Book Review: Pension Revolution by Keith Ambachtsheer

Why should an individual investor read a book about how to fix the pension system that is addressed to pension fund managers and legislators who make the pension rules?

1) To become an informed, opinionated citizen on a topic that is sure to affect you in a significant way, e.g. most recently in Canada, taking a position on the short-lived proposal to expand the CPP and the substitute federal proposal to start something called Pooled Registered Pension Plans (my take here ... written before I read this book, though reading it has only reinforced my opinion)

2) To get ideas to manage your own retirement income, such as probable investment returns, the risk premium for equities over bonds and most uniquely, the importance of matching the time horizon and riskiness of liabilities with assets / investment portfolio. Ambachtsheer doesn't intend to address the needs of individuals and he never explicitly says that the same principles should apply to individuals and to pension funds but they seem highly pertinent to me. As a foundation principle for people like me who must manage a personal pension fund of RRSPs/RRIFs/LIRAs/taxable accounts for themselves, the "match assets with liabilities" phrase makes much more sense than "match bond allocation age".

In other book reviews I have several times objected that the book title or sub-title doesn't deliver what it promises. Not this time. "Revolution" is not too strong a word. Ambachtsheer advocates drastic across the board change. He says corporate defined benefit plans were a disaster waiting to happen from their origins (what better supremely ironic example could there be than the fact that the very company that set the pattern for corporate DB plans after World War II - General Motors - in large measure was scuppered by the liabilities of its DB plan?). Corporate DB plans are good for neither companies nor employees, being riven with inherent unresolvable conflicts. Defined contribution plans are fatally flawed as well, for different reasons but the end result is still bad, an incapacity to deliver a good pension in retirement.

The Optimal Pension System - Revolutionary wearing-suit-and-tie Ambachtsheer (he is the director of the University of Toronto's Rotman International Center for Pension Management) proposes a solution, called TOPS (The Optimal Pension System) with the features below. The book dissects the issues that bedevil our existing DB/DC pension system and tells why and how his TOPS can be viable replacement system. TOPS includes:

• auto enrollment and set minimum contribution rate
• auto-pilot savings-investment process - no un-necessary choices (e.g. pick one of 20 mutual funds) for individuals to make
  
• auto-pilot conversion of financial capital into deferred life annuities all along during a working career (instead of suddenly needing to decide what to do with a RRSP at retirement)
  
• single -purpose pension plan co-ops (unlike DB plans where corporate goals and constraints interfere and DC plans where financial industry profit motives interfere)
• good governance and organization design (like appointing a board based on ability to help achieve the pension mission, not to represent a union or an employer), which he figures can add 3% per annum to returns!!
  
• economies of scale (yup, size matters and he's got the data to prove it - less than $2 to 3 billion - as of four/five years ago when he wrote the book - is too small)

Though much of this looks a lot like the CPP to me (yes, I am still on that hobby horse), Ambachtsheer cites a few other examples that comes close to his ideal - the Dutch national pension system e.g. one provider is APG and the USA's TIAA-CREF.

Investment Environment - Ambachtsheer devotes about 70 pages to investment topics that should interest every individual investor - the stocks for the long run question and the equity risk premium (ERP), which he says predictably varies up and down (metrics like P/E and dividend yield giving reliable indicators of future returns). His rule of thumb formula for the expected ERP gives sobering results these days: (market dividend yield + 80% of future real GDP growth - yield on real return bonds = 2.4% + 0.8*2%(?) - 1.2% = 2.8%. Ambachtsheer does not believe in the Efficient Markets Hypothesis. He thinks instead that skilled investment professionals can add considerable excess returns, especially over the long haul. He poo-poos people like Burton Malkiel (strange that Malkiel still writes a glowing blurb for the book at the front!) who apply simple mechanical investment rules and find no out-performance and then conclude that EMH works just fine - "Highly effective pension and endowment fund management teams know that there is considerably more to to generating excess return over time than applying simple decision rules to buying and selling stocks and bonds."

