Good new, bad news: Living even longer than previously expected

Back in February a Canadian Institute of Actuaries press release told us that as a result of compiling data specifically on Canadians (previously, they had always apparently relied on US data), they discovered that we can all expect to live a couple of years longer. If a man gets to 65, he can expect to live another 22.1 years, vs the older US-based estimate of 19.8 years. Women go up from 22.1 to 24.4 years. Good news - we get to live longer. Bad news - we have to find the money to pay for it, as do our pension plans, which apparently take anywhere from a 1% to to 7% under-funding hit. It also means we'll be getting lower monthly income henceforth when purchasing annuities. Fortunately, it seems from the detailed report on the CIA website that the revised estimates are in accord with the assumptions used in the C/QPP so their long term funding sustainability is not being put in question.

Book Review: Pensionize Your Nest Egg by Moshe Milevsky & Alexandra Macqueen

 Pensionize Your Nest Egg exhorts retirees to ensure that a good chunk of their income comes from sources that promise to pay a regular amount as long as they live. That advice is easy to accept given that one of the main risks in retirement is outliving savings.

The next part of the book's advice - how to do it using a combination of three "products" 1) annuities, 2) portfolio of stocks and bonds, 3) guaranteed living withdrawal benefit (GLWB), a complicated insurance company product - is much iffier. This part of the advice is problematic for three reasons, first because of uncertainties around GLWBs, second because the list of retirement risks is incomplete, and third because the list of products or methods to handle the various risks is incomplete.

GLWBs are worrying because they are complicated. There are various inter-acting moving parts that make them a challenge for the consumer, like resets and ratchets on the payout amount, choice of under-lying fund, initial payout rates, and fees. How can a consumer compare offerings from various companies and know which deal is better? Quite competent folks like Peter Benedek's Retirement Action here, Joe Tomlinson on Advisor Perspectives here and Wade Pfau on Advisor Perspectives here have crunched lots of numbers and the best choice of what to do seems to depend a lot on assumptions.

A key tool created by author Milevsky and promoted in the book, the RSQ and FLV calculator, does not put a GLWB into the mix. It only includes an annuity and a stock & bond portfolio. Why not? We are told it is "beyond the scope of this book". The reader is told to consult a financial advisor. Yet on the same QWEMA website, there is an ad for the PrARI calculator, aimed at financial advisors which does include the missing GLWB component, as well it seems, as other missing pieces like unexpected lump sum expenses. The book and the free tool look more like an illustration of concept designed to drive readers to seek out financial advisors than a practical self-serve solution usable by a DIY investor.

A question I keep asking myself was why I should even be interested in a GLWB. There is an excellent little table on page 66 where annuities, stock/bond portfolios and GLWBs are rated for how they offset the three big risks of inflation, longevity and sequence of returns, and for their benefits of legacy value/liquidity, sustainability and growth potential. Annuities and a stock/bond portfolio have exactly opposite offsetting Yes answers where the other is No, while GLWBs are either similar to one or the other, or in between i.e. GLWBs look superfluous.

It's always interesting to think of the position of the product offeror (the old saying is if you are in a poker game and you don't who the chump is, then it's you), the insurance company that sells the GLWB. GLWBs may (it's hard to tell and that is worrisome - we could call it chump uncertainty risk) be a game in large about stock volatility risk. Benedek's simulations found that a GLWB customer was better off if stock volatility is higher. Similarly, this technical paper by Australian researchers from the insurance company perspective suggest that their profits would be highly sensitive to stock volatility, customer mortality volatility and interest rates. Another thought-provoking piece is about GLWB provider Ohio National's different and supposedly more effective and cheaper method of hedging its own risk. It raises the question whether some insurance companies might be headed for a big fall because they don't really understand and control the risks properly. The fact that Assuris covers GLWB income 100% up to $2000 per month and 85% above that (but this is only mentioned in the book with respect to annuities and not explicitly for GLWB payouts as well) helps on the income side but not on the legacy side if the insurance company screws up. Do we really want to be trying to also assess how well the insurance company will handle the investment account to pick a GLWB?

Retirement Risks to wealth and income surely include more than the three (inflation, longevity and market sequence of returns) the book lists. Unplanned events like one-time or chronic health problems, divorce, (grand)child care, elder care can create large negative financial effects. There may be a need for on-going higher cash flow, or a big lump sum. There is a greater requirement for liquidity and flexibility than only an end of life legacy goal the book discusses. Though the book's stated aim is solely to describe how to create a guaranteed lifetime income, the process it proposes excludes such other considerations. Those considerations cannot be separated when deciding how much to pensionize. If you pensionize too much in order to ensure long term sustainability you may suddenly be caught short. Some things like health risks can and perhaps should be handled with long term care insurance but perhaps not if a greater amount of capital is kept in a stock/bond portfolio or if a no-longer needed house can be sold to pay for LTC.

Alternative products and methods to address income/lump sum needs are incomplete. The single best inflation protection product is inflation-indexed aka real return bonds, yet they are not discussed or incorporated into the planning.

The historical stock & bond return and volatility characteristics in the book are taken as given and baked into the RSQ-FLV calculator, yet new portfolio construction methods offer convincing promise to significantly lower volatility (e.g. see this individual investor Smart Beta portfolio). The pension fund and institutional investor world has moved to controlling risk/volatility to improve the return vs risk ratio and individual investors can too to some degree. Even a traditional but more diversified portfolio (i.e. more varied asset classes) will improve the return vs risk figures used by the authors. Changing the  historical assumptions about an investment portfolio's performance can appreciably reduce the likelihood of running out of money using a systematic withdrawal plan, improving its attractiveness in the product allocation structure the book presents.

That's what the book is missing in my view.

What the book does discuss is really well done and worth reading. The writing aims at a general audience. It has lots of good illustrations, clear uncomplicated explanations without difficult technical or mathematical material, very much like Milevsky's other excellent books that simplify and explain potentially confusing subjects. The free online RSQ-FLV calculator still provides insight despite its limitations. Another calculator created by Milevsky the book refers to, the Implied Longevity Yield calculator on Cannex, is very helpful for trying to decide whether current annuity payout and interest rates are propitious for buying an annuity now or later.

The book is to be applauded for forcefully making the critical point many people do not seem to realize that an RRSP balance (or the proposed PRPP) is merely a savings plan, not a pension, since it produces no automatic, guaranteed lifetime income. And they also make the equally critical point that most people need and should have real pension income (except those like Warren Buffett who has so much money he could never possibly run out).

