Wednesday, 28 December 2011

Stock Market Outlook - The Insider View

Insiders - company executives and board members - know better than anyone else what the prospects are for their own company. Investors are wise to take account of their views, as we have previously written about in relation to individual companies in Insider Trading: Using It to Get an Edge. There is no better indication of what insiders really think than when they put their own cash on the line by buying shares when good prospects loom, or selling when things look dicey.

The same idea can be extended to overall market prospects by totalling up insider buying and selling and comparing the two. Fortunately, we don't have to dig the data out ourselves as the Canadian Insider publishes on its home page what it calls Insider Sentiment versus TSX. The screenshot below of that chart is how things look today.

Insiders appear to be mildly but not wildly optimistic right now, based on the sentiment ratio somewhere around 125% (i.e. a bit more buying than selling). That's nothing like the huge insider buying that occurred in late 2008 after the crash, shown on this CI page, when the sentiment indicator reached about 550%.

This cautious view seems to be in rough accord with mainstream media reports on professional forecaster outlooks such as this one in the Financial Post on a BMO presentation, or this collection of 2012 outlook articles at the Globe and Mail.

Naturally, the situation varies by individual company as insiders at some are big net buyers and while others are big net sellers, as also shown at CI for the past seven days total on the homepage. For those readers interested in individual company insider trading, we note in passing that the CEO of Canadian Insider Ted Dixon publishes a regular commentary on individual companies in the Globe and Mail's Who is Buying and Selling.
Link
Among what might be called the pessimists are three of the big banks - Bank of Nova Scotia (TSX: BNS), National Bank (NA) and CIBC (CM). Could the insiders be worried about their bank stock being sideswiped by the "tough outlook" ahead as reported in the Financial Post? Also amongst the nabobs of negativity is TransCanada Corp (TRP) - is the selling a reaction to the Keystone XL fiasco?

On the optimistic side, insider buyers seem to be most prevalent amongst very small companies. One bigger company with an upsurge in buying is Canfor (CFP). Lumber companies have had a hard time for years but might the insiders be thinking that prospects are as good as this Financial Post article says 2012 will be? Another company with keen insiders is CCL Industries (CCL.B). In this case, the company's own outlook paints a modest growth story, so could it just be that it is under-valued, as the current P/E of 12.6 suggests. The sole stock analyst rating the company at TMX Money likes it too, recommending the stock as a "Strong Buy".

There's nothing like putting your money where your mouth is and the insiders are speaking. Of course insiders do not have infallible foresight but their opinion matters.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Tuesday, 20 December 2011

Investing Book Gift Ideas


Still need a few gifts and don't know what to get for that investor on your list, or are you an investor looking for something good to read during the holidays? Here are some suggestions.

The Intelligent Investor - by Benjamin Graham, updated by Jason Zweig

This classic should be on every investor's reading list. It teaches us how not to lose money in the market, both from the technical standpoint of assessing accounting and business factors to the psychological discipline required. If we can absorb and adhere to the lessons within, we can aspire to doing as well as Graham's most famous disciple, the multi-billionaire Warren Buffett.

Stock Market Superstars by Bob Thompson

A dozen of Canada's most successful stock-picking fund managers say how they do it in a series of rollicking free-form interviews which entertain and educate about how to succeed by being different from the herd. Not many investment books can make you laugh but this one does with the irreverent, no-punches pulled comments by the superstars.

Financial Statement Analysis (4th edition) by Martin Fridson and Fernando Alvarez

For the more advanced investor, once you want to get into the ins and outs of financial statements and the tricks of the accounting trade in order to assess companies and stocks yourself, this book will help enormously. It assumes you know the basics of income statements and balance sheets but you don't have to be a chartered accountant to follow along. Highly readable for the layman despite the subject matter, it tells us how to protect ourselves and spot trouble by taking account of the motivations of company managers.

Understanding Wall Street (5th ed) by Jeffrey Little and Lucien Rhodes

If you need something simpler to get started, whether it is to understand accounting statements or how markets and investments work in general, this is the book to buy. Very practical and intuitive with many simple examples, it can be read through or used merely as reference.

No Hype - The Straight Goods on Investing Your Money, 2nd edition by Gail Bebee

Here's another book that covers basics, but this one is aimed specifically at Canadians. It includes a brief rundown on everything from the types of investments out there (stocks, bonds, GICs, mutual funds, ETFs etc), the various accounts (RRSP, TFSA, RESP, taxable and so on), taxes on investments, annuities, advisors, the list goes on. There is little missing the average investor could want to know about. The book even includes sample portfolios, ranging from the ultra-simple starter to complex with individual stocks and with differing levels of conservatism.

Behavioural Technical Analysis by Paul Azzopardi

We've all heard that our own worst enemy in investing is not the market or some outside agency but our very own selves. We buy when we should sell and sell when it it time to buy. Lots of research has been done into the errors we make and there are some quite well-known books about how and why our behavioural errors happen. But no book does as good a job at explaining them and fitting them together coherently as does this one. The value for the investor is obvious - understanding can lead to fewer costly errors.

What Kind of an Investor Are You? by Richard Deaves

Those who take pleasure in their investing and are good at it may find it hard to believe that many people don't have the interest, time or skills to do respectably at it. If you are among those "many", here is a book that will guide you to figure out whether to simply rely on an advisor (and if so, how to pick a good one, since a bad one could wreck your financial future) or to do-it-yourself. If you are a DIYer there is guidance on how to build a sensible strategy based on Canadian ETFs or mutual funds. The book's advice is brief, simple and practical.

Unconventional Success by David Swensen

David Swensen's long and successful experience managing the gigantic Yale University endowment fund gives him deep knowledge of how the investment industry works and how various types of assets perform, knowledge that he passes along to the reader in this book. He recommends using only certain asset classes and passive index funds for most investors, and explains why in a cogent, persuasive fashion backed by logic and data. Who knows, in a few years the investment strategy he advocates could become the mainstream conventional approach.

All About Asset Allocation by Richard Ferri

This blog has emphasized the importance of asset allocation as a means to lower investment risk and achieve steadier returns. Ferri's book walks us through in more detail from the ground up why asset allocation works and how to do it properly using ETFs or mutual funds.

The New Investment Frontier III by Howard Atkinson

It's still the best book about ETFs in Canada, despite getting out of date due to the multiplication of new ETFs on the market. The explanation of how ETFs function in comparison to mutual funds, the discussion of indices, the run-through on income tax implications, all are as true today as when the book was last revised.

