Sunday, 26 February 2017

Book Review: The Essential Retirement Guide by Frederick Vettese

This book (available here on Amazon) makes a valuable contribution to the individual investor's bookshelf. It has some unique content on some extremely important topics like the frequency of health problems and their potential costs during retirement. It also provides a lot of common sense on the issues of how and how much to save for retirement, including the old bugbear rule of thumb on what percentage of working age income one should aim to replace in retirement.

The "Contrarian Perspective" in the book's subtitle is not explicitly stated but I would presume arises from key points that depart from the mainstream of advice, namely:
  • the 70% income replacement target is far too high for most people, especially the middle income earners who are constantly being hectored to save more to stave off retirement disaster; author Vettese makes a pretty good case too, showing with examples how major portions of pre-retirement expenses usually go away, such as mortgage payments, child raising expenses and retirement saving itself; instead he says, reasonable targets that maintain lifestyle are often closer to 50%; he usefully provides enough detail to allow readers to figure in variations for their own circumstances.
  • retiree spending declines with age, and at an accelerating pace, after age 70 or so, such that maintaining an inflation-adjusted constant real return overdoes the need; furthermore, he cites sources explaining that this decline is due to falling interest and capability to spend; thus, he believes that inflation at the government's 2% target rate is not as serious an issue as commonly stated.
  • buying an annuity, which only a tiny minority of retirees actually do, is a wise move to counter the risk of out-living your money if you do not have a defined benefit pension plan, which fewer and fewer people do.
The above is good stuff that has been said elsewhere, but the best content in this book is a topic of huge worry to retirees that I have never before seen treated in any kind of depth - the material on retirement health patterns and the costs thereof. It's a top of mind topic for all retirees but how significant is it in fact? I have been trying with great difficulty for some time to dig out hard facts about this and I can say that the book is worth buying just for the 40 pages devoted to health. The key health issues are addressed:
  • How long will you live and how much of that will you likely be healthy?
  • What are the most threatening health problems or diseases during retirement and how likely is it you will need to go into Long Term Care (LTC)?
  • What is the cost of LTC and what are the odds for average years in LTC and worst case?
  • Is it worth buying LTC insurance and might you be ineligible anyway? (which I discovered is my situation so I don't even need to fuss about LTC insurance)
Ironically, given the fact that Vettese is an actuary, the weak part of the book is the treatment of investing leading to and during retirement. Probably this is the result of the book's aim to address both Canadian and US audiences. There is mention of, but no in-depth discussion of types of accounts like RRSPs, TFSAs or the appropriate types of investments for each account and how this should change after retirement except the sound, but general, advice to buy annuities. Chapter 17 confusingly misconstrues the 4% withdrawal rule, ignoring the original formulation by William Bengen as a constant real (inflation-adjusted) annual withdrawal based on the portfolio value at retirement. Vettese instead states it as 4% of the remaining annual balance. The effect of Vettese's version of the rule is of course that you will never run out of money. Mathematically, taking any percentage less than 100% out of a portfolio will always leave something though at higher percentages the remainder gets awfully small. Even at lower percentages like 4, 5, 6% you will face quite significant reductions in spending in larger down market years, which goes against the objective to maintain lifestyle spending.

There is also no discussion of the dangers of poor investment returns early in retirement, termed sequence of returns risk. This is a critical risk (see this simplified example of how much sequence of returns can influence outcomes), one that finance professor and pensions expert Moshe Milevsky has found (in his book Are You a Stock or a Bond?) to be more important than inflation or longevity as a threat to successfully living off a portfolio during retirement.

Bottom line: This book is not the complete answer but it is well worth buying. Four out of five stars.

Monday, 16 January 2017

Suitability of Investments: Why it's so complicated but doesn't need to be

There is much on-going controversy in the financial advice industry amongst regulators, so-called and real advisors and their firms and consumer advocates about the current suitability standard for recommending investments versus a possible best interests standard.