Bottom line: pensionization via product allocation is a worthwhile approach but what the authors leave out is too important to make the book's content good enough for practical retirement income planning. 3 out of 5 stars.

A Tipping Point in the CPP Expansion Debate?

Surprise and initial disbelief was my reaction upon reading the headline "Canadians should be allowed to contribute more to CPP to ‘reignite a culture of savings,’ urges CIBC chief" yesterday in the Financial Post. But it's true - the head of one of Canada's banks has come out in support of an idea that has been portrayed by some as the stupid notion of an ill-advised anti-business left-wing labour movement but which actually makes a lot of sense (as I have blogged about comparing CPP to RRSPs and the like, in relation to retirees' needs, comparing to the proposed PRPPs). It is quite significant when a major bank head publicly expresses support. After all the banks make a lot of profit from RRSPs, mutual funds and would do so from PRPPs that are the private sector alternative to CPP. So kudos to CIBC and CEO Gerry McCaughey for saying something that may not be in their narrow best interest but which is good for Canada and average Canadians.

A fine but critical point of potential disagreement with what McCaughey said is that the voluntary participation in the expanded CPP should be made the default option i.e. people should be automatically included though they could opt out if they deliberately chose to leave it. That way, just about everyone would be in it. To offer participation as a voluntary opt in, where you have to take action to join, would be next to useless as too few people would join. People need a Nudge as Thaler and Sunstein tell us in the eponymous book.

Disclosure: I own bank shares directly and in ETFs (and so does just about every Canadian in their equity mutual funds or ETFs) and I will be getting CPP, though not any expanded benefits if it is expanded on a pre-funded basis as I believe it should be done.

Book Review: 52 Ways to Wreck Your Retirement ... and How to Rescue It by Tina Di Vito

Looking for an easy to read and digest introduction for the ordinary "Joe" with the basics of how to make a success of retirement? If so, this book by Tina Di Vito, who is the head of the BMO Retirement Institute, is aimed at you.

Written in an informal style with a smattering of numbers and almost no tables, graphs and calculations, the book speaks to the reader in the manner of a chat at the kitchen table by a knowledgeable friend. Each of the fifty-two chapters covers one or two ideas in about five pages, with single sentence "to do" points at the end of each. It is easy and pleasurable reading.

It is thus no surprise that the content provides a good understanding of the nature of problems and their solutions but for the most part, does not give enough knowledge for the reader to go off and fix things him/herself. It is not a book for the DIY person. Rather it is a book that prepares the reader to be a smarter consumer when going to seek the advice of a professional advisor.

To make the bottom line message of the book "go get professional advice" is fine. But I wanted more detailed and trenchant coverage than we get in the chapter (51) on the topic of who to get advice from. The reader is given a list of twelve types of accredited advisors with each designation's title, initials, website link and description. That's a good start but the descriptions are too overlapping and vague to allow someone to know which to choose for what problem and how or whether to assemble a team.

It was also disappointing not to read more cautions about advisor compensation and the potential for conflicts of interest between what is good for the advisor and what is good for the client. The existence of commission, fee-based and fee-only compensation models is not explained, nor the dangers lurking for clients whose advisors do not act first and only on their behalf. That is as surely a way to wreck one's retirement as any other in the 52.

Similarly, the author could have been more forceful in emphasizing that retirees should pay close attention to the costs and fees for various products mentioned. Whether it is mutual / ETF funds, insurance, principal protected notes, segregated funds, flavours of annuities and retirement income products, costs matter a lot in deciding whether any are worth buying at all. The idea may fit the problem but the fees/costs may be too high.

Favorite Bits:

• see yourself old and save more for retirement ... a research study is cited wherein people who were shown an image of themselves digitally altered into old age saved at more than twice the rate ... since I do not have such software, I'll just have to make do with looking at my parents instead!
• people buying stuff with a credit card instead of cash are willing to spend 50% to 200% more for an item
  
• retirees feel a loss five times more than a similar gain; that sensitivity, aka aversion, to losses compares to the usual 2:1 ratio cited for the average person; I looked up the original study at AARP here and discovered that in fact many retirees scale at 10:1 or more.
  

Rating: Not the complete story but worthwhile, 3.5 out of 5 stars.

Thanks to the publisher Wiley, where the complete table of contents can be viewed, for providing me with a review copy. It is also available there for purchase in Adobe's Digital Editions (software is free download) eBook format, which is how I've read it on my laptop.

What to do about Losing mental acuity or outright incapacity

A reality of getting older is declining mental ability. As with the body, so with the brain. It may be more obvious with the body but small gradual or sudden drastic falling away in our ability to make financial decisions will occur. It may be due to disease or natural ageing but it happens. We need to anticipate that and plan for it.

Among the kinds of decline: short-term memory recall, a long slow progression that starts from around age 40 (see graph here in Flickr); language facility; mathematical and analytic capabilities. The result is that good financial decision-making falls off with age, even amongst those who have known and applied good financial principles for a long time.

Whether the onset is gradual or sudden, mental decline gets to be a bigger and bigger issue as one gets older. The rising prevalence of dementia and increasing life expectancy ensure that it will become ever more common for retirees to reach a point of being incapable, both legally and practically, of managing their own financial affairs.

The problem is that when such incapacity strikes, chances are we won't even be aware of it. Worse, even if we are aware, at the point when we have been medically certified as mentally incapable, we lose the legal power to do all sorts of critical things.

What a mentally incapable person legally cannot do:

• make a new will, add a codicil to an existing will or revoke an existing will
• prepare a power of attorney
• put a bank account into joint names with children
• change the beneficiary of his/her RRSP/RRIF or an insurance policy
• carry out estate planning, such as reducing probate costs
• give investment instructions to his/her financial advisor.

What to do about mental decline and incapacity:

1. Mental exercise ... “use it or lose it” – The Seattle study (http://www.memory-key.com/problems/aging/seattle-study) followed a large group of people throughout their lives and discovered that amongst other factors a complex and intellectually stimulating environment and efforts to maintain a high level of perceptual processing speed seem to help reduce cognitive decline. The study suggested that cognitive decline observed in community-dwelling older people was mostly the result of disuse and could be reduced through training. Along with such activities as reading books, guessing at the answers of TV game shows, taking courses and doing a part-time job (paid or not), consider that continuing to manage your investment portfolio can be good mental stimulation, a challenging game that never ends.

2. Physical exercise - “a sound mind in a healthy body” - Though the original Latin expression was more a prayer than a prescription, keeping fit can help stave off mental deterioration.

