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You may be able to switch between funds but the fact that the investment management company knows the money will not be withdrawn means less need for cash balances and less urgency for short-term return-chasing by funds that undermine returns. 2) Marketing costs, which are embedded into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.

WaterFurnace Renewable Energy Inc 3Q2011 Results

In September 2010, I reviewed WaterFurnace Renewable Energy Inc (TSX: WFI), a manufacturer of geothermal heat pumps, and decided to buy shares. Four quarters on, how do things look?

Industry Prospects - The business environment remains weak.

• Residential slump continues - US Housing starts, a prime driver of demand for WFI's residential products, continue at an extremely low rate of about 500,000 - 600,000 starts per year vs historical norms well above 1 million. That situation doesn't look set to improve soon. In the latest conference call and in the published report on Q3 results, company management says it expects 2012 to see an overall industry decline of 10-15% for residential geothermal heat pump sales in the USA. Residential products, according to WFI management, have a higher profit margin than the commercial products that the company has emphasized to fill the sales gap. New housing, in which the substantial initial capital cost of geothermal is embedded and financed by a mortgage for amortization over a long period, overcomes the sticker shock impediment to geothermal's market success.

Financials - The overall picture is that the company is maintaining its financial strength, or even improving it slightly, in the continuing difficult environment.

• Gross Profit Margin - GPM seems to be staying about the same. This is not so bad considering the shift in product mix from residential to lower margin commercial. But GPM is not improving as management says on page 3 of the Quarterly report - if one adds back the $727k difference for Q1-3 of 2011 that resulted from the change in method of calculating Warranty costs (page 31), then GM is not 37.7% as stated but only 32%, which is at the lower end of those in the last five years according to ADVFN.
• Net Profit Margin - The same ADVFN page shows that the NPM has stayed quite stable at around 10% through the last five quarters.
• Cash Flow - Whether it is by simple cash flow from operations or including capital expenditures (or depreciation instead of capex since the relatively new factory doesn't seem to be needing much investment for now), 2011 results are stronger than 2010 which were an improvement over 2009. WFI is thus adding to its cash reserves, probably more than it has an opportunity to spend effectively at the moment. No doubt this has enabled and justified the announced increase this quarter in the dividend from USD$0.22 to $0.24 per share.
• Dividend - The strong and improving cash flow, along with complete absence of debt on the balance sheet, indicates that the dividend is quite sustainable. The dividend salves the pain of the stock price drop since last year.
  
• Warranty Reserves - The rapidly rising warranty reserves, a non-cash liability but one which eventually happens in cash if the estimate is correct, could become an issue down the road. About half the increased liability, according to note 12 on page 31, in the first nine months of 2011 came from increased claim rates, not merely extra sales of units. It does not yet come to a level that is at all a problem but might be something to monitor.

Market Share - In the Q3 report, management states that it is gaining market share but the story is not so clear to me. It may be a question of how one defines the market.

• WFI's sales increased 2.3% in the first nine months of 2011 while competitor LSB Industries saw a 19% rise (cf its Q3 report).
  
• Though the numbers are out of date and have not yet even been released for 2010, WFI's shipments fell from 2008 to 2009 (as indicated by the figures Indiana) while those of LSB rose (cf the numbers for its home base of Oklahoma) according to the US Energy Information Administration website.

Insider Trading - Company insiders are keeping the faith.

• The only activity in the past six months (see CanadianInsider.com here) consists of stock purchases or dispositions by gift.

Strategy - The theme at WFI seems to be "steady-as-she-goes".

• The HyperEngineering acquisition earlier this year has not been mentioned in the last two conference calls and is a minor revenue generator ($2.9 million in total with regular WFI international product sales) with a profit margin of around 8% (cf page 26 of the Q3 report), slightly less than the overall company margin.
• Cash is being given back to shareholders through dividends instead, for instance, being kept in the company to make acquisitions
• There are no initiatives to address a key issue of the large capital outlay required by a residential homeowner doing a retrofit conversion to geothermal of an existing home. The development of options to allow customers to finance installation costs as well as other strategic challenges and opportunities is laid out in the business school case study on WFI prepared by Charles Shanabruch in 2009.
  
• Not much has changed since that date under CEO Tom Huntington who took over from the dynamic former CEO Bruce Ritchey. Perhaps the only glimmer of a new direction is international sales expansion beyond the USA and Canada, where the tiny sales volume tripled despite receiving no focus by management.

Valuation - Somewhere above the low end valuation of $29 per share that I estimated last year seems reasonable.

