Tuesday 20 December 2022

ESG, a good idea gone bad

Some years ago we praised the assessment of Environmental, Social and Governance (ESG) factors to evaluate potential investments. Now we unfortunately must say, forget it, don't do it. Whether you are looking to ESG to apply your morals or values, or you simply want to find investments that outperform in the long run, ESG has become a waste of time and money.

Problem #1 ESG Scores are inconsistent, contradictory and opaque and therefore useless to the investor

Brian Tayan has saved us a lot of time compiling the details of ESG's sorry condition in a lengthy well-documented review article at the Harvard Law School Forum on Corporate Governance titled ESG Ratings: A Compass without Direction. A key comment in the review highlights a critical problem:

"Studies find low correlations across ESG ratings providers. [professional ratings companies like MSCI, FTSE, S&P, Sustainalytics, Refinitiv] This is perhaps surprising if ESG ratings are supposed to measure the same construct." 

They don't come up with the same evaluation result at all, so whose is one to believe? Which ESG fund is best amongst the many with non-overlapping holdings? It's impossible to tell. Diving into the details of the hundreds of data points each ESG evaluator collects would be daunting in itself. It is impossible in practice given the opaqueness of the assessment criteria along with the considerable dose of judgement calls by analysts looking at the exact same facts and figures. Even professional investors like big pension funds cannot figure out what the ESG scores mean. Do you think we individuals have the faintest hope of doing so?

An indication that ESG has become a fad that the investment industry is exploiting to "skin the rubes" is that the marketing of many ESG funds to the public emphasizes making the world a better place (i.e. the moral virtue argument) while the rating scheme actually aims to gauge the risk the world poses to the company (i.e. the maximize investment performance approach). Worse yet, Tayan cites research that "... companies in ESG portfolios (those with high Sustainalytics ratings) have worse records for compliance with labor and environmental laws relative to companies in non-ESG portfolios during the same period." High ESG can thus mean the exact opposite of what many morally-driven investors seek! Yiles!

More research is cited indicating a doubtful link between ESG and investment performance: "They conclude that “the financial performance of ESG investing has on average been indistinguishable from conventional investing.”

Bottom line, individual investors are best off in low-expense broad-market funds. There's little point to ESG funds. The top ESG scoring companies are all in the broad market funds anyway.

Problem #2 Mandated ESG scoring and reporting replaces markets with government coercion towards political and social objectives

An example is already here. The Canadian federal government announced in its spring 2022 Budget that banks, insurance companies and pension funds will be obliged to report "climate-related risks and exposures" after 2024. And not only about themselves but about their clients too. The climate crusade against fossil fuels is being institutionalised by force. The extension from reporting to mandatory financing restrictions on oil, gas and coal is merely a next step already being pursued. Banks are being forced to abandon lending at a profit as their primary driver to a different one imposed by force by political agents. ESG has become dominated by the single factor of climate. That's not healthy or sensible.

An excellent summary of the debasement of ESG is Why Business Should Dispense with ESG by Samuel Gregg on 4 Dec 2022 at the American Institute for Economic Research. The key knock Gregg levies against the new and useless strain of ESG is Stakeholder Theory, which maintains "... that the purpose of business goes far beyond profit and maximizing shareholder value". ESG is thus no longer "... the practice of businesses prudentially assessing their surrounding economic, political, and social environment to identify those constituencies (“stakeholders”) with whom any company must work if it is to realize profit."

Hilariously, Tayan reports a study that found more ESG disclosure does not improve consistency of scores, it widens the divergence due to the subjective nature of evaluations. 

Whatever value ESG had for investors to be able to invest as they see fit has rapidly been usurped and corrupted. 

Thursday 9 June 2016

Retirement Risks - Unexpected Events: Family Trouble, House Repairs, Bankruptcy, Funerals, Divorce etc

Bad things with significant negative financial effects can and do happen in retirement, not just occasionally but often. The 2015 survey by the Ontario Securities Commission Financial Life Stages of Older Canadians found that close to 60% of people 50 and over had experienced an event that was major enough to affect their retirement plans or ability to live off their retirement savings. Health issues were certainly prominent but a range of other matters also caused serious financial problems – helping out adult family members, permanently losing money in the stock market, major home repair bills after a disaster, losing employee benefits, divorce or separation, funeral expenses, collapse of real estate value, business or personal bankruptcy and investment scams. Often more than one event descends on the unlucky. Such events do not lessen the longer one is into retirement either. They happen at any age with about the same frequency.