3. Simplified portfolio and financial affairs – The simpler and more automatic are your affairs, the easier and less error prone they will be to manage, whether it is you yourself doing the job or someone else.

4. Power of Attorney – It is a dangerous misconception that a spouse or an adult child can automatically step in when incapacity happens. A sensible step is therefore to put in place, in advance of anything happening, a Power of Attorney (POA) that authorizes another person to take financial action on one's behalf. The POA authority may be narrow or complete, with the exception that the delegate, known as the Attorney, can never make a will on the person's behalf. The authority can include banking, signing cheques, paying bills, borrowing money, hiring contractors, selling or buying real estate, stocks, bonds, consumer goods etc.

Qualities of the Attorney - There are some obvious qualities the person(s) selected to exercise the POA power should have:

• the time and willingness to fulfill the responsibilities (BMO says the average time a person fulfills a CPOA role is four years - if you are well advanced in age, it probably isn't the best idea to name someone the same age as you, like your spouse)

• someone in whom you have complete trust (the CPOA has wide ranging power and possible abuse of the power is a major consideration; sadly, even one's own children can sometimes be less than reliable)

• enough financial knowledge, along with diligence and organization, to handle your affairs, or the astuteness to recognize the need for professional help (tax, accounting, legal etc)

POA Permutations - Many variations are possible in a POA to suit individual circumstances, including: when the POA starts (immediately, or upon incapacity) or stops (it ends automatically upon death but make sure it doesn't stop unexpectedly since special language needs to be in the POA to keep an immediate active when you do become incapacitated, since that event normally voids it), limits to the authority being granted, whether it is one or several people as Attorney, and whether they must act jointly or may do so separately, aka severally; and whether the Attorney must account to some third party regularly. Be careful about whether it is a continuing / enduring POA since one without that feature activated before incapacity would cease to be valid upon incapacity.

Consider using a lawyer or notary to prepare the POA – Consider how complex your finances and family situation are. The more complex, the more it makes sense to use a professional to set up the POA and avoid the nasty surprise that a home-made POA is not valid. Without a valid POA, someone will have to face the cost, time and trouble later on to go to court to apply for a POA. If there is no one around to step forward, the provincial government's Office of the Public Guardian and Trustee steps in as a last resort to manage the affairs of the incapacitated. Would it matter that a government official probably won't understand what you want done? If so, picking your own Attorney and creating a POA is the route to follow.

Watch out for – 1) Banks are apparently wont to ask people to sign their own POA forms, which might conflict with or invalidate a general POA. Try to insist on them accepting your own general POA or get words inserted that it does not alter other POAs. 2) Each province has its own variations and those slight differences might be critical. Get one for the province where you live, changing it when you move. If you spend time in the US and have US assets, a Canadian POA may not be accepted. You would need to consult a lawyer in the US state concerned.

Doing the Attorney job is work - Some may imagine that being appointed under a POA is an easy job but it is serious business, more onerous even than managing one's own affairs. There is a fiduciary duty, which obliges the Attorney to act in the person's best interest. The Attorney must avoid conflicts of interest, must keep records, must consult with the person when possible, must keep the other's assets separate from their own. As a result, an Attorney often gets paid. In Ontario, the permitted amount is 3% of monies received and paid out and 0.6% of average annual value of assets administered, though it is possible to state in the POA that the Attorney will not get paid (keeping in mind the Attorney is not obliged to accept the job either and is allowed to resign later on). It is also a good idea to name one or more substitute individuals as backup in case the first Attorney is unavailable for whatever reason.

Joint ownership and and Living Trusts as alternatives – It is possible to transfer property to joint ownership or to a trust, but those solutions have their own issues. Amongst the issues: deemed disposition rules can occasion capital gains taxes; risks of abuse by the joint owner, or dispute among siblings if only one is named joint owner (was it a gift, an advance on inheritance or merely a means to allow administration on your behalf? etc); exposure of the joint assets to the joint owner's creditors, spouse or estate; when the asset is real estate, joint ownership requires consent of the joint owner for sale, which will be problematic if you have become incapacitated, plus the provincial Public Guardian may decide to get involved; costs of tust administration if professionals are hired. Professional expert advice may help a lot to unravel the best option.

Resources:

BMO Retirement Institute – videos and paper Financial Decision-making: Who Will Manage Your Money When You Can't? on mental incapacity from medical and legal viewpoints, points to consider in creating a Power of Attorney.

Sandra E. Foster, You Can't Take It With You – Common Sense Estate Planning for Canadians, 5^th edition, John Wiley & Sons, 2007

Douglas Gray and John Budd, The Canadian Guide to Will and Estate Plannning, 3rd edition, McGraw-Hill Ryerson, 2002

Ontario Power of Attorney kit – pdf link from the Ministry of Attorney General

British Columbia Enduring Power of Attorney Form pdf link; Nidus Personal Planning Resource Center and Registry – centralized registry for POAs in BC with many FAQs

Alberta, Manitoba, New Brunswick, Nova Scotia, Yukon, Newfoundland and Labrador – info links but standard forms not available

Saskatchewan Enduring Power of Attorney and Common Questions at Ministry of Justice and Attorney General

Quebec – pdf link My Mandate in Case of Incapacity instruction booklet and forms at Curateur Public du Québec; prior to incapacity - Power of Attorney sample text with rules explained at Ministry of Justice

Nunavut (formerly North West Territories) – pdf backgrounder and forms

"Something Will Work Out" Retirement Planning

Benefits Canada reports in Retirement income adequacy still a problem for pension plan members some scary results of a survey of pension plan members by pension consultants Towers Watson. That people "just aren't getting it" and not even using such retirement tools as employers make available and just hoping and trusting that "something will work out" for retirement doesn't augur well for the future. The article also notes the continuing shift from Defined Benefit pension plans to Defined Contribution retirement savings plans, which places more onus on the individual to both save enough and to invest wisely. Towers Watson goes on from these to talk of other warning signs. Is all this likely to work out well?

Meanwhile, the progress (recently tabled federal legislation) on the federal government retirement solution for the private sector, the DC-type Pooled Retirement Pension Plan, is revealing some interesting features of the PRPPs. The banks and insurance companies are apparently objecting to established pension plans like OMERS trying to get in on the action claiming that OMERS has unfair advantages on costs and regulation. Hmm, so now we see an admission that PRPPs run by banks cannot and will not do as good a job (costs, planning assistance etc) as traditional DB pension plans run by purpose-built organizations for public servants. Is there something wrong here?