Uncontrolled Risk by Mark T. Williams

Interested to know who to blame for the 2008 credit crisis? Read this book to find out who else there is besides the obvious culprits in investment banking. Through the story of the collapse of central player Lehman Brothers, Williams shows how 2008 was the culmination of decades of build-up among many players. Along the way we learn what acronyms like CDS and MBS mean ... without our brain hurting too much. The scary thing is the author's conclusion that the risk of systemic financial collapse still remains.

Happy holidays to all and good reading!

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 16 December 2011

Gulp! Asset Allocation & Rebalancing Theory Meet a Scary Real World

Have you set up your portfolio structure according to a defined asset allocation with explicit rebalancing rules, as many experts suggest and as we advocate in this blog? Are you coming up to an annual review date to rebalance holdings in the new year after the 2011 results are in? Or perhaps the percentages allocated to each asset class have gone beyond the limits set to trigger rebalancing.

If you have noticed the large performance divergence of various asset classes this year, then the difficult reality of current economic and market conditions will surely test your resolve to go ahead with rebalancing.

Example portfolio - Complete Couch Potato
Let's take one of the model portfolios composed of common ETFs - the Complete Couch Potato - from the popular Canadian Couch Potato blog to illustrate the kind of anxiety-laden situations facing the investor trying to practise disciplined portfolio management. CCP also publishes up-to-date performance figures for the various portfolios and its ETF components, which is very handy since the value of distributions and the effect of currency swings on the US-denominated ETFs is taken into account. Below is a table of the portfolio and how it has performed since the start of the year.


Psychological barriers to rebalancing
The arithmetic about how to rebalance by buying some ETFs and selling others, as shown in the performance table above, is not the issue. The challenge is actually convincing yourself that it makes sense. Consider the situation:
  • Canadian Equity - The TSX has been in a downward trend for months now. It doesn't look as though things are likely to get much better anytime soon. The temptation is to wait.
  • US Equity - Thanks to the fall of the Canadian dollar against that of the USA along with the receipt of dividends, VTI has managed a slight gain. One might be tempted to put more money into VTI since it looks as though the economic situation in the USA may be stabilizing but our rebalancing calculation tells us to do nothing.
  • International Equity - Here is the scariest situation. Our policy says to buy more VXUS when all it has done during the year is slide downwards to a 10% loss. Not only that, the underlying problems in Europe could well get a lot worse, Japan still struggles and now China is said to be slowing down. Poor decisions by authorities might lead to disaster, or perhaps we are already inevitably heading that way. The urge to hold off buying, if not to sell and run for safety, is understandably strong.
  • Real Estate, Real Return Bonds and Canadian Bonds - These have been the bright spots, providing the biggest positive returns that have enabled the overall portfolio to eke out a small gain for the year. Rebalancing tells us to sell some of each yet it is hard not to consider that the underlying conditions that produced such returns seem still to be in place. Why not stick with the winners which, after all, are the safest of the holdings in these dangerous times?
Such is the dilemma facing the investor trying to follow the standard advice about diversification, asset allocation and rebalancing. It is much easier to rebalance when everything is going up and it is only a reallocation from a big winner to a small winner. Taking from winners to give to the losers is much tougher. Who knows it might not even be the correct choice.

Long term faith in outcomes is required
The dilemma today highlights that the main challenge we face as investors is ourselves in following our plans despite doubts and uncertainties. Should we adopt the same blind faith as one of the most successful investors ever, Warren Buffett, who said this?

"In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497" (source BrainyQuote)

Was the original portfolio allocation appropriate?
A reluctance to rebalance also raises the question of whether the original allocation percentages were appropriate for our individual circumstances. Is the 50% allocation to stocks necessary or reasonable if our savings goals have been reached? Is our time horizon for staying invested and not spending the money allocated to equity at least ten years, since that amount of time could easily be required before stocks again begin to pull ahead of bonds? The credit crisis and debt deleveraging troubles are very severe so it should not be a surprise that recovery takes a long time.

Diversification has worked again
The other thing to remind ourselves is that the diversified portfolio has produced a small but positive gain overall (2.2% in this case). That should help encourage us to continue following the basic strategy predicated on the idea that different asset classes will perform differently from year to year but will usually produce positive returns.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 9 December 2011

High Income Foreign Bond ETFs

With interest rates being so low these days, many investors are casting their eyes further afield in the search for better returns. The benchmark Canadian bond ETF iShares DEX Universe Bond Index Fund (TSX symbol: XBB) offers a paltry 2.3% yield to maturity. Even its current cash distribution yield is only 3.5% (per the TMX Money XBB quote). Let's therefore have a look at some foreign bond ETFs available from Canadian fund providers Claymore, BMO Financial and BlackRock / iShares (new entrant Vanguard doesn't seem to offer any) to see the pros and cons of what they offer.

The ETFs fall into two groups: US corporate bonds and government bonds from Emerging Market countries. Interestingly, no fund seems to offer developed country bonds (so there aren't any opportunities to take a flier on Greek or Italian debt!).

Emerging Markets
US Corporate
Currency hedging is a worthwhile common feature - All of the funds use futures contracts to hedge the swings of the Canadian dollar against the US dollar. Since currency swings can easily overwhelm the basic bond returns from interest and capital appreciation, we consider currency hedging to be a desirable feature in general. However, the hedging operation is not free or perfect and that usually causes a reduction in the net return and under-performance compared to each ETF's index. Not all the ETF managers do an equally successful job. In our comparison table below, we see that ZHY has done worst with a -1.3% performance drag against its index. In contrast, the best result over the past year has come from XIG which has achieved the unusual result of a performance boost over the index of 0.9%! Most probably XIG's boost comes from unintended profits from the futures hedging contracts, as suggested by the fact that XIG is one of the iShares ETFs with capital gains to distribute in 2011. For more on how tracking error comes about, see Rob Carrick's MoneyShow article Watch Out for Tracking Error When Buying ETFs.

There are a number of US-traded bond ETFs (see list here), both for US bonds and international bonds, but none are Canadian dollar-hedged. A Canadian investor would face both bond and currency risk. In our view currency exposure is best achieved, and sufficiently so, through foreign equity holdings. That's a big reason why we've left them out of this review.


XIG comes out best on MER - Its 0.3% MER is about half that of the other ETFs.