What's Good for Pensions Would be Good for the Economy - The book puts forward the intriguing idea that pension funds can exert positive influence on companies and on the economy through their long term investment perspective as knowledgable, activist shareholders with considerable clout. Ambachtsheer argues that better-managed pension funds will recognize that what he calls long horizon risky investing brings the biggest returns and in turn that depends on investee companies focusing on long run sustainable growth instead of short-term next quarter results.

How Much We Really Need to Save - It is a shock to read that the riskless creation (i.e. buying only real return bonds) of a riskless lifetime inflation-adjusted pension would require a 25% or more pay deduction rate sustained for 35 years. Failing that strategy, we can buy into equities for probable higher returns but we have to accept investment risk and that could mean taking a lower pension. We also learn that the most expensive pension feature by far - and thus the one that pension providers (whether governments or corporations) are most likely to cut back in cases of under-funding - is inflation protection. Boomers should not be surprised if and when inflation-indexing gets cut, since there has been no change in our pension system since the 2007 publication of the book. Everything in the book is as relevant and topical today as then.

Unless inflation goes up in a huge spike upwards as in the 1970s, the current 2% or so rate will eat away slowly and surreptitiously at living standards of retirees. Unfortunately, most often it takes a sudden crisis to provoke fundamental change. Ambachtsheer does not attempt to forecast the likelihood of change in pensions. He only plays the role of the technician who tells us what is wrong and how to fix it.

The biggest downside of the book is a lot of repetition. The same ideas are presented over and over with a bit of new material in each of the very short (5-6 pages each) 45 chapters. The book also lacks an index, so it is hard to find subjects again, even when one takes extensive notes during reading, as I do. A consolidated reading and reference list would help too, though key papers and books, such those on the investing ideas, are referenced within the text.

The publisher Wiley Finance listing for the book includes the table of contents.

My rating: 4.5 out of 5

The Next Step in Index ETFs: Risk Efficient Index ETFs

"The Moving Finger writes; and, having writ, Moves on"
The Rubaiyat of Omar Khayyam

Finance research fingers have written a lot on the various methods of indexing, poking holes in cap-weighting as being neither theoretically nor practically optimal for indexing, whether to use as a benchmark or an investment strategy. It's time to move on, apparently not to fundamental weighting or equal weighting, but to something called a Risk Efficient Index, which maximizes the reward/return to risk (Sharpe) ratio. The EDHEC Risk Institute came up with the new indexing method and provides a good FAQ here that explains the difference with the other indexing methods (and includes links to various papers with detailed comparison of the alternative indexing methods). The second-last question in the FAQ says the method could be used for an ETF. The new Index is where the institutional investors are or will be heading, so why not an ETF for individual investors?

Could we please have Canada Real Return Savings Bonds

Now that inflation is just starting again to rear its ugly head (2.4% in December, up from 2.0% in November), perhaps our federal government in its solicitous regard for the ordinary citizen could consider adding to the annual Canada Savings Bond line-up by offering a Canada Real Return Savings Bond.

The idea is very simple. As the name implies, it would be very similar to the existing Savings Bonds, sold in the annual campaign from October to December. In fact, the similar name would have the object of reassuring everyone of the same solidity and safety, as indeed it would have, being an obligation of the Government of Canada.

Why do this? There is a big gap in the product marketplace. While there are plenty of GICs and CSBs around with strong security of principal, the only true inflation-protection product of similar security is the series of real return bonds issued by the federal government. Unfortunately, the RRBs have several important limitations for the average person: one cannot buy small amounts ($5k is the RRB minimum); one has to buy through dealers (with their markup and loss of yield); long maturities only are available (the earliest one now is 2021 - see Finiki).

