for improvements to Canada's pension system.

The proposal only suggests a few minor improvements:

• small companies and self-employed workers would have access to portable group pension savings plans instead of being limited to personal RRSPs.
• contributions would seem to be locked in for retirement only, unlike RRSPs where people can withdraw funds anytime

PRPPs would have the following deficiencies:

• attempts to address only the first half of pension construction, the savings process and completely ignores how to turn those savings into a steady, reliable, inflation protected income that lasts as long as you live and pools those risks - that why it's more like a wading pool than a real pool
  
• it sounds nice for the proposal document to say low costs are an objective but there is no evident mechanism by which overhead costs will be kept under control
• the investment mechanism doesn't makes sense - how can the money be "co-mingled for investment purposes" with participants only having "personal accounts for record-keeping" alongside the idea that the plan administrators will offer a "manageable number" of "investment funds that permit a person to create an investment portfolio for his or her own objectives and risk preferences". I think the answer is that there will be a menu of mutual funds, like a DC plan, which, in fact, the draft document says on page 6. So the only real scale efficiency and risk sharing is what already exists in mutual funds. The proposal doesn't answer the critical question of who will be negotiating the lower fees with the portfolio managers and how the incentive scheme will make that happen.
  
• no mandatory participation, each province can decide whether to do so or not, thus ignoring the very big issue that too many people simply don't sign up when given the choice
• "tools" to enable people to make an informed choice. Har, har I can just see it now.... Mr Smith, would you like a Conservative Low-Risk Fund, a Balanced Fund or an Aggressive Growth Fund? On top of that, employers would have to figure out what contribution level to set for employees and themselves. How could employers have the knowledge and expertise to do this at all adequately? For the self-employed, they would have to do it themselves, or will this scheme include provision of expert personal financial advice supplied by advisors, working under fiduciary duty rules?

As the draft document says on page 8, PRPPs "will essentially be a new type of defined contribution RPP" catering to small companies and self-employed people. It's another addition to the already complex and confusing plethora of savings and retirement plans.

That this inconsequential and ineffectual proposal has been put forward tells us that Minister Flaherty has been convinced that there is no real widespread pension problem looming in Canada. Simple and straightforward CPP enhancement appears to have lost and if so, it will be business as usual for the financial services industry, which will continue to profit. Time to buy those shares again!

Book Review: What Investors Really Want by Meir Statman

Thought-provoking but at times a dull read. Full of insights but ultimately confusing. That's what my emotion and my logic give me after reading this excellent book.

Thought-Provoking and Full of Insights: When I read finance books I take notes of interesting points and I highlight ideas that can serve me for my own life or for my blogging. This book gave me about twice the usual number of notes and a large number of potential blog post subjects. For example, on page 95 Statman tells us that people typically spend more than the amount of the gift card they have received but less than the cash when they receive cash as a gift ... ergo, suggestion to promote frugality in these frugal times - for Christmas, give cash, not a gift card ... but, people who receive gift cards also tend to buy luxury products they really enjoy that they would not otherwise buy, whereas a cash gift gets spent on mundane items, which means that you might want to give a gift card after all depending on your motives! (oh well, there goes one blog post). The book was also the source for my recent Holiday Financial Tip: Eat Turkey Dinner post. Believe it or not, I also found in the book the simple but true root cause explanation ;-) of the whole credit crunch mess and will be posting soon on that.

There is much serious and substantial topic matter, covering the gamut from the conflict between the hope for riches to the fear of poverty, to the desire to avoid taxes, to the effects of status-seeking. The book is dense with ideas. Indeed, in pure factual terms, it is essentially an extended popularized annotated bibliography of behavioral finance research compiled by an authority in the field (Statman is Professor of Finance at Santa Clara University and has produced many well-regarded papers). As a well-organized - by chapter subject theme (table of contents here on the book's blog site) - comprehensive and documented - 31 pages of fine print footnotes - collection of the state of the art knowledge in this subject area, Statman's book is well worth the price on that basis alone.