Return vs default risk profile is the key differentiator - Whether we compare by cash distribution yield or more properly by the yield to maturity figures, we first note that all the ETFs offer superior returns varying from 1% to 6% over XBB. However, there's a catch - risk. There is a marked difference amongst the ETFs with respect to default risk, as measured by credit ratings from Standard & Poors (see Wikipedia's table that explains the ratings). Our comparison table shows with a big red line the key cut-off between ratings of investment grade and those riskier ratings underneath. XIG is clearly the safest and it correspondingly has the lowest returns to offer. ZEF and XEB on the S&P ratings measure rank next safest but the high concentration of assets in the top ten countries (such as Mexico, Russia, Korea, Brazil, Venezuela and the Philippines) makes us raise that risk estimate somewhat. ZHY, XHY and CHB are all quite diversified in the sense of having many holdings and low concentration but if a recession hits, it is likely many of these weaker companies will hit the skids at the same time. Peaks of default also happen with governments as we are seeing in the European contagion scenario and as we discussed a few months back in this post on Default Risk. All this is reflected in the year to date evolution of market price of the various ETFs , shown in the Google Finance chart below. XIG is up nicely, XEB and ZEF up a bit and the other three are down. XIG has also been more stable through the year.



Bottom line
XIG works best for investors who want stability with steady cash income.

The others work best when an investor wants cash income, is able to accept higher risk and wants to have another asset type that will help diversify the portfolio since the ETFs will not move in tandem with other equity or Canadian bond holdings.

All but one of these ETFs are best held in registered retirement accounts rather than a taxable account (since the cash distributions are foreign income). The exception is CHB which can be held in taxable account since it doles out Return of Capital and Capital Gains through its clever (and legitimate) use of forward agreements.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 2 December 2011

Avoiding an Unpleasant Year End Tax Surprise on ETFs

A few years back we delved into the Mystery of Fund Capital Gains in 2008, explaining how it came to pass that investors holding ETFs or mutual funds in taxable accounts (i.e NOT in registered accounts such as RRSP, TFSA, RESP etc) could be liable for tax on capital gains when 2008 was such a horrible down year in markets. Investors received no cash yet there was income tax payable!

Estimated 2011 ETF Capital Gains Distributions
It's time to pay attention again this year, though the problem is not so widespread or severe as 2008. The main Canadian ETF providers have recently published their estimates in the links below of capital gains distributions for 2011 in their funds (final figures are to be published between December 15 and 19):
ETFs with a Potential Tax Surprise
We have culled the lists and picked out the half dozen ETFs that will occasion significant capital gains tax to pay in taxable accounts despite what has been in most cases a year of declining market price of the ETF. Here are the ETFs to watch out for and their estimated capital gains distribution per share:
Why Pay Attention
These ETFs all have, relative to the ETF price, a high amount of capital gains to allocate to investors but that are not actually paid out as cash since the gains stay within the fund. For example, if you own 1000 shares of XCS at the end of 2011 when the tally of shareholders to whom the gains will be attributed is taken, there would be 1000 x $0.7841 = $784.10 of capital gains to report on a 2011 tax return. A top bracket Ontario taxpayer paying about a 23% marginal rate on capital gains would owe $180 extra for gains that he/she would not see in cash.

The only consolation is that the capital gain gets added to Adjusted Cost Base of the investor's ETF holding, which means less tax to pay down the road if the shares are later sold for a gain, or if sold for an eventual loss, it would create a larger capital loss to offset other gains. But that goes against the basic principle of tax minimization, which is to defer payment of taxes.

The investor can well feel aggrieved paying taxes up front on gains that he/she has not seen. The situation feels worse when we look at the price performance in the Google Finance chart image below of these ETFs over the past year.

Only two of our list - ZJN and CDZ - are in positive territory and the others are all down significantly during 2011 up to December 2.

What Can be Done?
For an existing shareholder of these ETFs it is possible to avoid receiving the unwanted capital gains distribution by selling the ETFs on or before December 22nd (from December 23rd onwards, the shares trade ex-dividend, which means that if you sold the shares on December 23rd, you would still receive the year end distributions as the trade settlement would not occur till after the new year and you would still be on the books as the shareowner till then).

The value of doing this depends on the price you bought the shares. In a taxable account, you would need to do the usual capital gain/loss calculation (here is our post explaining how that works). If you bought ZJG at its inception in January 2010 you would be sitting on a sizeable capital gain. Triggering the big gain's realization to avoid the much smaller 2011 distribution does not make sense. However, if you had bought ZJG in January 2011 there would be a big paper loss so the sale before year end makes a lot of tax sense. This would be tax loss selling at its best. For the ins and outs of tax loss selling see this post.

For those investors who do not yet own but want to buy any of these ETFs, they are better off waiting till December 23rd.

Possible Short-Term Substitute ETFs
One tricky issue when an existing investor wants to continue owning the ETF for the long term is to properly comply with the superficial loss rule, by which the Canada Revenue Agency will deny the loss if the ETF is repurchased within 30 days e.g. by selling ZJG December 22 and buying it back on the 23rd.

One option is to wait for a month before buying back the ETF but that takes the chance that the price might rise significantly in the interim.

Another option is to substitute/buy similar, but not identical, ETFs while the 30 day period elapses. ETFs that use the identical index are a no-no but many ETFs using dissimilar indices within a sector follow a similar price price pattern, especially for a short period. That is all one really needs. Here are some matchups for our ETFs that we found using Google Finance charts to give us an eyeball validation.
In mid-March, the fund companies publish the complete final tax breakdown of all types of fund income (dividends, interest, return of capital, capital gains) to help investors prepare their taxes and track their cost base. Meantime, this advance information helps investors make decisions and take action to defer capital gains.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Thursday, 24 November 2011

ETF Asset Allocation across RRSP, TFSA and Taxable Accounts

Many investors, including this blogger, whether by intent or happenstance, have their investments spread across multiple account types, such as RRSP (or a LIRA), TFSA and Taxable/Non-registered. As we advocate in this blog, the wise investor diversifies across different types of investments to maintain a portfolio asset allocation with the percentage breakdown specified to meet investment objectives - see example in our post on investment policy. A fundamental principle is that though the portfolio may span many accounts it should be managed as a whole, not as independent pieces. The next question then is - What is the best way to divide up the investments across the two dimensions of account type and asset type?

Key Portfolio Issues - Let's work through an example to see how it could look in practice, considering these factors:
Our example portfolio contains $100,000, a nice round number that makes it easy to match up percentage breakdown and dollar amounts. Our portfolio uses the ETFs and breakdown in the Balanced Portfolio suggested in the just-released update edition of Gail Bebee's book No Hype: The Straight Goods on Investing Your Money.