For people who only really want to preserve their capital and not garner big returns, CRRSBs would be a boon - small purchases, range of near to intermediate term maturities, and above all, no worry about inflation. At the risk of provoking a not-invented-here negative reaction, we in Canada have a convenient model to follow - the UK's Inflation Linked Savings Certificates. There's one feature they have that I especially like - no tax on the interest! (see item 5 in Terms and Conditions) That's only fair. In the UK the Certificates' return is next to nothing but at least the "inflation return interest" is not taxed as it is with our present product the real return bond (which only makes them worthwhile to hold in a registered account). A minuscule real return is still better than the net negative return currently on offer - e.g. 1.7% Bank of Montreal 1yr GIC minus 2.4% CPI to December (if that continues and is it likely to go down or up?) = 0.7% loss of purchasing power.

I can even suggest a silly slogan that would make it a big marketing success "Get Real Canadas"

Update March 9, 2011: It seems I am not the only person who believes shorter term RRBs would be useful. In The Missing Links: Better Measures of Inflation and Inflation Expectations in Canada published in 2009 by the CD Howe Institute, Gregor W. Smith advocates the creation of RRBs with maturities of 1, 2 and 5 years, for the dual purposes of providing savers better options and to enable better measurement of inflation expectations to guide government policy.

Book Review: All About Index Funds by Richard Ferri

Disappointing. After reading the excellent All About Asset Allocation by the same author (my review here), I expected more of the same quality from All About Index Funds, especially since this book is a second edition. Alas, too many small slip-ups and an inconsistent approach bring down the value of much useful information and sensible enough investment suggestions.

Slip-ups - Is it too much to ask for a proofreader to eliminate typos and for an editor to help with sentence construction? Yes, it is true that no book is perfect and we can usually fill in the blanks but such carelessness undermines credibility.

Unfortunately, I believe that loss of credibility is justified at times. Take this statement on page 160: "The sad part about modified-weight funds is that the issues claim to have found a new indexing nirvana when in fact all they have done is create more funds titled toward value stocks." Huh? "issues" find something? Would a better word not be something like "proponent" or "advocate"? As well, "titled" instead of "tilted"? We know what Ferri is trying to say but these trivial errors belie a too-casual, too-brief treatment of a critical issue in indexing. That issue is whether cap-weight funds are better than modified-weight funds such as equal-weight or fundamental-weight funds. Mere summary dismissal by Ferri does not help the reader make up his or her own mind. The absence of any footnotes or citations of research that he deems would answer any doubts about his position leaves the reader with a take-it or leave-it situation.

I happen to believe that fundamental weighting is better for the individual investor than cap weighting, my definition of better being a higher return to risk ratio. Whether I am right or wrong (and to find out I have a little experiment going in the form of the test portfolios at the bottom of this blog), the answer as to which is better is an empirical question that Ferri does not address. He should. Putting two and two together from information in the book, we can see that the supposed purist indices that underlie such index funds as the S&P 500 Spider (SPY) do not conform very well to purist cap-weighting conditions (e.g. violations like free-float adjustment, arbitrary stock selection by a committee, buffer zones to minimize trading and prevent front-running by hedge funds). All index funds can be seen to be merely trading strategies. The question is only which works best.

Ferri might answer that the book is only a beginner book, whose aim is to provide the "easy way to get started", as the sub-title says. Fair enough, but that raises the other problem I find with the book.

Inconsistent Approach - If the purpose of the book is to give advice, a basic how-to manual, then huge chunks of the material where the details and descriptions of various indices and myriad sector funds become irrelevant and distracting. In fact, Chapter 15 could do nicely for the investor who just wants to know what to do. The chapter lays out sensible sample portfolios with the names of specific funds and percentages to allocate across the funds.

On the other hand, if Ferri's objective is to give the investor the tools and rules to make up his/her own mind, then the pros and cons of his positions and of the alternatives need to be laid out. For example, there is lots of descriptive detail of commodities (with some errors, like saying on page 196 that cotton is an Industrial commodity! - see the S&P GSCI) and associated indices and funds but nowhere do we have an assessment of which are better, nor even a suggested method for deciding the matter.