You may well find that your job as a parent never really ceases. Retired parents often find themselves providing financial help to adult children. You never cease being a sibling or a child either. If brothers, sisters, mom and dad, maybe even cousins, aunts, uncles run into financial trouble there might well be requests for help or a perceived obligation to do so, especially if you are comfortably well off. However much one may wish to apply “tough love” and say no, it seems to be very difficult to overcome emotional bonds. A 2015 survey from the Bank of Montreal Wealth Institute, aptly named The Family Bank, found that parents were willing to delay their own retirement, save less, withdraw savings and have a less comfortable retirement, even take on debt at times, to provide financial support. Very often it's not just emergency or one-time support, it's also monthly bills and day-to-day expenses as the survey found.

People retired nowadays are giving support about twice as much to their adult children as they received from their own parents. BMO quotes psychotherapist and parenting expert Alyson Schafer who says there is a danger that this will create an unhealthy dependency and prevent the child from attaining the mental resiliency, skills and strategies to deal with life's inevitable frustrations, challenges and setbacks. It's tough to find the right balance between helping people get on the road to self-reliance and creating dependency.

There are various possible ways to deal with these life events to ease or avoid the financial pain. The simplest and most general plan is to have a larger cash emergency fund and a spending buffer in the form of a higher income than you need strictly for yourself. On specific events, pre-paying for a funeral is one tactic. Home insurance is a natural protection against major home accident repair bills. Permanently losing money in the stock market, to the extent that it could cause serious financial harm, should simply be avoided with a proper set of investments, as we have explained in many previous posts (see our Guide to Self-Directed Investing). One of the key principles to do that – diversification – also applies to preventing catastrophic harm from personal or business bankruptcy and real estate value collapse. When bad events do happen, most already-retired people end up cutting back their spending i.e. being forced into a lower standard of living and / or cashing in savings earlier than desired.

Sunday 31 January 2016

Long Term Interest Rate Outlook: Persistently Low

In our last post we explored how much interest rates would need to rise to justify holding off purchasing an annuity by five years. It wasn't much - depending on present age, sex and assumptions about returns on the interim portfolio, it could range from 0.30% to 2.85% rise over five years. But constant expectations of rate rises since the financial crisis of 2008 have come to nought as the Bank of Canada base rate has remained at 1.0% or below since then (see Global rates.com graph here). Yields on long term Government of Canada bonds have steadily dropped from around 6% in 1999 to 2% recently (see Investing.com's historical table of 30-year bond yields). In December 2015, the US Federal Reserve finally raised its interest rate by 0.25% after seven years at 0.25%. The Bank of Canada did not follow suite and the business media speculation seems more pointed to a rate cut than a rise in Canada due to the effects of plummeting oil prices on the Canadian economy.

So are these low rates still just a temporary phenomenon till the economy gets going again? How much longer could temporary last? The answer is many years, it appears. Here's why.

Demographics will be a decades-long stiff headwind - The combination of increasing longevity exacerbated in the immediate future by a mass of retiring baby boomers (mea culpa, I'm one of them) means the working age population will continue falling for the next several decades (see graphs in the Globe and Mail's Boom, Bust and Economic Headaches of November 2015). It's happening not just in Canada but throughout most developed economies as shown in the chart below from the Bank of Canada report Is Slower Growth the New Normal in Advanced Economies?
(click image to enlarge)

A growing population and a growing working population is a major source of economic growth so when it is slowing down, as it forecast to do, that is causing forecasts for economic growth to be constrained to lower than historical performance. Long term Canadian economic growth forecasts hover around 1.7% (TD Bank, Royal Bank and the Centre for the Studies of Living Standards and the Parliamentary Budget Office cited in a paper from the CD Howe Institute), or a bit higher 2% (OECD in an older 2013 forecast). That's a contrast to the heady years of the 1970s, 80s and 90s when 2% growth was considered a poor year. The downward trend is very evident in this chart from Trading Economics.
(click image to enlarge)

Sluggish growth means continuing low interest rates as central banks including the Bank of Canada attempt to provide policy stimulus. In slow growth there is less demand for money for investment to take advantage of business opportunities. Meantime, the greater mass of retirees buying bonds or pension funds and insurance companies offering annuities, i.e. supplying money for companies and governments to borrow, provides supply that also pressures rates lower.