There are three main issues:
1) suitability definitions (e.g. IIROC Rules or Ontario Securities Commission requirements) for investment industry salespeople are meant to stop abusive practices. Most often this involves putting clients into highly risky, high cost securities. This issue accounts for 99% of the whole suitability vs best interests debate.
2) suitability for someone like me, a reasonably informed self-directed investor (who thereby has no ethical conflicts), equates to the best interest standard. The only thing that's suitable for me is what's best for me. ... But it still leaves a very wide possible variation of investments. I could probably ask three highly experienced, completely ethical true financial advisers to tell me what investments to make and I could probably get three very different answers. This reality shows up in the definitions - beyond the words about Know Your Client and Know Your Product, the regulatory definition of suitability is still either circular where the word suitable itself is repeated, or it says something vague like "must apply sound professional judgement". That's because there is no single correct best answer even when you take into account risk tolerance and risk capacity, short and long term objectives, complete financial circumstances, including taxes and so on. The world, and life, is too uncertain to be sure you have what will turn out to be the best answer. I can say that things get even more complicated in retirement when additional factors become as or more important than the investment portfolio, such as future inflation, unknown longevity, other products like annuities, unknown health, mental decline, account choice for holdings and withdrawals (TFSA, RRSP, RLIF, regular), CPP and OAS changes by the government. If you don't believe me, peruse the writings of Wade Pfau whose research seems not to (yet?) have uncovered, after probing many suggested approaches, a right answer on how to organize the investment side alone. For example, see this discussion of three ways to incorporate bonds in a retirement portfolio about which he notes "Scholars and practitioners have numerous disagreements about the best way to incorporate bonds into a real-world retirement income plan."
3) suitability can and should also apply at the portfolio level, not just individual securities, funds or ETFs. Asset allocation is a powerful risk mitigation tool that works at the portfolio level. Thus, robo services that propose and actually implement collections of ETFs with rebalancing rules should not have to apply a suitability judgment against individual ETFs - a more volatile emerging markets ETF as a minor portfolio component with USA equity and a bond fund can reduce overall volatility and that would make it ok even for a conservative investor. On its own, it would probably not be ok however.

When all is said and done, I believe, for example, that a low fee balanced equity - fixed income fund (such as Larry Macdonald's One Minute Portfolio or our similar Reluctant Investor's Lifelong Portfolio) is suitable for everyone and anyone, of whatever age or financial circumstances. Why? simply because it is not unsuitable. The anti-definition is best >> What is suitable? = Anything that is clearly not unsuitable. 

Eliminating the Unsuitable by avoiding dangers
In practical terms, a default automatic suitability pass could consist of individual securities, mutual funds, ETFs or portfolios with all of:
  • no leverage 
  • no use of derivatives
  • low fees, for example under 0.75% MER
  • diversification, such as individual mutual funds or ETFs with holdings of 50 or more individual securities
  • avoid over-concentration by holding less than 10% of total portfolio value in individual securities, which also must be listed in the TSX Composite index, or S&P 500
  • fixed income (individual) with ratings of investment grade or funds with no less than 70% investment grade holdings
  • portfolios (such as robo advisors provide) of equity combined with fixed income where each of the two is limited to 30% to 70% of the total value
  • minimum liquidity characteristics, an exact number for which I cannot suggest but would be based on trading volumes in a public market
It's quite possible that other securities could pass the suitability test - indeed one of my favourite and highly suitable funds is BMO's Low Volatility Canadian Equity ETF with only 46 holdings. Such alternatives would need to have more justification as to why they are suitable e.g. low volatility is very beneficial for a retired investor to reduce sequence of returns risk (a large market drop early in retirement combined with portfolio withdrawal causing an irretrievable reduction in the portfolio) while retaining the equity exposure.
Such a restrictive approach to suitability as the above makes investing simpler and allows the focus to shift to the other elements of financial management for individuals, which is where it should be.

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