• WFI has grown EPS 4.5%, and Free Cash Flow from negative to positive, over 2010; both are positives
  
• US housing starts remain flat, a constraining negative that tends to the lower valuation. The guess/assumption last year that it might take two years to get back to normal levels should probably be re-stated as two more years from today in order to be conservative.
• The stock price of WFI has slumped considerably from the $25-26 range of last year to around $19 nowadays. That makes WFI an even better value. Last year I said that WFI is a good buy, but for the long term. That is still my view.

Disclosure: I still own the shares I bought last year. I even bought more at around $21.

Disclaimer: This post is my opinion only as to how and why I came to my own investment decision. Whether you agree or not, it should not be taken as investment advice.

Book Review: Financial Statement Analysis by Martin Fridson & Fernando Alvarez

Any book that reaches its 4th edition (updated to 2011) should be good. That's true in spades for Financial Statement Analysis. Fridson and Alvarez have written a classic. It should be required reading and a constant reference source on the bookshelf of any investor intending to buy individual company stocks or bonds. It is a book for those who intend to follow Warren Buffett and increase the security of their investments not by diversification but by depth of knowledge and confidence in the companies whose securities they hold.

The book is not primarily an accounting text in the sense of indicating the mechanics or the theory of accounting. It assumes basic familiarity with balance sheets, income statements and cash flow statements. What the book does thoroughly and brilliantly is to explain how to analyze and interpret the numbers to enable an investor to figure out what is really going on in a company.

The authors take account of and put heavy emphasis on the motivations of company management for their own personal ends - everything from presenting results in the best light at the legal end to outright fraud at the illegal end. Through many simple examples they show where and how to look for signs of manipulation of accounts. They admit the limitations of even the most expert analysis. They note, explain and give examples of the necessity to be wary of auditors, regulators and boards of directors. Frank and severe commentary abounds but the book is not a diatribe and the reader is not left with a sour or negative view. It is entirely practical and realistic. The book moves the investor from the textbook into the real world.

Though not to the same depth, the book also explains how industry conditions need to be taken into account in interpreting financial ratios. It explains how factors like seasonality, cyclicality, capital intensiveness, size of company, maturity of the company or the industry all can impinge on the safety/danger of debt or equity and the relative over-/under-valuation of securities. Want to know the hows and whys of leveraged buyouts, mergers, serial acquirers, stock buybacks, reserves and write-offs? This book will tell you.

The viewpoint is that of an investor arming him or herself with defensive detective tools. Its motto could be the modification of the adage "trust but check" to "check, and keep checking".

One of the surprising, given the subject matter, and delightful features of this book is that it is highly readable and accessible. The writing style is engaging with enjoyable turns of phrase, the sentences are understandable and never confusing, the examples are simple enough but not too simple, the organization of topics within chapters flows naturally. The authors have mastered the art of providing just enough detail - sometimes only a little, sometimes a lot - to make their point.

My Highlights:

• The walk through the dividend discount model is the most intuitive and insightful version I've come across.
• The five pages on Nortel weave together the methods (mostly abuse of accruals) and motivations (management bonuses) of the company's death spiral into a succinct morality tale.
• My strongest takeaway is a sense that the integrity of management is a critical element to judge since there are so many ways for manipulation to be done and it can be very difficult if not impossible to detect till it is too late.
  

Caveats:

• Page 232 reflects a small lapse in updating the new edition as the dates in a table do not match the text and the table on page 234 does match the text, though one can still understand what is going on. Perfection is hard to achieve!
• The reader can only gain understanding through this book. Being able to apply the knowledge would require a person to work through examples to fully absorb it as a practitioner. Presto! The authors have written a companion Workbook.
  

Rating: A gem, 5 out of 5 stars.

Individual Investors Need a Strong Ombudsman

OBSI. It looks like another boring acronym ... until your investment advisor screws up costing you money, refusing to reimburse or compensate you when you complain. Then the OBSI (Ombudsman for Banking Services and Investments) becomes a top of mind way to get redress.

It seems to have been doing too good a job, at least for investors, since the financial industry is now ganging up to undercut, criticise and opt out of OBSI being the one and only dispute resolution body (see various articles in the Financial Post over the last few months).

In fact, far from being watered down the OBSI needs to be protected and strengthened as a recent review commissioned by the OBSI Board suggests in the package of balanced recommendations that meets both consumer and justifiable industry interests. But the industry thinks the report is "delusional" according to a quoted reaction in a Financial Post article by Theresa Tedesco.