Paying off massive accumulated government and private debt will also work to keep rates low - The huge amounts of debt that helped precipitate and exacerbate the 2008 financial crisis still have not been paid down to more normal sustainable levels according to common consensus (e.g. see the Bank of Canada paper cited above, also the US-based money manager Research Affiliates 3-D Hurricane's colour-coded map of countries' debt levels). McKinsey & Company reported in early 2015 that worldwide debt has increased, not decreased since the financial crisis. Canada may have started better off with significantly lower debt but it is worsening. One of McKinsey's charts (see below) shows Canada's total private and public debt rising much faster than the USA and the UK. It is hard to see that changing with a new federal government in Canada taking the stance that deficit spending to stimulate the economy is a priority.
(click image to enlarge)

The motivation of many countries to make their debt loads more sustainable will lead them to keep interest rates low, a policy caustically termed financial repression.

In October 2015, the CD Howe Institute published a paper by Craig Alexander and Steve Ambler that projected a 1% real interest rate on T-Bills for the long term based on expected economic growth, itself based on projected demographics. Adding 2% inflation, that would amount to a 3% nominal rate, which is about 2.5% above the slightly less than 0.5% as of the end of January 2016 (see Bank of Canada T-Bill rates). A 1% real rate is far below the 2.2% real T-Bill return achieved over the last half century according to the Credit Suisse Global Investment Returns Yearbook 2015.

1% real risk-free interest rates are most likely an upper bound. The Credit Suisse report says the real T-Bill return was only 0.4% from 2000 to 2014. When TD created its forecast in December 2015, it projected a 1.8% end of year nominal rate on 10-year Government of Canada bonds. But no sooner had it done so than the yield dropped to about 1.25% where it stands now. One wonders if TD would still stand by its forecast of a 10-year rate rise to 3.45% by the end of 2019. Leo Kolivakis at Pension Pulse even makes a case that negative interest rates might be around the corner in Canada and the USA in his observations following the Bank of Japan's recent cutting of rates below zero (i.e. charging banks to keep cash on deposit).

Bottom line: It seems within the realm of possibility that interest rates in Canada would rise the 1.2% or so over five years that we previously calculated would make it worthwhile for a 60 year old man to defer buying an annuity till age 65. But the more likely outcome is for much less a rise. The strong forces of demographics and debt seem to be pushing in hard against a rise and they are not going to get better anytime soon. Looks like interest rates will continue to stay very low or at best rise slightly and slowly.

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.

Copyright 2015 Jean Lespérance All Rights Reserved

Thursday 5 November 2015

How Much do Interest Rates Need to Rise for Deferral of Annuity Purchase to Make Sense?

When interest rates are higher, annuity payouts are higher. The big question is, exactly how much would interest rates need to rise in order to justify deferring the purchase of an annuity? Not that much, is the answer, but there are some crucial differences according to age, sex and assumptions about portfolio returns. And there is a significant risk if interest rates do not rise but merely stay the same.

A 1.2% increase in interest rates over five years (i.e. 0.24% per year) could suffice to make it worthwhile for a man, taking money out of an RRSP or RRIF, to defer buying an annuity for five years from age 60 to 65.

The table below shows the results of our calculations. The base case of the assumptions we think most logical is shown in the left most column, along with other possible assumptions for male annuities and the base case for women in the right-most column.

In all cases our approach is simply to make the ultimate lifetime income the same, whether the annuity is bought immediately or deferred five years. While the deferral is under way, we assume the same amount is withdrawn every year from the investor's portfolio as the immediate annuity pays out. The later deferred purchase is then priced on whatever amount would remain after withdrawals and each year's portfolio return and, crucially, at the higher annuity payout rate the five year older person would get. The older you are, the more mortality credits boost the annuity payout, as we explained in Is it Worthwhile to Wait for Higher Interest Rates to Buy an Annuity?.
(click on image to enlarge table)

Here are some other observations on the results:
1) The younger you are, the more worthwhile it is to defer - At age 60, the required rise for a male annuity buyer is only 1.2%, but deferring from 70 to 75 would require a 2.4% rise. The same age pattern exists for women, it's only the numbers are different. The reason is that mortality credits (the money that comes from other annuitants dying) are much more important the older you are, so missing out by deferring makes less and less sense.

2) It takes less of an interest rise to make deferral worthwhile for a woman than a man - The right-most column for female annuity pricing shows that deferring from age 60 to 65 requires only a 0.95% rise in interest rates to gain higher annuity income. The reason again is mortality credits. Because women live longer than men, it is as if the whole age scale for mortality credits is shifted youngwards - women get fewer mortality credits than men of the same age. Note that single-sex, men vs women, annuity pricing, where the differing lifespans influence payouts, applies only to non-locked in registered retirement accounts, TFSAs and non-registered accounts. Locked-in retirement accounts are subject to unisex pricing rules that create payouts in between those of the single-sex prices, (Our table does not show those payouts)

3) A high return in the investment portfolio during deferral can significantly reduce the required interest rise - When we set the investment portfolio's annual return at 2.7%, matching the return embedded in the annuity, the required interest rise was only 0.3% for the 60 year old investor, versus the base case 1.2%. The required interest rise was much lower for the other two age groups as well. ... however ...