Pooled Retirement Pension Plan Draft Legislation Revealed - Will PRPP Help?

Last Thursday November 17th, the Federal government announced and tabled draft legislation (Bill C-25) for creating Pooled Registered Pension Plans.

Will this help the target group - people who have no company pension and are not voluntarily saving through RRSPs or TFSAs? The answer is a mild "yes" in absolute terms and a resounding "no" in relative terms.

Yes, it does help somewhat.

• Anything is better than nothing - The most critical problem is that those people right now are not saving for retirement, so any program that gets them to save will help. Despite the provisions of the PRPP legislation that do not require companies to opt in and that allow individuals to opt out, the default auto-enrollment rule (par.39(1)), the default investment option rule (par. 23(3)) and a default contribution rate (par.45(1)) will be quite effective in getting more people to save. "Nudge" works.
• Cost and fees have a fair chance to be less than for mutual fund RRSPs - Why might there be a grain of truth to the confident assertion by Minister Menzies who told the Globe and Mail, subsequent to receiving financial industry assurances, that management fees will be "substantially less" than they are for RRSPs? 1) Money will be locked into the PRPP unlike the RRSP. You may be able to switch between funds but the fact that the investment management company knows the money will not be withdrawn means less need for cash balances and less urgency for short-term return-chasing by funds that undermine returns. 2) Marketing costs, which are embedded into management fees could well be less since the target market for the financial industry is not the individual consumer but small and medium-size companies. That should mean no glitzy TV ads. There will be no trailer fees to salespeople (aka financial advisors); in fact, the draft bill specifically bans kickbacks by fund companies to employer sponsors (par.33). 3) The regulatory structure should help to control the most egregious overcharging. Good 'ole politics might even have a bearing since the Governor in Council, i.e. the government, gives itself the power to decide what "low cost" fees means (par.76 (1) (j)).

No, the PRPP will NOT help, it may even do harm.

• NoHype Investing author Gail Bebee emailed me her comments, which I think are spot on, so I'll simply reproduce them with my highlighting):
  

  "1. Employers are not required to offer this, or any other, employer-sponsored pension plan.

  2. Employees will be able to opt out at will.

  3. The financial industry, the same folks who charge Canadians some of the highest mutual fund fees in the world, will be managing the pension funds and will have a major say on the fees charged to do so.

  4. More government bureaucracy will be set up to regulate this new program.

  5. RRSPs already offer a similar retirement savings option. The issue is that not enough Canadians participate."

• Wealthy Boomer Jonathan Chevreau's comments in the Financial Post gave some nuance to Gail's points.
• The PRPP will complicate and confuse - The retirement landscape is already tough enough to understand, what with RRSPs, Defined Contribution and Defined Benefit Pension plans and TFSAs. Another layer of complexity is added. How will people make intelligent informed decisions about which to choose under what circumstances? There is no advice-giving component included in the PRPP structure. Blogger Preet Banerjee was right on the mark pointing this out in a CBC article on the announcement. With each province being required to implement its own complimentary legislation, it's a sure thing Canada will add another patchwork of permutations and combinations in rules, all of it totally unnecessary. What will happen when people move to different jobs in different provinces or with different companies? The minister says the plans are portable and transferable but sure as to betsy a lot of folks will end up with several plans. I already have two different LIRAs that cannot be combined (one is federal, the other provincial) on top of an RRSP and a TFSA. Another possibility to add?! Gimme a break!
• Low pay workers will likely get scr***d - Tax-wise, the logic of the PRPP will work the same as an RRSP. In a couple of posts here and here on the HowToInvestOnline blog comparing the TFSA and the RRSP for retirement savings, it is quite clear that anyone earning less than $37,000 is better off using a TFSA. If such workers get auto-enrolled into the PRPP and they don't opt out (who is to tell them to opt out except for lowly bloggers that they never read anyway?), they will be appreciably worse off in retirement. Thanks for your help, government!
  
• PRPPs pale in comparison to the CPP - The much debated alternative solution, that of expanding the CPP, as we have previously argued here and here, meets the criteria of what is needed much better. Over at Moneyville, author and pension expert Moshe Milevsky points out that the Pooled Retirement Pension Plan doesn't even live up to its name. It doesn't provide a pension - a lifetime of secure guaranteed income - at all, it is only a savings and investment plan that will go up and down with stock and bond markets.
  

Later addition: Commenter Leo's new blog PRPP Canada devoted to PRPP (the blog's mere existence is a sign of the additional complexity Canadians are soon to face) contains a link to lawyers McCarthy Tétrault's review of some of the ins and outs of C-25. From what McCarthy says, the law won't require that there be a default option if the PRPP offers a menu of investment (aka fund) choices that a "reasonable and prudent" person could use to assemble a retirement savings portfolio. That's one less small but critical nudge.

One Limit to Financial DIY - Mental Incapacity

There are limits to everything, including being a DIY investor. One such limit is when mental incapacity strikes. It gets to be a bigger and bigger issue as one gets older. The rising prevalence of dementia and increasing life expectancy ensure that it will become ever more common for retirees to become incapable of managing their own financial affairs.

The problem is that when such incapacity strikes, chances are we won't even be aware of it. Worse, even if we are aware, at the point when we have been medically certified as mentally incapable, we lose the legal power to do all sorts of critical things, as the report Financial Decision-making: Who Will Manage Your Money When You Can't? from the BMO Retirement Institute points out, including:

"• prepare a power of attorney
• make a new will, add a codicil to an existing will or revoke an existing will
• put a bank account into joint names with children
• change the beneficiary of your RRSP/RRIF or an insurance policy that you own
• carry out estate planning, such as reducing probate costs
• give investment instructions to your financial advisor."

As the report recommends, a sensible solution is to put in place, long in advance of anything happening, a Continuing Power of Attorney (CPOA), that kicks in automatically if and when incapacity happens. The report also mentions some obvious qualities the person(s) selected to exercise the CPOA power should have:

• the time and willingness to fulfill the responsibilities (BMO says the average time a person fulfills a CPOA role is four years - if you are well advanced in age, it probably isn't the best idea to name someone the same age as you, like your spouse)
• someone in whom you have complete trust (the CPOA has wide ranging power and possible abuse of the power is a major consideration; sadly, even one's own children can sometimes be less than reliable)
• financially-knowledgeable enough to handle your affairs, or astute enough to recognize the need for professional help (tax, accounting, legal etc)
  
  

An interesting issue is what BMO calls "family dynamics", aka family politics, where other children are jealous because only one child is named as the CPOA attorney. In a sense, being picked as a CPOA person is a badge of honour but there is also work involved and like it or not, children do not always have the same capabilities and talents, not to mention availability. Being a Parent is a lifetime job (!) and making sure peace and fairness are maintained while doing what needs to be done may be a key part of setting up a CPOA successfully.