Apart from the multitude of small insights that the book recounts and relays from other sources, the book's main insight is that people invest for more than the utilitarian or profit-making value. They also seek a payoff in emotional terms to make themselves feel better, and for expressive benefits to exhibit their own values, tastes and status to themselves and to society. Instead of portraying behavioural finance as a negative series of biases and errors contrary to rational behaviour, Statman says that much, though not all of it, actually is a positive feature of investing. There isn't always only one answer or one best outcome - maximum profit - for all investors. However, I suspect that his suggestion that it is good to invest for fun and status - "we should enjoy all the benefits of investments - utilitarian, expressive, and emotional" (p.241) - would quickly take a back seat to utilitarian money if losses began to accumulate.

Dull: I believe it's mostly due to the nature of the book as a collection of very disparate ideas, since the writing style is simple, direct, informal and understandable, but I needed to force myself along through the pages. The book is not a gripping tale with flow that pulls the reader through. However, the frequent nuggets of gold make the effort worthwhile. It reminded me of my experience in a former business life of attending business conferences - most talks are a waste of time but one or two good ideas or contacts - make the cost and effort of attending worth it. This book has more than one or two good ideas.

Confusing: The deluge of motives and forces that Statman describes chapter after chapter eventually becomes overwhelming. Two or more interpretations may be possible for any action or situation. What makes it worse is Statman's admission in the final chapter: "It is often hard to distinguish facts from from cognitive errors and even harder to distinguish cognitive errors from wants or expressive and emotional benefits." (p.237) On the next page, I believe Statman is right when he says "I see no benefit in cognitive errors that mislead us into sacrificing utilitarian benefits for no benefits at all." How do we differentiate the errors from the expressive and emotional benefits and what should we do?

The answer to this last question is not be found in the book. His effort is a descriptive tome. To be fair, Statman evidently did not aim to answer the question so he cannot really be faulted for the missing piece.

Maybe we are meant to read it all, digest it and fabricate our own answers. I believe, however, that what many, if not most, investors really want and need is a prescriptive book that incorporates all the lessons and observations to tell people what to do. Hopefully, someone will write it soon. Statman would have the perfect follow-on title - What Investors Really Need, subtitled Apply (instead of the present book's "Want" and "Learn") the Lessons of Behavioral Finance.

Nevertheless, this is a fine and useful book for the individual investor to spur self-analysis and self-knowledge of his/her own personal finance and investment emotional and expressive drivers.

My rating: 4 out of 5 stars.

CPP Adequacy "Myth" in Greg Hurst's Financial Post Pension Article

In Pension Myths published Dec.2, 2010 on the Financial Post website private pension consultant Greg Hurst rails against what he says are myths about CPP.

Myth 1 according to Mr. Hurst is "Canada's pension system is insufficient for the delivery of adequate pension income." He then cites the Mercer Melbourne 2010 Global Pension Index as a source to assert that Canada is well positioned compared to the rest of the world with a number two rank on the pension adequacy sub-index. Fortunately, the Mercer study is available on the web here, so your faithful blogger, ever the nit-picking detail guy, happily dove into the Mercer documents to do a reality check.

The reality:

• Mercer doesn't say that Canada's system is sufficient, it merely says that Canada's system is better than most of the other insufficient systems around the world. No country attains an A grade from Mercer as a "first-class and robust" pension system on an overall level and though Mercer does not actually assign grades on its three sub-indices, Canada's 75 score on the Adequacy sub-index would put into the B grade of "a sound structure with many good features ... but has some areas for improvement"
  
• Canada's score fell from 2009 to 2010 in Total and across every sub-index (p.19). Is that cause for complacency and doing nothing?
  