The financial industry needs to realize is that in-reality fair, and perceived-by-consumers to be fair, dispute resolution is good for it. One of the lasting psychological effects of the credit crunch is that bankers and investment dealers are a bunch of devious, avaricious crooks (witness the "Occupy" protests), lining their pockets and then letting taxpayers or investors take the fall. The industry's current campaign against OBSI reinforces the negative perception by showing unwillingness to fix errors or misdeeds . As both a shareholder in Canadian financial firms (directly and through ETFs) and an investor / consumer I want to see a fair, balanced system, not one that stacks all the advantages on one side (the FP Tedesco article cited above makes reference to the statistic that industry already wins 70% of cases adjudicated by OBSI - is it only 100% that is acceptable?).

It's not just perception either. When effective penalties are known to occur, firms will tend to improve their internal processes and controls so that problems don't arise in the first place. Industry calls this zero defects or six sigma. Consumers call this peace of mind.

What really needs to happen is for the federal minister of Finance Jim Flaherty to put the OBSI function on a stronger footing through permanent legislative authority on a national level, instead of its present voluntary, industry-funded status and to include insurance in its mandate.

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.

Investor Fraud: the IFFL Brost Sorenson Case and How to Caveat Investor

The indefatigable Ken Kivenko of CanadianFundWatch.com (I don't know how he manages to keep positive given the seeming endless flood of info he collects and analyzes about the weaknesses of investor protection in Canada) sent along a CTV W5 video link to Who is protecting your investments? on the latest yet-to-be-proven-in-court fraud perpetrated on investors - that of the Institute for Financial Learning (IFFL) operated by Milowe Brost and Gary Sorenson. It's a sad and shocking tale, especially in view of the fact that the RCMP and the Alberta Securities Commission have been completely ineffectual in preventing the fraud. If the past is any guide, little or none of the many millions that have disappeared will be recovered and the perpetrators will not suffer any punishment, except for having to spend years going through the legal system while drinking their pina coladas in Panama or wherever.

It is one thing for us to indulge in gawking at the financial catastrophe of others or to stoke our anger at the various "SOBs" who fail in their duty to protect us. More important is to remind ourselves how to do due diligence or exercise caution before we invest - a penny of investigative prevention is worth a million dollars in lawyer cure.

1) Official Sources like the various provincial securities commissions, the RCMP, e.g. through links in my previous post on this subject Scam and Investor Fraud Alert Sources - Fraudsters often do it again and again so they may well show up in previous judgments (maybe it's the light penalties and sanctions that encourage them? just asking). Do a search for Brost in the ASC website and lo and behold we see him caught doing naughty things way back in 2005.

2) Google search - Ain't the Internet handy, typing in Milo Brost brings up a whole host of links that would or should raise a dubious attitude. One that is wryly amusing is this 2004 Institute for Financial Learning discussion thread on www.scam.com where a certain Winer says the promised 40% return is entirely reasonable and is not a warning flag! The Internet savvy will always have their idiot and BS detectors in operation I hope. Bottom line: Trust, but verify. The more the stakes, the more you need to verify. The hard-hit couple featured in the CTV story did the former but obviously not the latter. It might even be worthwhile to get a second opinion from someone else with your interests at heart and without an interest in the potential investment.

The obvious answer to the CTV W5 title question right now is "you yourself, my friend, you are the only one protecting your investments". Caveat investor.

PS In one of my Google searches for this post, I came across the Behind MLM blog, an amusing anti-scam site. It also displays Google ads, one of which advertized a "200% Return on Investment Exclusive Diamonds from £5k". With the Google good comes also the bad ...

Book Review: The Rules of Risk by Ron Dembo & Andrew Freeman

The book isn't just about investing risk though the book's subtitle is "A Guide for Investors". This must have been added by the influence of the publisher since the more accurate description of the content is on the back cover: "A Dynamic Framework for Forward-Looking Risk Management". Likely the latter would have been judged too technical and jargonish to appeal to a broad book audience.

The book is a broad conceptual guide, and a useful one, to figuring out what to do about various financial risks one faces in life, like house buying, insurance or investing. There is some jargon (do you want to figure out your lambda?) but it presents mostly common sense argumentation and nothing beyond arithmetic in the numerical examples.