This raises a crucial point - what rate of return on the interim investment portfolio is most logical to assume. Our base case uses 1.0% per year, which is about the net return (yield to maturity of 1.26% minus the fund's MER of 0.28%) currently on the iShares Short Term Bond Index ETF (TSX symbol: XSB). This ETF has very high credit quality and its duration of 2.79 years means that it will have limited exposure to capital value losses that would result from the very interest rate rises the investor is trying to take advantage of. As we discussed in What Happens to a Bond ETF When Interest Rates Rise? duration also tells us how long it will take for the ETF to recover from capital losses as newer higher yielding bonds replace outgoing issues in the ETF portfolio. At the end of the deferral period, the investor wants to be sure to have enough money to buy the annuity. Investing in much more volatile longer duration higher yielding bond ETFs, or a stock bond portfolio, is taking on considerable exposure to volatility risk.

One thing that does not make much difference is how much of the interest rate increase is captured by the interim investment portfolio. The second column from the right shows the results when only half of the interest rise gets reflected in the interim portfolio. This might well be the case for the short term bond fund when the interest rise, which is the rise in the long term rate used to price the annuity, is not matched at the short term end.

4) If interest rates stay the same, there is a big hit to the deferred annuity income - The 60 year old man would be forever stuck with about 13.1% less yearly annuity income, the 65 year old 15% less and the 70 year old 18.7% less. There will be less of a hit to a woman but it will still be very noticeable as our table shows.

Bottom Line: Is it worth taking the chance? What are the chances of a rise in interest rates and by how much? We'll explore that question in the next post.

How we came up with the calculations - Note that this blogger is not an actuary or annuity pricing expert. Our calculations are rough (and rounded to the nearest 0.05%) but hopefully reasonable. First we followed the method for roughly pricing an annuity laid out by professional retirement researcher Wade Pfau in Income Annuity 101. Then we applied recent mortality tables from the Canadian Institute of Actuaries - Canadian Pensioners' Mortality, published in February 2014 - that contain data on pensioners of private plans (apparently public plan pensioners live longer!). Next we compared resulting actual current prices of annuities as quoted in the Globe and Mail to find what implicit interest rate is embedded in the current quotes. That's how we got the 2.7% rate to discount annuity payouts. The 2.7% discount rate also lines up pretty well with what a portfolio of highly secure investment grade long term bonds would yield nowadays i.e what the insurance companies would invest in to back up the annuities. For instance, a mix of federal ( holdings like BMO's Long Federal Bond ETF (TSX: ZFL) with a yield of 2.25%) and provincial (holdings like BMO's Long Provincial Bond ETF (TSX: ZPL) with a yield of 3.28% could average out to 2.7%.

There are other signs we are close to the mark in the calculations. First, retirement researcher Wade Pfau in his post Annuity Pricing Sensitivity also calculated the effect of interest rate changes on annuities based on annuity pricing principles. Historical Canadian data in this post came up with 0.58. The two approaches give us reassuringly close estimates that every 1% rise in interest rates will cause annuity payout rates to rise about 0.6% (Pfau gets 0.63 to 0.65% and my Canadian data shows 0.58). On our simple annuity model the figure is 0.61%.

Second, the TIAA-CREF Institute, a research offshoot of one of the largest retirement income providers in the world, looked at the general issues around possible deferral of an annuity purchase in Annuities: Now, Later, Never? At unchanging interest rates they found that annuities always look better than deferring indefinitely and living off drawdowns from an investment portfolio.

However, they also showed that deferring in period of rising interest rates could be worthwhile. For instance, they calculated that if interest rates increased 0.25% a year for five years (i.e. 1.25% in total after five years), deferring the annuity purchase at age 65 by five years (and living off drawdowns from the portfolio in the meantime) would enable the purchase of an annuity with more than 7% higher income. The benefit tails off with a longer deferral. A 10-year deferral would produce only 3% higher income. A big caveat that they note is this result depends on the interest rate embedded in the annuity pricing (i.e. the interest rate the insurance companies receive from investing the lump sum premiums) being the same as the interest rate / return the portfolio could obtain. The interest rates won't be the same, if one is to construct a realistic apples to apples comparison. With the annuity, the insurance companies will invest in long term highly rated bonds while someone intending to defer five years would logically opt for much shorter term bonds as we argued above. So our results are more cautious than TIAA-CREF's though with the same patterns.