1) RSSP and TFSA are the major accounts for the portfolio - The tax-free growth in both the TFSA and RRSP produces the best long run returns and that's where everything should go if possible. However, we assume for illustration purposes that the investor has run out of RRSP room and must also maintain a taxable account, which allows us to show what should go in there. We also assume that the person wants to use both a RRSP and a TFSA but of course the TFSA has a $15k contribution limit. A person in the highest tax bracket might want to concentrate everything in the RRSP.

2) Cash is split amongst all three account types to facilitate rebalancing. Possibly the cash may be handy for emergency needs and it can be put back into the account when it is in a TFSA (in the following calendar year) or a taxable account (anytime). Note that the Manulife Financial Investment Savings Account (MIP510), may face higher minimum purchase amounts from certain brokers though Manulife itself does not impose a minimum.

3) Highest tax rate interest bearing bond ETFs go in the RRSP or the TFSA where there is tax protection.

4) TFSA gets some bonds and some equity to facilitate rebalancing, since those are the assets most likely to move in different directions. Equities worldwide tend more to move in sync. It is far easier to do rebalancing trades within an account. Indeed, it is not permitted to transfer money into a TFSA to rebalance if the TFSA's contribution limit has been maxed out. Taking money out of the RRSP to rebalance to a Taxable account loses the tax advantage so that doesn't make sense. The Claymore 1-5 Year Government Bond ETF (CLF) is split between RRSP and TFSA since it has a bigger allocation and will be cheaper to rebalance considering trading costs. Similarly it is the larger iShares S&P/TSX Capped Composite Index Fund (XIC) that is split between the RRSP and the TFSA.

5) Taxable account gets ETFs with US and international holdings due to foreign withholding taxes that cannot be recovered.

The same principles would apply to other ETFs that can be used to construct the same or other portfolios. The percentage allocations may vary towards more or less fixed income or equities but the asset classes and the tax characteristics will be the same.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 18 November 2011

Dividend Initiators as a Stock Selection Concept

In his first feature article for the recently acquired Canadian MoneySaver, new owner Peter Hodson, formerly hedge fund manager at Sprott Asset Management, provides an intriguing idea for finding stocks that will pay off well in future. He goes so far as to state that this is the single best investing theme he has to offer after 25 years in the business. His principle: take a serious look at companies that declare their first ever dividend.

Why dividend initiation is significant
Hodson believes that initiating a dividend tells us the company: a) is doing well; b) has excess cash; c) is managed by a Board that respects shareholders and likely owns lots of shares itself; d) is likely to pay out a steady stream of stable or rising dividends for many years. That sounds sensible but how can we take the idea forward?

Finding first-time dividend payers
His article mentions two companies that have have recently declared their first dividends: Primary Corp (TSX: PYC) and DSW Inc (NYSE: DSW). To find others, we cannot unfortunately rely on that standard investor tool, the stock screener. We could find no screener with a first-dividend filter or even some proxy that would cleverly achieve that end. Instead our list below relied on the basic Internet tool that everyone knows, the Google search, where we searched for words such as "dividend, stock, initiate, first, Board".



Tracking and investigating the candidate stocks
Compiling a list is a start but not the end of the story. No doubt some of these companies and stocks look better than the rest and some may not look good at all.

Watchlist - A simple starting point is to set up a watchlist of the potential stocks, for example by using the GlobeInvestor My Watchlist (see screenshot below of the above list with a few of the customizations that the tool allows). It can contain both Canadian and US stocks and shows many of the financial indicators and ratios on profitability, growth rates, valuation and safety that give a good preliminary view of the attractiveness of the stock.


Company financial reports - Each company's website will contain the quarterly and annual financial reports that are replete with data and management comment on the company. Before buying stock, one should have read through a number of them.

Stock data websites - As well as the basic financial data in the company reports, several go much deeper in calculating a multitude of ratios and barometers of financial health of companies.
  • ADVFN - most extensive free set of data and ratios around
  • InvestorPoint - includes insider trading info
  • Google Finance - includes data on similar companies, though the degree of similarity varies (see example below of screenshot for WJA)


Stock discussion forums and boards - Though one should always be wary of the motives and expertise of the commentary, there may be nuggets of useful information in such online sites.
Whether this method really helps zero in on stocks worth buying, we don't know for sure as Hodson doesn't offer any systematic or rigorous data to back up his claim. However, it is always interesting to experiment with and entertain a new angle to stock selection.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Wednesday, 9 November 2011

Borrowing to Invest: Examples of Potential Profits

In our post last week we explored the factors that contribute to success in using borrowed money to invest. Today we work out the numbers for two current possible investments that look reasonable according to our criteria.

The Calculation Tools
Many kudos go to TaxTips.ca's free Borrow to Invest Calculator that takes account of different tax rates in the various provinces (and shows how the bottom line can vary a lot across the country). We have used the calculator for our examples.

The yield to redemption on the preferred share example has been figured out using Shakespeare's yield to call calculator.

Example 1 - Leveraging a Canadian Equity ETF
Our first example uses the most popular Canadian equity ETF, the iShares S&P TSX 60 Index Fund (TSX: XIU), which features several desirable qualities:
  • Diversification: This ETF holds shares of the 60 biggest companies in Canada, as determined by their market capitalization. Default risk is more or less nil, though of course there can be severe market dips of up to 40% as investors well know having passed through the 2008 crash.
  • Passive Index Tracking: XIU only occasionally trades when the index itself changes. That meets our goal of trade minimization to defer paying capital gains. We note that despite its passive investing strategy, even XIU has unavoidably not been perfect in this regard in the past, as can be seen in the hefty capital gains distributions in some recent years, like 2006 (see the Distributions for XIU here).
  • Canadian Equities: The Canadian-only holdings mean that dividends distributed to the investor are eligible for the enhanced dividend tax credit, another tax advantage.
  • Healthy Dividend Yield: XIU's dividend yield is currently around 2.3%. This cash income to the investor will help meet a substantial part of the cash outflow for interest on the loan taken out to invest, thus lessening the potential for strain and stress on the investor.
The scenario we examine makes the following assumptions:
  • Investment in Taxable Account: this is to take advantage of the deductibility of loan interest, the favourable tax treatment of capital gains and the tax credit for dividends.
  • Investor Taxable Income: $60,000 or $120,000. The investor's job earnings provide the stable base to support the leveraged investing. We compare what happens with either middle income or a high income investor.
  • Amount Borrowed: $50,000. We use the same amount for comparing the middle vs higher earning investor, though the latter could probably easily manage a bigger loan.
  • Loan Interest Rate: 4%, based on secured loan rates commonly available now per Fiscal Agents Consumer Loans.
  • Investment Time Horizon: 15 years, to allow for market swings up and down and increase the chances that the net market return over that period will be positive and reasonably close to our expected return.
  • Expected Return: 6%, a total of the current 2.3% dividend rate plus capital gains to make up the rest. As we wrote about in our previous post, that seems a reasonably conservative and achievable figure given the current TSX market level.
Results:
A) TaxTips calculator screenshot below for an Ontario investor earning $60,000 of other taxable income.
  • Despite loan interest payments of $2000 per year (4% of $50k) the disposable income difference after tax only requires a net cash outlay of $264 at most in year 2, which declines and becomes positive - the investor receives cash in pocket - from year nine onwards.
  • After 15 tears, the investor is better off by a total cumulative amount of $34,665, i.e. net of the loan. That's a very nice gain, providing of course all goes according to the assumptions.