Despite some attempt to flesh out their methods, the book falls short of being a practical guide. I find it difficult to see exactly how I could systematically apply, in order to develop an overall financial and investing plan, all of their ideas in their multi-step process, which consists of:
1) Know the value of your holdings today - I'm ok with this one, I think, though an important caveat is the definition of "my holdings", which they do not explore. They seem to think of such holdings as consisting only of a portfolio of financial securities, which I believe is far too limiting. The single most valuable financial asset we own is ourselves, our own money-earning capacity, often called human capital. Unlike almost every other financial risk, which they explicitly define as those subject to changes in the [external] environment (i.e. that we can do nothing about directly), we can enhance, or neglect, our earning capacity through education, diet, health protection etc. I suppose the authors might respond that their book does not intend to go into that detail. And I suppose that doesn't matter as long as this book is only considered a conceptual, not a practical, guide. This book does not hand you solutions on a plate. You would have to do quite a bit of work to apply them to your own circumstances.
2) Pick an appropriate future time horizon - Though Dembo and Freeman acknowledge that most people are likely to have multiple future financial goals (car, House, retirement etc) with different time horizons, they do not flesh out how to deal with the resulting complexity when this fact is added into downstream steps below. Nor do they address at all what to do about the very real fact that life contains surprises and your best laid plans / time horizons may not be the ones that actually happen e.g. a good number of people retire sooner than they thought due to job changes or health. That really complicates the next step.
3) Choose a range of scenarios of the future, making sure to include bad extremes and assign a probability to each scenario - This is the range of future end results for "the portfolio under consideration". Of course there could or would likely be multiple portfolio possibilities an investor might want to consider. This is the point where I'd guess almost anyone trying to follow their method would give up. Huh? How do I make up scenarios and figure the odds? They touch on but do not resolve the issue on page 81: " ... there are many occasions when it is impossible to attach useful probabilities to an unknowable future, then we have to find ways to model the uncertainties we face."
4) Pick a benchmark - The benchmark seems to be a kind of base case to compare the scenario & portfolio combinations (& presumably the multiple time horizons). They say that one can choose whatever benchmark one desires.
5) Value your portfolio and benchmark for time horizons under all scenarios - a lot of mechancial work
6) Compute the appropriate risk measure based on values coming out of step 5 - Here enters one of the intriguing contributions of the book, the idea that something they call Regret is the best measure of risk to use instead of popular commonly used measures like standard deviation (aka volatility) or Value-at-Risk (VAR, used by institutional investors).

Regret, with a capital R, is what I found to be the most useful, as well as the most accessible and natural, concept in the book. It is a way of taking account of potential harmful outcomes to make better decisions. Regret deliberately embodies the emotional impact of negative possible outcomes. A wrong decision, as judged later, can gnaw away at a person forever after. Second, the Regret evaluation process of Dembo and Freeman tells us to assess the cost of preventing the big negative, which in many cases is just insurance. Then we decide whether the cost is worth it considering more the consequences of decisions rather than the probabilities of particular outcomes.

As the authors say, "It is a sensible rule of thumb that an operation should not take on positions that expose it to the worst possible outcome - that a catastrophic loss might occur, resulting in ruin." This way of thinking would be very helpful in considering, for instance, whether to buy long term care or critical illness insurance. The same loss may matter a lot more to some people than others e.g. Warren Buffett will never be interested in buying long term care insurance since he can easily afford the fanciest care imaginable.

The obverse of Regret is what they call Upside, a positive consequence that can result from a choice. The thinking process is the same - how much could the positive result amount to and is the cost of the "bet to enter the game" worth it?

The book also has several interesting or amusing bits:

• there are a number of praiseful references (this book was written in 1998) to the revised and improved risk management techniques of major investment banks following big losses in the 1980s and 1990s, rather ironic given the 2008 debacle; the notion presented by the book that these financial institutions were really trying to manage risk and avoid disastrous financial consequences instead of going willy nilly for the gigantic gains strikes me as rather naively quaint. Dembo and Freeman's own framework provides a handy simple tool to figure out the big banker's personal risk perspective - lots and lots of personal $$$ Upside with the worst personal Regret being fired and having to look for another job.
  
• Dembo and Freeman show in Chapter 3 that Kahneman and Tversky are wrong to say that people are irrational or making behavioural mistakes when they make choices that violate expected value (EV = probability x outcome) rationality. They also make buying lottery tickets an entirely reasonable and rational decision (spending a few dollars a week won't cause even poor people financial ruin but it could, despite the bad odds, make them rich, so there's lots of Upside and really no potential Regret).
  

Bottom line: Though the framework will get too complicated to apply to a total personal financial planning effort, it can apply to one-off decisions. The Rules of Risk is worth buying for its thought-provoking content and useful concepts.

Rating: 4 out of 5 stars