• Mercer's Adequacy entails a miserly low level of income. The Adequacy sub-index doesn't just use the CPP, it uses ten questions to arrive at a rating. Canada does comparatively well because of its score on the two heaviest weight questions (attachment 1, p.64). Question 1 assesses the ability to provide a pension to the aged poor. Thus, in Canada OAS/GIS enables people to receive 32% of the average single person's wage (0.32 x $40,600 = $13,000), which is, according to the OECD, where Mercer got its data on this question, enough to keep someone above the poverty line set at 30%. Whooppee, happy days, huh? It is ironic that Hurst should cite Mercer whose conclusion on Adequacy relies on OAS and GIS when his myth 3 says that those two programs are at risk because they are funded from general tax revenue. Would an increase in tangible funding to CPP through higher rates not then make sense? Q2 deals with a target income replacement rate. Mercer says the net (considering taxes and deductions) replacement rate of lifetime average earnings for a median income single earner should be in the range 70-100% and Canada is reasonably close at 63.6%. Lest these numbers seem to be a high target, Mercer reminds us that the lifetimes earnings model from OECD (found in Pensions at a Glance 2009 - gotta love the sly humour in that name for a 283 page document) on which the scores are based assume no real (though it does keep abreast of inflation) pay increase throughout a working career and should thus be targeted much higher than a replacement rate based on final salary. A median Canadian worker thus would get 0.636 x 40,600 = $25,820 to live on. Would that support an active fulfilling retirement or one that entails working to supplement income? Mercer themselves comment that "A net replacement rate below 70% of lifetime earnings suggests a significant reliance on voluntary savings" (p.24).

This last point is the nub of the current problem and debate, one which Hurst himself acknowledges, and Mercer confirms (see its recommendations for Canada on page 57). The reliance on voluntary savings in defined contribution plans and RRSPs isn't working too well, it needs improvement. People are not saving enough and the trend towards types of plans where they have to manage their own investments with all the exposure to their own mistakes and high fees makes the future quite problematic.

As I have blogged before here and here, the CPP seems to offer a better solution to meet retirees' needs. Probably, changing the CPP by both raising the contribution rate and increasing the earnings limit on which CPP is deducted will both help. So what if "Expanding CPP benefits is a very complex undertaking that would likely have widespread repercussions for Canada's pension system overall"? Perhaps one of those repercussions might be a reduction in Hurst's pension consulting business as no-longer-so-necessary private pension savings declined. But is that a reason not to make changes?

His conclusion that Canada merely needs to deploy targeted solutions (harkening back to the notion that there is only a pension problem for a limited few, which I doubt, as expressed in this blog post) and leave aside CPP-enhancement, while somehow boosting employer-sponsored workplace pensions or individual retirement savings, ignores the failures and deficiencies of such options.

CPP enhancement certainly doesn't solve all pension problems. It only pays off gradually over many years as people work and earn a higher pension. Present-day retirees without sufficient savings won't get anything - we'll just have to keep working or buying lottery tickets and/or reduce our standard of living down towards that OAS/GIS level.

I'd like to see arguments more convincing and practical regarding CPP than what looks too much like self-interest or guilt by association from the fact that major labour unions are backing such proposals. Though the labour movement too often itself proposes stupid things merely for ideological reasons, we shouldn't make the same mistake should we?

Waterfurnace Renewable Energy - Insiders Buying Post Q3 Report

When I did my first post on Waterfurnace Renewable Energy (TSX: WFI) assessing it as a stock to buy, insider trading had been quiet. Now we are getting the encouraging signal from a couple of insiders who have been actively buying shares themselves in the last month or so since the release of the company's 3rd quarter report, which I reviewed in this post. Both Board Member Thomas Dawson and the CFO Fred Andriano have been tangibly demonstrating their faith in the company's future according to this list of recent WFI insider trades from CanadianInsider.com - all purchases and fairly large amounts too, given the size of company. It looks like they took advantage of the recent price dip too, paying pretty much the bottom price.

Canada Savings Bonds Needs to Change Motto

Yesterday, blogger Michael James on Money left a good comment on my post about taxes and inflation - how people with Canada Savings Bonds are irrationally wistful for the old days of high interest rates. However, even at today's low interest rates, the CSBs are awful - paying only 0.65% this year (see this rate chart for ordinary anytime cashable CSBs and this chart for the once-a-year cashable premium bonds), they don't come close to compensating for the current 2.4% CPI inflation even before taxes. The stealth tax of inflation is quietly, and probably mostly invisibly to most CSB holders, giving the government almost a 2% real return.

What can one do with cash? In his post on this year's CSB issue, Canadian Capitalist and his commenters discussed some higher interest alternatives for liquid and secure cash. Rob Carrick of the Globe and Mail posted a list of investment savings accounts in his October 29th column How to get some bang for your safe bucks, though one should check the current interest rates as they may have changed.