B) Summary Table By Province and Taxable Income Level
  • Income level makes little difference overall within each province. The net gain is very close to the same whether income is $60,000 or $120,000.
  • Provincial tax rates make a substantial difference in the net gain, almost a 20% difference between the highest / best in Quebec (over $40,000) and the lowest / worst gain in Nova Scotia ( about $34,000).


Example 2 - Leveraging a Canadian Split Share Preferred
Our second example uses Big Bank Big Oil Split Corp (TSX: BBO.PR.A) as the investment. Its features:
  • Redemption Date & Exact Return: On 30 December 2016, the investor is promised the $10 redemption value, which means the current $10.25 market price will converge by that date to the $10 amount. The fixed duration of the investment allows us to compute the exact return, or yield, that our investment will achieve, using the above calculator from Shakespeare, in this case 4.58%. In addition, the investment held to maturity will produce only dividend income for tax reporting each year. There will be a small capital loss ($10.25 - $10) to report, only at maturity.
  • Dividend Yield: Note that the current dividend payout is 5.12%, which exceeds the total yield due to the capital loss.
  • Investment Grade: Backed by the value of the corresponding Split Capital shares (see our discussion of how Split Preferreds work here), which are invested in a portfolio of shares of six Canadian banks and ten oil and gas producers, DBRS rates BBO.PR.A as P2-low, which is investment grade and thus well protected against default.
Results:
  • An Alberta investor with $60,000 taxable income would be $3,340 richer after 5 years. (The total gains are less in total than for Example 1 since the investment only lasts 5 years.)
  • Net after tax cash flow is positive every year (we do not show the TaxTips screenshot of this result). The investment should sustain the loan on a cash basis.
  • Provincial differences are even more pronounced, with Quebec, still at the top of the list, gaining twice (!) as much as the perennial heavy tax bottom feeder, Nova Scotia.


Caveats and Cautions:
The results depend on the assumptions. That the loan interest rate will stay at 4% is unlikely. Plugging in different numbers to the calculator, for example to see what a 5% interest rate might do to the net result, or a much smaller capital gain on XIU, could show how much leeway there is for a profitable outcome. Another variation would be to make the loan amortize, which would progressively reduce the loan and the leverage and thus the risk, over the investment horizon. An amortizing loan could enable you the investor to lock in a fixed loan interest rate. It would also indicate the cash flow required and give you an idea whether it would be supportable. Finally, to be sure of what you are doing, it may be wise to consult a professional.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Thursday, 3 November 2011

Borrowing to Invest: When & How to Do It

The basic idea and attraction of borrowing money to invest is simple - if the cost of the loan is less than the return on the investment then there is a profit. You have used money you don't own to earn. That's why the operation is also called leverage - you use the borrowed money as a lever to gain a profit. However, as usual, there is a downside, since it is possible to lose money too. If things go awry, the leverage makes you lose faster, which is why there are many dark warnings e.g. What are the dangers of borrowing to invest? on the GetSmarterAboutMoney.ca site sponsored by the Ontario Securities Commission, or Wealthy Boomer Jonathan Chevreau's Financial Post column When does it pay to borrow to invest?

A few months ago, we looked at various ways to carry out leveraged investing. Today we will drill down to see under what circumstances it can work, to examine the risks, to look at tax and book-keeping implementation do's and don'ts. That should give you a better idea if borrowing to invest is worthwhile for you.

Favourable Conditions
A beneficial combination of factors specific to you and of conditions in markets and the economy will increase the chance of success.

Investor's Personal Situation:
  • Able to sustain the loan payments - Whether it be an interest-only or an interest plus principal repayment, you must be able to keep up payments, otherwise you may be forced to liquidate the investments, which as bad luck could have it, might be at a time when the investments have declined in value. There should be some leeway for higher payments since some forms of loans have floating interest rates that will rise with general interest rates. In addition, when the investing is within a non-registered taxable account, there is income tax to pay each year on the investing income. Thus, the following conditions give you an advantage.
  • Stable job with a steady reliable income,
  • Little or no other debt
  • Long term horizon - If you can invest the money for a longer time, such as ten years or more, and not need or expect to spend it for urgent needs, that allows you to wait out inevitable difficult market periods. Having other resources for near-term needs or wants helps a lot.
Markets & Economy:
  • Low interest rates to borrow - This is one of the best factors in the current situation, with loans available at 4%, perhaps even a bit less. When the cost of borrowing is low, it sets a lower bar for earnings from interest, dividends or capital gains to beat in order to make a profit.
  • High yields on dividend stocks - There are many solid companies paying dividends over 3%, and some even in the 4-5% range,. Against current borrowing rates that offers the promise of cash in- vs out-flow that can sustain payments on interest-only loans. Added to the benefit is that most dividends from Canadian companies are eligible for the enhanced dividend tax credit, which effectively means a very low marginal tax rate on that type of income. This improves the investor's chances of making a net profit in a non-registered taxable account.
  • Reasonable stock market valuation level - The indicators we discussed in Is the Stock Market Over- or Under-Valued? suggest that US and Canadian stock markets are at a level that promise modest returns of 4 - 8% over the next ten years.
Risks & Counter-Measures
Some of the major things that could go wrong include:
  • Psychological stress and panic - No one wants the anxiety of a very large debt hanging overhead when facing a large market decline that could get worse. That leads those with experience in leveraged investing to suggest: 1) only going ahead when you have at least several years of investing under your belt, which gets you mentally and emotionally familiar with the frequent falls in the market; 2) starting out with a small loan and investment; 3) buying the investments progressively so that if the market goes down after the first purchase you feel less regret (a line of credit is well suited to this tactic since you borrow as you go).
  • Job loss - For most people, employment income is the source of cash flow that protects the ability to pay back the loan. The danger is that the layoff might occur at just the wrong time - the economy is bad, you lose your job and the markets / your investment goes south simultaneously. Opting out and repaying the loan to limit the damage may not be possible ... unless you have included that safety margin in planning as we suggested above.
  • Interest rate increases - A rise in borrowing costs when the loan is on a variable rate basis may make the whole scheme unprofitable. If fixed income investments like bonds or preferred shares were bought, these would decline in value so an attempt to opt out and collapse the scheme could incur a big capital loss. There would then be a large lump sum to find to make up the total owing to the lender.
  • Family home subjected to collateral call - In what could be termed a disastrous case of "collateral damage", the necessity to sell a home that had been used to guarantee a home equity loan or a mortgage might result after a big loss on an investment. Apart from the above-discussed preparations to avoid such an eventuality, before proceeding with borrowing to invest the investor should contemplate whether the potential investment gain is worth the potential pain of having to sell his/her home, alongside the probability of that event occurring.
  • Investments fall in value - The most basic risk as inferred above is that the investment has lost value when you sell. The defenses against this: a long holding period for equities to ride out market slumps; a personal situation that allows you to sell only when you decide and; diversification and solid investments to avoid total default loss. (point inserted after first posting following blogger Michael James on Money's mention, which highlighted that this obvious point might not be obvious enough!)
Investment Candidates
First, we note that the maximum value from leveraged investing comes when the tax advantages are utilized, in particular the deductibility of interest expense and the lower tax rates on dividends and capital gains. The implication is that investing is best done within a non-registered taxable account. It also means that Canadian equity should make up the investment holdings.