The BMO website hosts five other short worthwhile videos by lawyer Elena Hoffstein and Dr. Michael Baker talking about topics such as: how to recognize mental incapacity; its effects on ability to marry (you can still do it! I can imagine the smart alec comments that one must already be mentally incapable to get married at all... ) or to make a will and the unintended consequences of the two facts together (you may end up with no will at all); pitfalls of joint ownership (of house, investments, bank accounts etc) as a method to address incapacity.

Managing Financial Effects of Health in Retirement: 2) Narrowing Your Own Chances of Problems

The figures in the previous post on health problems that could happen and their likelihood are averages for the population. Everybody's individual chances will be different partly based on genetics – ask yourself how many in your family have had the various ailments – and partly based on your lifestyle actions. You can tilt the odds in your own favour. The same kinds of factors that the life expectancy calculators use to estimate your lifespan will greatly influence your health while alive.

1. Diet – Eat fruits and vegetables. Eat foods with Omega-3 Fatty Acids (helps avoid Alzheimer's apparently). Eat fish and shellfish. Limit salt, caffeine (over 3 cups of coffee per day starts to do damage), high cholesterol and fatty foods. Drink some alcohol – 1 to 2 drinks per day – but taking more is to your detriment. Warning sign - being overweight, or even worse, obese with a Body Mass Index over 30. Oh, and remember to floss as it might keep a heart attack away, according to the Livingto100.com lifespan calculator.

2. Smoking – It's bad, there is no dividing line or upside. Smoking raises chances of cancer and stroke.

3. Friends and Family – Having regular social contacts, loving and being loved, obviously will improve emotional satisfaction with life but there is a spillover into physical health too. Keeping a pet dog or cat falls into this category as well.

4. Exercise – Nature-walking, mall-walking, golf, curling, tennis, treadmill, skiing, ballroom dancing, weights and, why not, sex. Take your pick, anything that requires muscle use, gets you moving, breathing a bit hard and the heart rate up helps bring about healthy life.

5. Brain Activity – Your brain is like your muscles. It needs regular workouts to stay in shape. Keeping your mind active can delay or avoid the onset of dementia. Reading books, blogs, magazines and better, trying to figure something out or learn something about whatever is of interest to you, will benefit your brain. Doing some sort of work, paid or volunteer, where there is responsibility and a sense of achievement, however small in the grand scheme of things, does wonders for the mind. It can also be a good social activity. On-going brain exercise may be a reason people with higher levels of education have lower incidence of dementia.

You can reduce health risks but the fact remains that you cannot eliminate them.

The next post in this series will look at the range of financial consequences of the various types of health problems, i.e. if you get cancer, have a stroke, or get Alzheimer's, what will it cost?

Managing Financial Effects of Health in Retirement: 1) What can happen and what are the odds?

"Odds are you don't know what the odds are."

Gary Belsky and Thomas Gilovich, Why Smart People Make Big Money Mistakes

Health is a big concern to most people as they get older. The image of a decrepit, half-deaf, frail, confused person immobile in a wheel chair haunts us all. Such a prospect is scary, not only for the feeling that life will be joyless and empty but also for the financial implications. Will costs of care bankrupt us? Will we become a resented burden on family? Are financial products that can provide protection like critical illness insurance and long term care (LTC) insurance necessary or worth the cost? How should we go about deciding whether to buy them and what are the alternatives?

Most Seniors Will be Healthy During Old Age and Never Need Long Term Care
This is the encouraging news. People do not get to 65 or whatever retirement age and suddenly become wheelchair cases unable to take care of themselves. In fact, the 2011 OECD report Help Wanted? Providing and Paying for Long-Term Care contains a chart showing that only 2% of the Canadian population as of 2007 was receiving LTC. Most of them are women over 80.

In another study (in the Eight Conference on Health Survey Research Methods), Michael Wolfson and Geoff Rowe of Statistics Canada projected levels of disability in Canada for the year 2021. In the chart below, presented by Wolfson using that data in Projecting the Adequacy of Canadians' Retirement Incomes, the predominant light grey area in the centre is the population with no disability at all and the next area outwards from the middle are those with mild disability, moving through ever darker bands of moderate to severe disability to institutionalized. Note that at every age group moving upwards the vast majority of men and women will be generally healthy and able to enjoy life, even for people in their 80s and 90s. Even in the 90+ age group, only 43% are likely, according to this projection, find themselves moderately or worse disabled.


There is a very gradual increase in the amount of disability with age, but no sudden abyss of decrepitude. There is an increase nevertheless.

The Big 4 Old Age Health Problems
The things that will hurt most, both physically and financially, are:

• Cancer – the biggie at 65, around double the rate of any other problem, hits 8.5% of women, 14.2% of men age 65

• Heart attack and Bypass surgery – affects men more than twice as much as women

• Stroke – tends to have long term consequences since 75% survive a first stroke and 60% are left with a disability according to Critical-Illness-Insurance.com citing the Heart and Stroke Foundation

• Dementia (including Alzheimer's) – much more a woman's disease, it is already significant at 65, rises with age and really spikes upwards in older age, affecting 35% of those over 85. With people living longer and medical advances controlling chronic diseases better, dementia will become an ever greater issue for the Baby Boom generation. The 2010 report commissioned by the Alzheimer Society, Rising Tide: The Impact of Dementia in Canada, projects that the number of people living with dementia will rise from 1.5% of the population in 2008 to 2.8% in 2038. Of course, almost all of that increase will be amongst older people. The following graph from the report shows the huge spike upwards from age 80 that is expected to occur.

The next post will mention a few of the actions we can all take to reduce those odds to live healthier longer. After that, it's on to the the financial consequences of ill health during retirement and then the options for dealing with the financial risk, like various forms of insurance and whether they are worth it. Meantime, where the heck is the darn dental floss?

Working after Retirement Not a Government Conspiracy

Those who observe the recent changes to the Canada Pension Plan rules which punish early retirement and reward later retirement, can be misled into thinking that the idea of working in retirement is somehow a bad thing, that it is a negation of the luxury of complete leisure that we have worked for throughout our lives.

Well, it ain't so. From a purely selfish point of view, working as long as you can is a good thing, even ignoring the money it can provide. We humans are happier and physically and mentally healthier when working.