Content - The book is divided into three parts. Part 1 puts forward the case for basing individual investing on low-cost index funds. Part 2 describes the many categories of index funds, their underlying indices and lists most of the available ETFs/mutual funds as they existed in 2007 (so inevitably this is out of date as ETF proliferate - is a book the right way to catalogue ETFs?). Part 3 says how to combine and manage index funds in portfolios. The portfolios suggested should do investors fine. The portfolios are based on mainstream cap-weighted funds and should perform well enough, even if fundamental- or equal-weight index funds do better over the long term. They offer the key feature of avoiding loss of money through high-fee funds and through the protection from diversification.

The content is at a beginner level, with no math, not even arithmetic. There are lots of illustrative tables and charts. The appendix includes a short reading list with classic books like those of John Bogle, William Bernstein and Burton Malkiel. A number of low-cost fund provider website addresses are given (I wish it included the handiest one for quickly finding all the ETFs by category, the completely mis-named Stock Encyclopedia).

The target audience is squarely people in the USA. Canadians will find it useful for their US ETF investing, but need to ignore all content to do with taxes, account types and mutual funds. No Canadian ETFs are even mentioned, nor is any pertinent history (Ferri could have acknowledged that the first successful ETF, the TIPS was created in Canada in 1990, predating the 1993 SPY - see Wikipedia).

Despite the beginner orientation, there is lots of interesting content for more advanced investors. I got many blog ideas, for questions that came into my mind during reading (but which Ferri does not answer), such as:

• what would happen if everyone indexed?
• book says there isn't an index ETF for high-yield bonds ... there is now, Powershares' PHB
• past correlations of asset classes have not been stable and tended to peak during crises - can we construct a model of correlation effects for various crisis types? e.g. asteroid strikes earth = all assets perfectly correlated at 1
• some indices are based on free-float, others on full cap for weighting, so does it matter and what is the effect?
• why have index providers all discarded the definition of Value stocks as those in the bottom half of price to book for more complicated multiple factors and what difference does it make?

My rating: 3 out of 5 stars.

Disclaimer: Thanks to McGraw Hill for providing me with a copy for review.

Governments' New Extraordinary Data Snooping Powers into Offshore Tax Havens

It used to be under older style tax treaties that countries like Canada going after their taxpayer citizens hiding their money in offshore tax havens could only request the data the foreign country had at its disposal in the normal course of doing its own government administration, which conveniently would normally be very little in a tax haven.

The new breed of tax agreements that are progressively being forced upon the tax haven countries contains a far more intrusive power. The snooping country Canada can request in Article 4 that the tax haven country like Jersey (see Finance Canada's announcement) to actively collect and compile information! And by the agreement, the tax haven country agrees to collect it and hand it over.

" If the information in the possession of the competent authority of the requested Party is not sufficient to enable it to comply with the request for information, the requested Party shall use all relevant information gathering measures necessary to provide the requesting Party with the information requested, notwithstanding that the requested Party may not, at that time, need such information for its own tax purposes."

It's hard to tell how many tax havens are affected so far but the steady flow of new agreements (e.g. Cayman Islands, Bahamas, Isle of Man, Bermuda, three of which are in a recent list of best places to open an offshore account on the Offshore Tax Haven blog) and the fact that the OECD countries back this thrust, suggest it will be more and more difficult to hide from the tax tentacles of governments the world over.

update Jan.19 ... and today Guernsey joins the list

Fantastic Performance Results for RAFI Fundamental US Equity Index ETF

The RAFI US 1000 Portfolio ETF (Symbol: PRF) has outperformed its cap-weight rivals the S&P 500 and the Russell 1000 by a huge margin over the past five years since its inception according to a press release by PRF's manager Powershares. That's 23.1% for PRF vs 11.99% (S&P 500) / 13.8% (Russell 1000). Even better from a practical viewpoint, the PRF fund has outdone the indices i.e. the higher expenses of PRF have been more than offset. The cap-weight indices portray better results than an investor could actually achieve since the indices do not reflect the cost drag from the MERs of ETFs that invest in those indices.