Our take on the best combination at the moment includes:
  • Passively managed index ETFs - The passive index management results in low turnover, which minimizes annual capital gains distributions and tax to pay. It also ensures diversification through multiple holdings, which eliminates the possibility of complete loss of capital through default and reduces the year-in-year-out volatility.
  • Equity ETFs - Equity provides its return in the form of the desired dividends and capital gains. Over the long haul, equity has outperformed fixed income. We do not like some of the specialty dividend ETFs despite their enticing high distributions because often a sizable chunk of their distributions consists of Return of Capital, which causes problems with the deductibility of the loan interest (see MillionDollarJourney's Key Tax Considerations on an Investment Loan).
Some reasonable though less attractive possibilities:
  • Pipeline and utility stocks - These are amongst the most stable in a business sense and as a result are so on the stock market too. All offer much better than average dividends (see our January 2011 post on these stocks)
  • Split Share Preferreds - Unlike most preferred shares, this type of preferred has a redemption date and price. The price and yield you buy at today is locked in to the redemption date if you hold till then. If interest rates rise in the meantime, the market price of such shares may decline temporarily but by the redemption date the market price must converge to the redemption price. The catches are that such shares still have some default risk and that redemption dates may be within only a few years so you would need to be renewing and reinvesting the holdings with capital gains taxes to settle up earlier than desired. See our detailed post on assessing Split Preferreds.
Interest Deductibility Tax and Book-keeping
The general principle is that interest on the investment loan may be deducted against the investor's income (and not just investment income but against other income such employment earnings). However, the rules for carrying out the borrowing to the Canada Revenue Agency's satisfaction to ensure the deduction is not denied can be quite tricky. Consider getting the guidance of an accountant! Amongst the tricky bits:
  • Investment must be capable of earning income, though it may not actually do so. If it can only ever achieve capital gains, that will not qualify.
  • Book-keeping is much easier if the investments purchased with the loan are in a separate account.
  • Similarly for book-keeping ease, once income is received, take that money out of the account to keep the cost basis of the debt the same as the investment.
  • Watch out when withdrawing funds from the account since the amount of eligible debt may change.
Helpful info on these matters: TaxTips.ca's series of pages on Borrowing to Invest, MillionDollarJourney's article link mentioned above, Tim Cestnick's Borrowing to Invest article on Fiscal Agents website and his It's in your interest to know the deduction rules for borrowing in the Globe and Mail.

Next post, we will work through an example with the help of available online tools to see how the numbers work out and give a feel for how big the benefits could be.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 21 October 2011

RRSP vs TFSA? Critical Differences and Imponderables

Our last post compared the RRSP with the TFSA strictly on the basis of numbers - which generates the most after-tax income during retirement - and concluded that the TFSA is best for people earning below $37,000 during their working years while the RRSP is best for higher earners. Today we look at other features of these plans to see why that conclusion might not hold up.

Tax Rate Changes - Contribution vs Withdrawal
The RRSP gains a monetary bonus if the tax rate in retirement is lower than when contributions were made and it incurs a penalty if it is higher. The TFSA is completely unaffected by such a tax rate difference (since all contributions are made with after-tax funds and withdrawals are not taxable). In the section titled What happens when rates change? on his lengthy page on RRSPs RetailInvestor works through an example and concludes that "This effect (of a change in tax rates) is the major difference between the TFSA and the RRSP".

Most probably, figuring out whether your retirement tax rate will be higher or lower is well-nigh impossible for most people. On the same page under What are the unknowns that will determine a rate change? RetailInvestor lists many factors that can cause a change, such as: a large RRSP/RRIF (or LIRA/LRIF/LIF) balance at death that all becomes taxable income through deemed disposition tax rules and pushes RRSP income into higher brackets; big lump sum withdrawals for illness, long term care, round-the-world cruises that push RRSP withdrawals into higher brackets; non-registered investment income that might get boosted from inheritances or profitable sale of a home; government decisions to raise or lower taxes. As a result:
  • for top bracket earners ($120,000+) who stand a good chance of taking money out at lower tax rates, the RRSP solidifies its advantage
  • lowest bracket earners will almost certainly experience a rise in tax rates in retirement and thus should forget the RRSP and focus on the TFSA
Savings Discipline
Simply getting around to making contributions is a big psychological challenge for both the TFSA and the RRSP. It isn't the only one however. Each has its own pitfalls and each investor must figure out which ones he/she is most prone to fall prey to. This could be the key factor - obvious though such a comment might be, if you don't save and keep the money in the plan, it cannot grow.

RRSP - The Tax Refund Temptation
The first issue is that in order to get the full value of contributing, compared to a TFSA, the tax refund portion must, in effect, be invested as well. In one example from the TaxTips comparison calculator we used in our previous post, a $5000 RRSP (pre-tax) contribution was, for instance, only equivalent to a $3550 TFSA (post-tax) contribution (the actual equivalent amount varies according to your tax bracket). Put another way, if you have $5000 cash to contribute either to a TFSA or a RRSP but spend the RRSP contribution tax refund you will be far short of your retirement spending goal when the RRSP's deferred taxes have to be paid (see a detailed explanation in the TFSA vs RRSP comparison on Million Dollar Journey). TFSAs don't offer the temptation of the seemingly found money refund, which all too many Canadians succumb to. Score one for TFSAs.