Within Michael Wolfson's Projecting the Adequacy of Canadians' Retirement Incomes is the following table. Isn't it interesting that when people who are actually over 65 were asked the question what gave them the most satisfaction, work came out on top! That's right - ahead of all those activities people supposedly look forward to doing, like volunteering, dining out, clubs. Now some activities are curiously missing from the questions, such as travel and ahem, intimate activities, but it still confirms what I said before here and here about the merits of working in retirement.

Reading across the table, we can see that over 65s even enjoy work more than any other age group. Perhaps that has a lot to do with the fact that many people in retirement get the freedom and flexibility to do work they like and the hours they like.

It is certainly not all just working for the fun of it though. As Jonathan Chevreau's recent Financial Post article Full retirement a thing of the past noted, a good portion of working retirees need the money too.

Whatever way you slice it, working in retirement is good.

CPP "Diseconomies of Scale" Study by Fraser Institute - Spreading FUD

FUD, for those unfamiliar with the acronym, stand for Fear, Uncertainty and Doubt. It is a familiar marketing technique to make people doubt and prevent them doing something. In this case, the Fraser Institute is applying FUD against the idea of expanding the Canada Pension Plan.

The FUD is found in Should the Canada Pension Plan be Enhanced? by Neil Mohindra, published and downloadable on the Fraser website here. The Fraser summary blurb says:
"The study concludes that diseconomies of scale present a risk to the CPPIB’s investment performance. The actions that the CPPIB is taking to offset diseconomies of scale in investment returns will likely become less effective as its assets continue to grow."

The first sentence is true, the Mohindra study does arrive at that conclusion. The problem is that neither the research it presents, nor other facts, support the statement in anything more than the sophistical (as in sophistry = plausible but fallacious argumentation) sense - yes, if diseconomies of scale do arise, then there is a risk, although not a certainty, that the CPPIB's investment performance will suffer. Mohindra delves into a series of research papers that address aspects of diseconomies of scale/size associated with investment funds and pension funds. Here is why I think we can dismiss the alarmist rhetoric of the Fraser report:

1. If diseconomies of scale were inevitable, the CPPIB would have hit the wall long ago. As Mohindra belatedly notes, "A limitation in applying existing literature on economies and diseconomies of scale to the CPPIB is the sheer size of the CPPIB in comparison to the size of funds covered in the literature." The CPPIB years ago had assets that dwarfed any funds in the literature. Why did CPPIB not exhibit diseconomies of scale long ago? The rise in costs that Mohindra documents about the CPP/CPPIB has become apparent only in the last two years (look at his table A1 on page 34).That rise has less to do with scale than other reasons.
   
2. The higher admin/expense numbers of the CPPIB can just as plausibly be interpreted as temporary, a result of the financial crisis and markets' recovery process combined with the investment mix of the CPPIB. It all hinges on the considerable amount of private equity, real estate and infrastructure investments that the CPPIB has deliberately made since 2006. While stocks on public markets such as the TSX rebounded sharply in 2009, the other stuff has lagged and the higher overheads that go with those other types of investments has driven up those costs as a percentage of assets. It's possible the CPPIB may be fundamentally wrong about investing in such other assets (along with many other pension plans out there, like the Alberta Teachers' Retirement Fund Board whose 2010 annual report announces that it has switched its investment policy to go in that direction). However, the explicit aim of the CPPIB is that such assets present the opportunity to gain higher returns that more than offset the higher fees. It is ironic that Mohindra quotes a speech by CPPIB CEO David Denison where Denison sets out a vision for using scale as a competitive advantage. If scale is a reality, I think I prefer the "glass half full" view (opportunity) from the CPPIB over the "glass half empty" picture (diseconomies) of the Fraser Institute.
3. The pursuit of private equity, real estate and infrastructure by the CPPIB, rather than being a symptom of incipient diseconomies as Mohindra claims, is in fact the appropriate response and strategy to keep costs low and maintain superior risk-reward results. One of the studies cited by Mohindra, that of Dyck and Pomorski confirms that the CPPIB is following the successful path of other large funds: "In their private equity and real estate investments large plans have both lower costs and higher gross returns, yielding up to 6% per year improvement in net returns." Furthermore, most of the increase in operating expenses of the CPPIB during 2009 and 2010 came from the ramping up of internal management capability to replace external managers, another factor that Dyck and Pomorski say is a significant source of cost savings for bigger plans. It looks more like like CPPIB is on the road to exploiting increasing economies of scale, not butting up against diseconomies.
   
4. Governance matters a lot more than scale. Small organizations can be poorly run as easily as big ones. A much more convincing explanation of what determines the success of a pension/investment fund comes from Keith Ambachtsheer of the Rotman International Centre for Pension Management. Pension organizations properly aligned with the interests of the pension benficiaries, proper definition of roles between a board and professional management, appointment of financially knowledgeable and independent individuals to boards, effective risk management processes - those are what get good results.
5. The CPP's overheads, if they were to stay at current total all-in levels of about 1% (total operating expenses in 2010 of $498 million Government of Canada plus $236 million CPPIB plus $466 million in external investment management fees on average CPP total assets of $120,721 million per Volume 1 of the Public Accounts of Canada with CPP data starting page 171 of the pdf), or even rise further, are still small compared to the all-in costs of alternatives, like TFSAs and RRSPs. Start adding up the costs of mutual funds where most people place their retirement investments, or even of the best case lowest fee ETFs around, then add fees like deregistration/withdrawal fees from RRIFs, or the implicit charges when buying an annuity to turn the savings into retirement income (read Peter Benedek's series on annuities on this page of his RetirementAction website to see how poor a deal they are). The average person will be losing more in various costs than 1%. This ignores the "costs" from investing mistakes that so many people make along the way when left to do it themselves in TFSAs and RRSPs.
   

Instead of concluding that "the size of the assets the CPPIB will be managing even without expansion shows that diseconomies of scale is a reason not to expand CPP", Mohindra would be more accurate in saying that "the opportunity to exploit economies of scale is a reason to expand CPP".

The large size of the CPPIB portfolio is NOT a problem. As long as CPPIB governance and management continues to be good, the move into private equity, real estate and infrastructure provides opportunity, not rising risk. In the 2006 speech quoted by Mohindra, CPPIB CEO David Denison also mentioned that the size of private market opportunities is vastly larger than those in public stock markets. It is a good thing for CPPIB and for Canadians who have their money being invested there by the CPPIB.