The CSB motto is "the way to save, guaranteed" (see top of page here). More accurate would be "the way to lose, guaranteed".

How Taxes Increase Inflation's Effect as a Return Killer

Income tax reduces investment returns. Inflation does too. Together they enhance each other's effect in quite dramatic fashion that surprised me when I did some simple example tables.

First, to be a little technical but more precise, whereas the rule of thumb to figure real returns net of inflation is to take a nominal return and subtract inflation, the more accurate formula divides (1 + nominal return) by (1 + inflation) as Wikipedia explains in the article on Inflation Tax. Our calculations below use the precise formula. When inflation is low the difference between the approximation and the precise formula is very small but at higher returns and inflation rates, the difference can be substantial, which comes out in the tables below.

Here is the first table (click to see it large). Observe that:

1. Taxes make the investor a net loser even when nominal returns equal inflation. The yellow highlighted cells on the diagonal show nominal return equal to the inflation rate. In every cell except where both are zero, taxes on the nominal return eat up part of the inflation compensation. The higher the inflation, the worse it gets and the more taxes reduce returns. As we see sliding down towards the right e.g. when both nominal returns and inflation are 8%, someone at the 40% tax rate of this table actually loses 3.4%!
2. Taxes can result in negative real after-tax returns even when nominal returns exceed inflation and again it gets worse the higher the inflation rate e.g. a 13% nominal return would not be enough to make a net gain when inflation is 8% in the bottom right corner. Another of looking at this is to note case A) (the cells highlighted with a blue border), where a combination of nominal pre-tax 4.47% return and 0% inflation equals the net return of the much wider 6% spread combo of 8% nominal and 2% inflation.
   
3. Note how the GIC-zone of 1 to 3% current rates (per Canoe Money) within Bank of Canada target 1% to 3% inflation is pretty well entirely in negative red returns for a 40% tax rate. And it's true for more or less the whole gamut of tax rates as our other tables for 46% (posted below) and 25% (not posted here but I did the numbers) tax rates show.
4. Net returns are higher in low inflation even when pre-tax real (after inflation) returns are the same e.g. in case B) the real pre-tax return of 5.88% equals the 8%-2% combo but the 5.88% - 0% combo would produce 3.53% real after-tax versus only 2.68%.

The second table shows the effects at the highest Ontario marginal tax rates of 46.21%.

1. Net returns are even worse at the higher tax rate, not a surprise, as there is more red / negative returns and lower numbers throughout the table.
2. The spreads necessary to make money are even more accentuated at the higher tax rate - it takes more difference between nominal returns and inflation to compensate when the tax rate is higher e.g. whereas at 40% tax, the 6%-0% combo could be equalled by the 9.58%-2% combo, at 46% it takes 10% nominal to be equal at 2% inflation (case E) the green framed cells).

What defences and counters are there? Apart from praying and maybe doing a little political lobbying to have government set even lower inflation targets (noting however, that when the investor loses from taxes and inflation, the government is a big beneficiary), the basic strategy is to defer taxes as long as possible:

• Though one cannot escape the effects entirely with registered accounts since taxes must eventually paid upon withdrawal, using registered accounts for tax deferral becomes even more important the more inflation rises;
• In taxable accounts, trade less to avoid realizing capital gains, buy and hold with index funds (on page 71 of Jeremy Siegel's Stocks for the Long Run that shows how the inflation tax effect on capital gains lessens progressively with longer and longer holding periods; hat tip to Siegel as well since that is where the idea for this post came from).
  
• Pick funds or ETFs for taxable accounts like the new Horizons BetaPro S&P/TSX 60 Index ETF (symbol: HXT) (reviewed here) that produces no immediate taxable distributions.
• In taxable accounts, seek returns from lower tax rate types of income - the lowest being dividends, then capital gains, with interest the last choice (Canadian real return bonds have the unpleasant feature that the inflation adjustment component is just as taxable as the real return portion, as Bylo Selhi notes here)

It used to be that only death and taxes were inevitable. Unfortunately, inflation is too nowadays, so we need to be aware of its toxic effects.