Perhaps most telling for PRF fans, of which I am one (I own shares), PRF has outperformed by an even greater margin the Russell 1000 Value Index, which produced a measly 6.68% over the five years. If RAFI is only/merely value investing, it sure seems a better way to do it.

THE Priority for Improving Canadians' Personal Financial Success: Advisor Professionalism

Like it or not, bloggers like me, and even mainstream financial media like the Globe and Mail and the Financial Post, have little influence on the financial success of most Canadian adults over 35. Last February the Investor Education Fund's GetSmarterAboutMoney.ca website published the results of a survey with the tell-all title Advisors Top Source of Information for Older Canadians. People in that age group overwhelmingly rely on financial advisors (see Exhibit 1 in the study report for the over 34s) - and primarily those within banks or other financial institutions - as the experts to guide their financial decisions.

The report foresees more and more new advisor relationships being started up over the coming years so it is time to get going now. A higher degree of professionalism, such as doctors, engineers and accountants have, is what is needed.

Two things are required of those advisors and their recommendations to clients that really are not sufficiently the case today. They must be:

• broadly well-informed to give holistic or integrated recommendations - knowledge of investments, taxes, plan types (RRSPs, RESPs, TFSAs etc), mortgages, insurance;
• bound by fiduciary duty with strong sanctions and enforcement of ethics so that client interests come first.

The national priority is not financial literacy or a national securities regulator but better advisors. Few people have the time or the inclination to develop the skills to be DIY financially. Though we all can and should always bear the ultimate responsibility for our finances, just as we do for own health, it does not mean we should not expect to find ready availability of expert financial "doctors" to give us trustworthy impartial advice.

Btw, bloggers need not despair. The under 35s use the Internet extensively to find financial information. 48% read online forums and blogs according to chart C-1 in the key findings for the 20-34 age group.

Cap-Weight vs Fundamental Portfolios: 2010 Year End Update

Last June I created two parallel test portfolios to determine whether Fundamental Weighting really does a better job than a Cap-Weighting as proponents like Robert Arnott say. The two portfolios have the same asset classes and proportions invested in each asset class. As much as possible, the portfolios mirror the investor experience, as I described in the initial post about this mini project.

The 2010 year end has come and the cash distributions have been received by the portfolios in a mix of Canadian and US dollars. Where offered by the ETF vendor - BMO and Claymore only - the distribution has been reinvested in its ETF. Per the intention announced in the October update, in the Cap-Weight portfolio, I've now sold the iShares S&P TSX 60 Index ETF (symbol: XIU) and bought in its place Horizons BetaPro S&P TSX 60 Index (HXT), which cleverly uses swap derivatives to track the same index but with the key difference that it implicitly automatically reinvests distributions. That will make a fairer comparison against Claymore Canadian Large Cap ETF (CRQ) which has a DRIP.

The Competition Results:

• It is still more or less a dead heat overall between the two portfolios - only $128 dollars out of a portfolio total value of $113,400 or 0.1%;
• Fundamental Weighting leads in four asset classes and Cap-Weighting leads in two (I ignore RWX since it is the same ETF in both portfolios and the Cap-Weight portfolio has one more share so it will always be ahead by that one share)
• Cap-Weighting is ahead in Canadian large cap equity but Fundamental Weighting leads by a significant margin in the two small cap equity ETFs for the USA and for Developed Markets. It is curious that Fundamental Weighting leads by most in two of the asset classes which have had the biggest increases. Cap-Weighting is supposed to be the bubble follower I thought. Maybe it's a sign that the rise in those stocks is not a bubble at all, that in fact the previous weightings were out of whack - Cap was too high - and now Fundamental has been catching up.
  