TFSA - The Cookie Jar Temptation
In a recent GlobeInvestor article about TFSAs and RRSPs, Wealthy Barber author David Chilton said he feels the ease of TFSA withdrawal, greased by the thought that the money can be replaced the following year, which is not allowed with RRSP withdrawals, makes it more prone to the withdrawal temptation than the RRSP. Will Canadians delve into their TFSAs for luxury spending more than they have into RRSPs? That remains to be seen. Score a minor plus for the RRSP.

Tax Management
The TFSA has several significant post-retirement tax advantages:

TFSA withdrawals do not count for income-restricted benefits such as OAS and GIS.
  • When you need a bigger lump sum of cash in a particular year e.g. for that cruise, home renovations, health costs, gifts, new car etc, a bigger RRSP/RRIF withdrawal can push you into a higher tax bracket and reduce or eliminate GIS or OAS.
TFSA allows contributions up to any age
  • In contrast, the RRSP must be converted to a RRIF or an annuity i.e. be progressively withdrawn starting by age 71 at the latest. This TFSA feature is very useful to gain tax-free earnings from investing surplus funds, such as on-going cash not needed for current living expenses or perhaps an unexpected lump sum like an inheritance. The cumulative, non-expiring annual $5000 contribution room of a TFSA enhances this advantage. You cannot put inheritances received into a RRIF.
  • Example - Putting these factors together, suppose you withdrew $30,000 extra during retirement from a RRIF, pushing you from $36,000 taxable income to $66,000 that year. That would cost about $10,000 more in taxes for an Ontario resident. Suppose a year later, you received a $30,000 inheritance, you could not put it back into the RRIF. Your choice would be to invest it in a regular taxable account, subject to tax every year, or into a TFSA if you had the contribution room. With the TFSA, the money would come out with zero effect on taxes and the withdrawal would create $30k in contribution room, permitting you to return the inheritance money to tax-free gains.
TFSA simplifies income splitting between couples to lower overall tax
  • Income splitting is easier with the TFSA since both spouses automatically get $5000 in annual contribution room and one spouse can contribute up to that limit to the other's account. With the RRSP, the receiving spouse must have available contribution room built up through earnings, a problem when one spouse is a low- or no-income earner.
TFSA is simpler to manage and figure out.
  • With a RRIF you must content with: having to pay attention to forced RRIF minimum annual withdrawal amounts; and figuring out the net cash available immediately upon withdrawal after witholding tax (from TaxTips) or after tax filing, which amounts will probably differ, for withdrawals above the minimum from a RRIF. With the TFSA, to use the hoary phrase "what you see is what you get". There's no confusion or uncertainty. The amount you withdraw is what shows up in your bank account to spend. There are no tax implications to figure out, things to file in a tax return or later amounts due or refunds. Life is simple, as it should be.
RRSP/RRIF qualifies for Pension Amount
  • One plus of the RRSP is that withdrawals from a RRIF qualify, if you are 65 or older, for the $2000 pension income tax credit (see Canadian Tax Resource's What is Eligible Pension Income? for details). TFSA withdrawals do not qualify.
RRSP/RRIF Witholding Tax superiority
  • Since the US government recognizes only the RRSP/RRIF and not the TFSA as a bona fide retirement account, 15% US-government levied witholding taxes eat away at returns on US-listed ETFs, as we wrote about in Pros and Cons of Cross-Border Shopping in the USA for ETFs. That penalty for TFSAs applies pre- and post-retirement and across all income levels and would also apply to US-listed equities paying dividends or bonds paying interest. That can make a significant difference to returns on such holdings in the long term, as we noted here.
Bottom Line
  1. Highest income earners of $120,000+. Focus on the RRSP first due to the likelihood of a drop in your tax rate. If the RRSP contribution room isn't sufficient for savings goals, put any extra in the TFSA. After retirement the TFSA makes a fine parking spot for surplus funds.
  2. Income earners below $37,000. Focus exclusively on the TFSA. If you are frugal enough to save more than the $5000 contribution limit, then look to the RRSP.
  3. In between $37k and $120k. Save through both TFSA and RRSP to gain the advantages of each and the flexibility of having both.
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

RRSP vs TFSA? First, the Numbers

Trying to save for retirement but unable to figure out if putting money into an RRSP is better than a TFSA? Welcome to the party, you are not alone.

Our previous blog post RRSP vs TFSA vs RESP vs Non-Registered Taxable Account took a general look and gave rules of thumb. Now we get more specific in comparing the RRSP against the TFSA.

The Calculator
TaxTips.ca offers a free and quite complete tax TFSA vs RRSP Calculator (see screen shot below) that can compare the two in terms of after-tax cash flows from the working and saving years right through retirement. The customization to one's own circumstances includes all the key factors - province of residence to reflect different provincial tax rates, current age, intended age to convert RRSP to RRIF or to begin receiving CPP, how much CPP and OAS entitlement one will have, pension income other than the RRSP or TFSA, amount of contribution to the RRSP, or TFSA (the latter which the calculator adjusts to make it exactly equivalent after-tax to the RRSP contribution) and estimated future portfolio rate of return within the RRSP/TFSA. Behind the scenes the calculator uses the appropriate tax rates, tax clawbacks and credits to show year by year how much spending after-tax money you end with.

After you select all the variables and click "Calculate" the big blue text line tells you whether the TFSA or the RRSP is best overall. Wonderful!


The Results
We tested across a range of income levels from $35,000 to $120,000 for a hypothetical single 30 year old in the various provinces. The bottom line number we look for is what percent of after-tax disposable income the RRSP/TFSA replaces, the higher the better.