The 4% Retirement Withdrawal Rule: International Data Casts Doubt

There is a rule of thumb that says a person can withdraw 4% of the value (as of the date of retirement) of an investment portfolio and adjust the amount every year for inflation without fear of running out of money. A prime proponent of this idea is William Bengen (review of his book here) who based his conclusions only on US data.

Not all countries are created equal, so a key question is how people elsewhere might have fared using the 4% rule. Along has come Wade Pfau and his provocatively titled paper An International Perspective on Safe Withdrawal Rates: The Demise of the 4% Rule in the February 2011 issue of the Journal of Financial Planning. (Author Pfau has his own blog here)

The results are not very encouraging: "... from an international perspective, the 4 percent real withdrawal rule has simply not been safe." Using data over a longer period from a different source than Bengen (but which validates Bengen's results about the US), Pfau calculated what would have happened in 17 developed countries using quite generous assumptions and found that in only three other countries - Canada, Sweden and Denmark - the 4% rule would have worked out.

The paper's main aim is really only to get a feel across different countries. It deliberately excludes several extremely important factors that could dramatically alter the specific maximum Sustainable Withdrawal Rate in realistic conditions:

• mainly downwards - no adjustment for rebalancing trading and fund management costs to the index data, no taxation on returns, using the stock vs bond allocation that gave the best result, as if the retiree could perfectly forecast the best combo for the next 30 years;
  
• or upwards - possible other asset classes like REITs, foreign stocks, small cap stocks, value stocks; longer rebalancing intervals than yearly
  

The study confirms another Bengen US finding, though exact figures vary country by country: stocks always comprise a substantial part - at least 50%, some up to 100% - of the portfolio that had the best SWR; for Canadians that was about 50%.

A scary bit to the paper is table 4 (which appears in the blog article version but not in the FPA version). Table 4 shows that for an arbitrary commonly cited 50% equity/50% bond portfolio (as opposed to the stock bond split that gave the best result), in no country would a retiree never have run out of money using the 4% withdrawal rate.

The key question highlighted in the conclusion applies to every country. The past is all well and good but for any particular country, which past will most resemble the future? Will the US or Canada continue to outperform compartheed to everywhere else
or will they revert to some lower international mean? One can simply blindly lower the SWR e.g. to 3.5% or 3%, or try to adjust expected future stock and bond returns using current relative valuation.

The even larger issue for the retiree is whether an investment portfolio with systematic withdrawals is the most appropriate way to fund retirement expenses. I don't believe so. I've already noted objections to the 4% SWR approach by Scott, Sharpe and Watson. The critical correction needs to be that assets should be matched with liabilities in terms of income risk (variability, default) and timing of income.

Alzheimer's: NOT a Reason to Become Bilingual

Any news about Alzheimer's attracts my attention these days since it will become the major health issue for Canada as the population age profile gets older and it will have many financial consequences for retired people.

It is thus that a press release from the Baycrest health institute affiliated with the University of Toronto announcing with breathless seriousness that "A Canadian science team has found more dramatic evidence that speaking two languages can help delay the onset of Alzheimer's symptoms by as much as five years." Wow! Here comes the government with programs for teaching French, English or other second languages (any two will do, apparently). As a bilingual person I would love to believe the conclusion but skeptical me wonders if these professionals have made a very fundamental mistake in confusing association or correlation with causation.

Do a Google search with the words spurious correlation and causation and read the dangers of confusing the two ideas. One of my favorites is the video Everything is Dangerous: A Controversy from the American Scientist in which many spurious claims in medical research are dissected by Stanley Young Director of Bioinformatics at the US National Institute of Statistical Sciences for their faulty science and application of statistics. The most basic smell test - does this sound too incredible to be true? - when as they say themselves "There are currently no drug treatments that show comparable effects for delaying Alzheimer's symptoms", should make everyone highly suspicious. The lack of any reference to a physical causal (chemical, biological etc) process to link language-speaking with slowing down the brain gunk (to use a term that shows the depth of my medical knowledge on the subject) present in Alzheimer's undermines my confidence in the announced results even more.

The researchers say they are "dazzled by the results" in the original 2007 study announcement from Baycrest. Too ironically true.

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
  

Pension Reform and What Retirees Need

Pension reform in Canada seems to be gathering steam, a too-rare and laudable case of government taking action before, instead of after, the crisis hits. (Those who look at the fact that today's pensioners are doing relatively ok and that therefore no need for action exists should read the June 10 TD Economics piece Retirement Income Security Reform in which they project how things will evolve if nothing changes.)

Some proposals seem to ignore what a pensioner really needs, so here is my list of qualities that retirement income should have. It is based on the simple principle that a base pension needs to support a continuation of basic lifestyle spending, the everyday needs that are constant, non-discretionary, fixed, lifetime and that consequently the pension should have similar characteristics.

1. Guarantee / highest possible security - when it is your grocery money or your heating bill, it absolutely needs to be there. Retirement should be about peace of mind. So the question is, which organizational pension provider rates highest? Government might be that entity but can it keep its grubby hands off money set aside for the future if Canada goes back to the 1980s deficit and debt era? Is CPP and its associated investment body the CPPIB enough "arm-lengths" away to ensure no fast moves by future crimped governments? Are banks and insurance companies stable enough, even with guarantee funds in place?
2. Fixed frequent automatic payment - the income needs to be constant to enable family budgeting and money management, it needs to be regular and frequent, ideally monthly, at worst quarterly, and ideally automatically deposited into a bank account to make financial life easier and simpler to manage. In the accumulation years prior to retirement the saving process should be just as easy, automatic and regular.
   
3. Inflation-adjusted - this point is critical since the government policy rate of 2% inflation (actually 1-3% is the official range) will hugely undermine the purchasing power of a fixed amount over a 20-30 year retirement, which is the new norm due to rising life expectancy.
4. 40-45% Income Replacement - this level is a trade-off. It is deliberately a bit below the usual minimum of 50% pre-retirement income replacement to maintain lifestyle. People will be squeezed a bit, not far from the 50% goal so that the goal can be easily achieved by either a bit more saving during pre-retirement or a bit of work during retirement. Giving an incentive for people to work during retirement is doing them a favour since they will be healthier and happier.
5. Lifetime - ultimate peace of mind requires that people be assured of receiving the steady income for as long as they live, whether it is 65 or 105, and not have to worry (hope?!) about dying before the RRIF runs out.
   

