Tuesday 25 June 2013

Steps Foundation Stock Contest raising money for financial literacy - how ironic is that!

The other day I received an email from a member of the Steps Foundation, promoting their latest fundraising venture, an online stock contest with play money and real stocks. For a $50 entry the biggest portfolio after 1 month (contest starts June 25, though one can apparently enter late, and ends July 26).wins half the money from the total of entry fees (I cannot find the rules on the website, maybe they appear after one has paid, but I know because the email I received had the rules attached). Now the Steps organization looks legit (yes, I did check it out some since scammers are not confined to Nigeria) and their aim to raise funds to support other organizations that actually teach financial literacy by debt counseling and that kind of thing does jive with what I try to do informally with this blog. So I do have some sympathy for their aims.

However, the contest itself exemplifies the very worst way to approach the stock market, as a kind of short term lottery to make the most money in the shortest time. Maybe the Steps people, who are all financial professionals themselves, intend to write something afterwards to say "don't actually try to invest like this in real life, because you will surely lose all your money in a very short time". Given recent market action, the best strategy might well be to sit tight with the initial play cash anyway. That would certainly be a fitting and truly worthwhile financial lesson if it did happen.

Maybe if they modified the rules so that the winner would be the person with the highest Sharpe ratio aka most return per unit of volatility they might provoke some real financial literacy by obliging people to learn about and to consider that important concept and it might be a good contest too, instead of a pure game of chance.

Thursday 20 June 2013

Pension funds are thinking seriously about sustainable investment

Sustainable investment, aka Socially Responsible Investing (SRI) or Environmental Social and Governance (ESG) oriented investing to many people has the image of being the domain of fringe do-gooders. That's not so if one is to judge by events like the recent workshop held at U of Toronto's Rotman School (that's a management school, not a sociology or arts school). The workshop (U of T press release here) had a lot of pension industry heavyweights from Canada and around the world like the CPPIB, Ontario Teachers, Caisse de Dépôt, TIAA-CREF, CalPERS discussing what was worth doing and how to do it. U of T has made available the workshop notes here. The notes have links to background papers and to headliner Al Gore's (yes the real Al Gore and he actually took part in at least some of the workshop) paper on Sustainable Capitalism.

There is a lot of emphasis on investing with a long-horizon, an idea that seems to unite pension funds and socially/environmentally focussed people in the five main topics the workshop covered - stranded assets (what happens when climate change or price of oil destroys business models), integrated reporting (going beyond financial-only reporting to include social etc), evils of quarterly earnings guidance (stop being so obsessively short-term!), executive compensation (wrongly structured and excessive) and constructive investor behaviour (i.e. acting more like a long-term investor)

Some notable comments:
  • executive compensation "...the current executive compensation situation constitutes a ‘market failure’ situation in the sense that there is no obvious relationship today between executive performance and the levels and structures of executive compensation. ... the sense in the room that a strong, coherent collective action initiative is needed " If the big pension funds develop an activist stance on compensation and do it the right way, maybe they can break through the incestuous self-reinforcing cycle of upwardly ratcheting executive compensation, a problem I have written about before.
  • constructive investor behaviour "The key concept here is the broad adoption of ‘concentrated long term investment mandates ’ that require investor engagement. This would be a radical departure from the traditional Keynesian ‘beauty contest’ style of active management, and also from the broadly-diversified ‘formula’ style of passive management. A high number of workshop participants judged this to be a potentially high-impact initiative at the individual fund level." In other words, the pension fund people attending think this is worth doing and they see themselves doing it. Unlike joe average investor who can only influence by voting with his/her feet, when a giant pension fund calls, or several do, big-shot CEO and aloof Board are likely to listen. The swipe at passive index-ETF style investing is interesting - most individual investors in such ETFs are probably there because they believe the mantra of investing for the long term yet because of the passivity they can only take what they get, including those companies who operate only with a short-term horizon.

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.

Wednesday 12 June 2013

Mutual Funds - what's wrong and what needs to be done

Long time investor advocate and member of the Ontario Securities Commission investor advisory panel Ken Kivenko tells us how the mutual fund sales, distribution and advice system in Canada is fundamentally and critically flawed and what needs to be done about it in his latest post Eliminate embedded commissions and professionalize advice.

I must admit that I haven't paid much attention to mutual funds and have not owned any for many years since I became aware of the issues Ken so succintly and forcefully summarizes. So I was surprised to read in his piece that despite the industry going on about how the invisibly embedded commissions pay for advice, there is actually nothing in the industry standards about how and what advice must or even should be given.

FAIR Canada in its submission on mutual fund fees to the too-numerous (but that's another problem) Canadian securities commissions provides a longer and more detailed take on the required reforms.

There is lots more support for change on blogs and in the press, e.g. links in on the FAIR website, so maybe there is hope for change. Should reform happen, I might even consider mutual funds again.

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