  • TFSA Always Wins for the $35,000 Wage Earner - that's in every province; the result is mainly due to not losing out on benefits like OAS and GIS
  • RRSP Always Wins for All Higher Pre-Retirement Income Levels - MillionDollar Journey's post TFSA vs RRSP - Best Retirement Vehicle? puts the cut-off more precisely at $37,000
  • The Margin of Advantage is Always Quite Small, No More than About 1.5% - that's right, across all income levels and the scenarios discussed below, whether the TFSA or the RRSP wins, the total lifetime cash flows, as expressed in their Net Present Value, and shown at the bottom of the Calculator's Results table, is never very greatly different!
  • TFSA Alone is Not Adequate for High Income Earners - the $5000 annual contribution limit on the TFSA makes it impossible for those at $120,000 to save enough to achieve even minimal 60% income replacement. Thus, in practical terms, the RRSP is a required element for retirement saving for high earners.
Key Scenarios
Next we looked at a couple of scenarios for the assumptions that matter the most: a) portfolio return - instead of our base 3%, we tried 5%, which we dub the "Excellent Market Returns" scenario, and b) savings to be depleted over 20 years (by age 85) instead of our base 30 years, which we call the "Die per Average Life Expectancy" scenario.
  • Higher Portfolio Rates of Return Matter More than How Long the Savings Must Last - Effective investing matters. The results of our scenarios show a much greater effect in retirement disposable income from a change in returns to 5% than shortening the retirement period from 30 to 20 years. A low-cost portfolio that includes a good portion of higher-return, though riskier equities, makes a big difference, as we blogged about in our previous post.
Those are the numbers. Overall, it looks as though the TFSA should be the automatic choice for low earners - those earning $37,000 or less - and the RRSP the preferred vehicle for those in the highest income category. In between, it doesn't seem to matter much.

However, there are other considerations that can change the picture and in our view affect the best strategy, as we will explain in our next post.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Monday, 17 October 2011

What is a Viable Mix for Retirement Savings Success?

Are you on track for building a financially sustainable retirement? How can you know if you are making progress whether you are 35 or 55?

Saving and investing enough depends on several factors that inter-twine and affect one another:
- what age you stop working and retire,
- how many years you save,
- your savings rate,
- your desired retirement spending,
- how long you will live,
- the returns from the portfolio where your savings are invested.
In addition, there is the make-up of the portfolio between stocks, bonds and other asset classes to decide.

It is easy to see that deciding on a viable mix can seem dauntingly complex. Obviously, the longer you work and save, delaying retirement, the lower the required savings rate needs to be. The more stocks in the portfolio as opposed to bonds, the higher the return should be, but there is more chance of stocks doing one of their familiar nose-dives at the wrong time, just at the start of retirement. The question everyone faces: what are the numbers to use?

The Past as a Guide
One way to get a good idea, if not a definitive answer, since we can never be sure the future will be exactly the same, is to look at what happened and what worked in the past. Using a long enough period that includes recessions, inflationary periods, depressions, booms, wars, financial crises, bubbles and crashes, we can gain some confidence that the numbers might be worth considering.

Enter researcher professor Wade Pfau of the National Graduate Institute for Policy Studies in Tokyo, Japan, who has done some interesting number-crunching in his paper Getting on Track for a Sustainable Retirement: A Reality Check on Saving and Work. He has figured out what various combinations of retirement age, income replacement level and asset allocation would have ensured that a person would never have run out of money up to age 100 (few of us get to live as long as Jack Rabbit Johannsen) assuming that the person had already saved a certain amount to date. In other words, he has looked at the worst case scenario for anyone retiring anytime during most of the 20th century (though he cannot go beyond anyone who would be less than 100 in 2010 e.g. a 55 year old retiree of 1965, who would have 45 years of retirement by 2010, or a 65 year old retiree of 1975, who would have 35 years).

The Example of a 55 Year Old
Pfau uses as his base case the example of a 55 year old making decisions about what to do. This is what Pfau determined.
  • To maintain a spending rate of 50% of final salary, a person could have retired at 67 if he/she had already accumulated savings of six times his/her annual salary and was prepared to save 15% of their annual salary continually till retirement using a mix of 60% stock (S&P Composite Index) and 40% fixed income (six-month commercial paper) - see the blue-circled cell in the top panel of the table below copied from the paper. For instance, a person earning $60,000 per year would need to have $360,000 in retirement savings already and to set aside $9,000 per year till age 67.
  • If the person lowered the stock allocation to 40%, retirement age would rise to 70 - per the middle panel blue-circled cell
  • If the person wanted a higher 60% of final salary replacement spending level, retirement age would rise to 69 - per the lower panel blue-circled cell
  • If the person had only saved up four times their annual salary so far and could only manage to save 10% of earnings per year, retirement age would rise to 72 - per the upper panel red-circled cell.


Ages 35, 40, 45, 50 or 60
Prof. Pfau has used the same assumptions and methods to calculate the path forward for individuals 35, 45, 50 and 60 in his blog post Getting on Track for Retirement. The table for 40-year olds is here in another post.

Taking one example from these tables, we see that a 35 year old with zero retirement savings today could still retire at 66 (blue-circled cell in the table below) at the 50% spending rate by saving 15% per year.



Stock Allocation Sweet Spot 40 to 60%
One fascinating fact coming out of the middle panel of all the tables, whatever the age at which the look forward starts, is that an optimal allocation percentage to stocks looks to lie between 40% and 60%. A higher allocation to stocks lowers possible retirement age little if at all. Below 40%, the safety of fixed income comes with a significantly increasing higher retirement age, due no doubt to the much lower returns historically achieved by fixed income.

Lower Income Replacement Gives Earlier Retirement
A 10% cut in income replacement rate from 50% to 40% has as much effect in lowering viable retirement age - three years, from 67 to 64 - as having saved eight times your salary by age 55 instead of only six times (see the green circled cells in the first table above). In the example of the $60,000 earner, is it easier or more worthwhile to save $480,000 instead of $360,000 by age 55, or cut annual retirement spending from $30,000 to $24,000.

Caveats and Cautions
We believe that though very useful, the tables should be used to ballpark and to judge rough trade-offs, not to set precise expectations.
  • Data is for the USA and though similar, Canadian investment returns have not been identical and will not be in future either. Whether this means higher or lower, we cannot be sure since Prof. Pfau has not run any numbers for Canada.
  • Investment management fees have not been deducted as the study uses index data. That would lower returns and raise potential retirement age and required savings rates to obtain the same income replacement rate.
  • A constant spending rate throughout retirement probably over-estimates what usually happens as people slow down as age advances. People also can cut back if returns are poor. Similarly, setting 100 as the age to which income is required overdoes it since life expectancy, while it continues to creep up constantly, is still only just over 80. Applying those factors would all enable a lower retirement age or lower savings rate.
The test that the portfolio should never have run out of money is very stringent. The high required savings rates are necessary in a minority of all the years considered, as Pfau's figure 4 shows. Taking a chance that the retirement years will be blessed with reasonable investment returns may suffice. Which part of the past will the future be like? No one knows. Pfau lays out an ultra-cautious approach. It may not even suffice if the future brings something worse than any period yet recorded. We sincerely hope, and expect, not.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.