The above list leads to a set of criteria and features needed in a pension scheme:

1. Mandatory participation - everyone must be in it for several reasons. The sad reality is that, left to their own volition and devices, too many people do not save enough out of their income for their retirement. The automatic default enrolment, with people allowed to opt-out, has pretty well the same effect since few people bother to opt out. Buy why beat around the bush - in exchange for the guaranteed lifetime inflation-adjusted income it seems a fair trade to be obliged to participate? The other reason is,
2. Large pool of participants for longevity risk sharing - a big challenge for individuals in financial planning of their retirement is not knowing how long they will live. Population averages, on the other hand, are known more or less to the decimal point of years. That allows much more precise planning and lower safety buffers for a fund than an individual must have. The "mortality credits" of those who die sooner allow higher payments for all than any cautious person could achieve using the commonly accepted 4% safe withdrawal rate from their own RRIF. The pension stops when the person dies. There is nothing to pass along to heirs. The purpose of the pension is not for a legacy, it is to fund lifetime living expenses. The people who die sooner than the average subsidize those who live longer. (Mandatory participation gets rid of the issue of adverse selection, whereby people opt out when they think they will die sooner than others.) But it is a fair exchange in my mind - give up the possibility of a legacy for certainty and the peace of mind of knowing the money will not run out. Families/children are saved the worry or actual burden of having to financially support parents in old age. As a result, big plans with hundreds of thousands, if not millions of people enrolled, are better. Actuaries can figure out the exact scale required and then the feasibility of private pension schemes can be judged. A national program obviously has the largest scale.
   
3. Low administrative cost - costs directly reduce money available to the pensioner, so a pension fund should max out at perhaps 0.2% of assets on the investment side - the CPPIB proves the investment side can be done cheaply as its overheads amount to under that figure. What costs are reasonable on the collection and payment side, I do not know. Can the private sector compete? Update 8 September2010 - It seems that the experience in other countries where mandatory enrolment retirement investment schemes have been set up, private sector fees are way too high, as FT reports in Why Proceeding with NEST is Crucial (hat tip to RetirementAction for the link)
   
4. Fiduciary obligation - a pension fund must first and last put the direct and quite narrow financial interests of pensioners ahead of anything else. That means ahead of private sector profits or other government policy objectives like economic development. A very large pension fund will want to (and probably need to because of its scale) go beyond Canada's borders to invest. There should be a high degree of transparency in all regards for such a fund. Again, CPPIB is a good model.
   
5. Long term investment view and perpetual investment horizon - individuals in retirement are critically aware (at least those who know what they are doing are aware) of their uncertain lifespan and their decreasing or expired ability to weather possible long periods of poor stock investment returns. As a result they must adopt a very safe portfolio, which in the long run means lower returns. A perpetual fund can be more ambitious and expect to ride out down periods of a decade or more. That will mean a higher allocation to equities and higher expected returns than an individual could do. It can also have access to, due to scale, to illiquid private equity and infrastructure type of investments, with the capacity to wait for fruition. Individual investors do not, and can never, have that capability.
6. Professional management - properly trained and motivated (cf fiduciary duty) professional managers have the capability to find and exploit market inefficiencies (which of course is the very mechanism that brings markets to be generally quite efficient). Very few individuals have the knowledge and even fewer have the scale of funds required to do the same profitably. Professional management have the potential to be less susceptible to the errors indentified in behavioural finance if good control systems are put in place. Professional management can have the knowledge to apply finance theory for critical tasks like asset allocation.
   
7. Portability - the pension should not be tied to a particular public, private or self- employer or province and should follow the person throughout their working life and through retirement. It should be a baseline pension, which individuals or companies can use to plan supplementary savings and investments.

In my next post, I will take a shot at rating how two pension options - the Canada Pension Plan vs a RRIF/LRIF - stack up against the above criteria.

Note that the above does not address health risk, which even in socialized medicine Canada, can have appreciable negative financial impact in retirement. A significant portion of retirees will end up needing to spend a lot more all of a sudden in a lumpy amount for a critical illness or for long term care.

Financial Literacy Proposals - You Gotta Be Kidding!

Amongst the less-than-sensible ideas floating around these days is the notion that the general population can be sufficiently trained to successfully manage on their own all their finances, investments, pensions and the like. There's even a national task force doing the rounds of consultation to come up with a strategy.

There are two big reasons that proposals to improve financial literacy don't make sense:

1. It's not knowledge, it's behaviour that is the key problem people have - not saving enough and taking too much debt results more from lack of judgment and self-control not from knowing the difference between simple and compound interest. The large and growing body of research on behavioural finance shows that the main impediment to financial and investing success is the irrational decisions we are all too prone to make. I do believe it is possible to train people to a certain degree - some people being more naturally capable of being trained, just like some people learn to play golf faster than others, even with lessons. However, I seriously doubt that the task force will be going down that path (unless somehow the "skill" they define as being part of financial literacy means the ability to manage their own reactions, impulses, fear, greed, over-confidence, framing errors and all the other quirks, foibles and thinking errors identified in behavioural finance).
2. It is rocket science - whenever people give out simplistic financial advice it reminds me of simple instructions for playing the clarinet "just blow in the top and run your fingers up and down the holes". Modern finance is not simple. Part of the cause of the credit crunch and financial crisis is apparently that the executives of the banks did not themselves understand the models and products concocted by the math and physics PhDs. Look at the random page below from the book The Calculus of Retirement Income by Moshe Milevsky one of the few dozen people on this planet who properly understand how pensions work. I don't know about you but I have an MBA in Finance, I have spent the last three and half years reading and blogging about investments and personal finance and I estimate it would take me about another two years of hard work to relearn math sufficiently to really understand what he has written.
   

Noted author William Bernstein writes in his latest book The Investor's Manifesto: "I have come to the sad conclusion that only a tiny minority will ever succeed in managing their money even tolerably well." By managing their money, he means the ground-up type of DIY investing that is assumed when the leaders of our society foist defined contribution retirement plans and RRSPs upon us and pretend that we will be fine with a little "financial literacy" i.e. technical knowledge of finance. Bernstein does propose some relatively simple methods, imperfect but much better than what happens now, but I doubt they could be adopted as public policy education goals due to their bias in favour of some specific industry products like index funds and against others like actively managed mutual funds that are perfectly legal though harmful to the investor.

So what could and should be done? First, I believe the government should undertake public behaviour modification in favour of saving more and borrowing less. A societal attitude change is necessary - like anti-smoking and anti-drink driving. Second, proper retirement income reform that considers first and foremost the income needs of retirees along with the risks they face in retirement needs to happen. I'll post more about that tomorrow.