General Investing Results:

• Both portfolios are up a healthy 13% since June, when we pretended to invest $100k
• Every asset class is up by double digits, except Bonds
• The rise of the Canadian dollar has reduced foreign returns but they were still much stronger than those of Canadian holdings after conversion
  
• None of the asset classes is anywhere near the threshold set for rebalancing (1/4 of its allocation percentage), which we said anyway we'd only do after a year.
• Cash inevitably has started to pile up unproductively in these accounts as in real life when distributions are not immediately reinvested. The Fundamental portfolio has $1767 in cash (1.6% of its total value) and the Cap portfolio a bit more at $2066 / 1.8% (since fewer of its ETFs offer a DRIP). This brings out the real-life no-perfect-answer dilemma of having idle cash vs paying too much in trading commissions to reinvest small amounts. At the year anniversary in July after two more quarterly distributions by the ETFs, there will be more cash and we'll reinvest & rebalance per our portfolio policy.
  

The details of the two portfolios are in a Google spreadsheet at the bottom of this blog page.

Worth Reading: Gail Bebee's New Year "Resolutions"

Personal finance author and speaker Gail Bebee reverses psychology and provides a tongue in cheek wish list of ten changes the financial industry could make to help Canadian individual investors in 2011 over on Morningstar.ca. Hear, hear Gail, great list. I'd like to add a couple to make an even dozen - the 12 by 2012 list:

• "Federal Minister of Finance Flaherty along with Alberta and Quebec agree to do the right thing to ensure a solid pension for future Canadian retirees by raising CPP contribution rates and earnings deduction limits."
• "Discount brokerages at the major banks will finally all enable registered accounts to hold US dollar cash in the same easy way that non-registered accounts do as a matter of course so that trading in and out of US securities does not incur un-necessary currency conversion costs."

Of course, if all this got done, what would we bloggers have to write about? What are the chances of even one out of twelve happening?

Book Review: The Mystery of Capital by Hernando de Soto

Years ago a former boss gave me some advice when I too enthusiastically waxed on about the merits of a project I proposed to him - "Don't oversell". While interesting and with a good point to make, this book suffers from the same mistake I made. It is a serious flaw.

The book's subtitle is Why Capitalism Triumphs in the West and Fails Everywhere Else. Unfortunately, the author demonstrates nothing of the sort. All that the book demonstrates - and even then at too great length (I figure the author could have made his point in about a quarter of the pages) - is that property systems in the West (i.e. developed countries) are effective in allowing everyone to turn their real estate into capital. In contrast, in the "everywhere else" countries, the legal property system is dysfunctional and effectively serves only the few of the elite, leaving the mass of society with enormous assets in total, in extralegal, informal, localized, ad hoc property systems that severely their use as capital for other purposes. The assets are locked in and more or less "dead".

The book's big mistake, stated by the subtitle, is that an effective property system is a sufficient condition to ensure the success of capitalism and by implication to promote prosperity and wealth in a society. Property rights are a necessary condition to societal wealth but they alone do not suffice. So much is made clear in more comprehensive tomes such as Rosenberg and Birdzell's How the West Grew Rich (reviewed here) and Lipsey, Carlaw and Bekar's Economic Transformations (reviewed here). Many other factors like rule of law, science, societal institutions for commerce, favourable culture and religion and most especially technology and innovation all must combine. Capital formation apparently has not been the most important factor at all. Thus, the deficiencies of property systems in many countries in preventing effective use of assets for capital would not explain on their own why capitalism, which de Soto seems to use as shorthand for the western economic system, triumphs only in the West.

For the individual, the main value of this book is for general interest to understand and recognize how laws and formal systems like property arise successfully only out of real, on-the-ground practice and not from theoretical, logical constructions devised by lawyers in the abstract. Such a lesson would apply today, for instance, in the methods being used to reform pensions. We should be practical and not ideological, providing pensions that actually suit people's needs, just as our property systems have successfully evolved.

Favorite quote from the book: "Lawyers are the professionals most involved in the day to day business of property. They sit in the key government offices where they can suppress major decisions. No group - aside from terrorists - is better positioned to sabotage capitalist expansion. And unlike terrorists, the lawyers know how to do it legally." Ouch! (He does say a minority of lawyers do help drive reform.)

In short, Mystery is more an essay than a book, maybe worth borrowing from the library for a quick scan (read the first 68 pages, then the concluding chapter).

My rating: 2 out of 5 stars.