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.

Copyright 2015 Jean Lespérance All Rights Reserved

Tuesday 13 October 2015

Surprise! Equities can Outdo Bonds for Cash Distribution Attractiveness

October 2016 Update: Little has changed since last year and since the original 2013 post. The various equity ETFs continue to power ahead of bonds, both in terms of total returns and of cash distributions. Thankfully, all the ETFs, including bonds, are handily beating inflation. Many would think of bonds as sources of steady cash but ironically, the positive return for the bond ETF (symbol XBB in the graphs) has come from capital gains. Financials still rule, far outstripping the other types of ETFs and the average market in cumulative total return over the past five years. Energy has continued to be a severe disappointment for investors, not even managing to outdo inflation.

The updated charts are as follows:
1) ETFs with the longest history back to 2002
(click on image to enlarge)

2) ETFs with a shorter history back to 2007, such as dividend and fundamentally weighted ETFs
(click to enlarge)

3) Returns and table of cash distributions
 (click to enlarge)

October 2015 Update: The same pattern described in the original article below has continued. Equity distributions have continued to rise while bond distributions in the XBB ETF are still falling. A few of the charts updated to include 2014 distributions demonstrate how cash distributions from various types of equity ETFs have continued on a steady upward path. The big exception is the highly volatile energy ETF XEG, whose distributions have been way up and have now fallen back considerably. After the big fall in 2009, REIT distributions have maintained an upward path. All the equity ETFs have far outstripped inflation.

1) ETFs with the longest history back to 2002
(click on image to enlarge)

2) ETFs with a shorter history back to 2007, such as dividend and fundamentally weighted ETFs
(click to enlarge)

Returns matter too ... and that changes the overall picture. The table below for the same ETFs shows the overall change in cash distributions along with the annual compounded total return (distributions plus capital gain or loss) for the five years up to 30 Sept 2015 for these ETFs. 
(click to enlarge)

First, we note that XBB's results are not all bad - its total return has been positive despite falling cash distributions. Next, we see that XEG's returns have been strongly negative to go along with the fall in distributions. Energy has been a very poor investment. It has done worse than inflation, unlike every other ETF, both bonds and equities. Ironically, one ETF with weak growth in cash distributions - CDZ - is the one explicitly targeting companies that have shown strong dividend growth. The ETF seems to pick up companies after they have had a burst of increases, a fine example of past results not necessarily being indicative of the future. Neverheless CDZ's total return has been very strong, second best overall. The clear overall winner has been the financials - the XFN ETF has had both healthy cash distribution rises and excellent capital appreciation to produce an outstanding total return of 9.3% per year compounded.

The Original article ...
Back in January (2013) we looked at the cash distributions of a few mainstream Canadian equity ETFs and made the pleasant discovery that such income was quite stable from year to year in recent times despite the often gut-wrenching moves of the ETF's price in the market. That is very pleasing to know for long term buy and hold investors who are seeking income, such as those in retirement. It was doubly pleasing to see that the equity ETF distributions were as stable as those of a broad market bond fund. A third attractive feature was that the distributions of the equity ETF had risen appreciably during the 2000s decade while that of the bond fund had declined as interest rates fell continually through the period. Today we return to this theme to find out more - how specific industry sectors like financials, energy and real estate (REITs) have fared and what the longer term history of dividends can suggest about the likely future.

Equity ETF cash distributions generally rose ....
The chart below shows how distributions per unit / share have evolved from the inception of each of the following ETFs.
Immediately we notice that the gap between per share payouts on the bond ETF, the yellow line, and the various equity funds has narrowed considerably over the years.
... but the progression has been uneven amongst sectors
The orange line of the energy ETF XEG is up over the long term but it has seen wild upward then drastic downward movement, not very attractive to anyone seeking steady cash income. 
The dark red of the REITs XRE started quite high but there was a big drop during the financial crisis with some recovery since but the overall income level is slightly down from its 2003 start year. That's a surprise for a sector that is often portrayed as a steady high-income investment. We explore more why this happened below. 
The mid-blue line of the financials in XFN is the best performer of the lot. Another surprise is that it took the least hit during the financial crisis. The big banks merely held their dividends steady for a few years then started boosting dividends again. Now the sector has recovered all the lost ground and is at a new peak. 
The broad TSX 60 XIU fund, which contains a large dose of financials and energy as well as other sectors like mining, industrials and utilities for which we do not have data, has gone steadily but slower ahead overall. The ETF with the broadest diversification across economic sectors has had the steadiest payout record.

Equities look even better on a total income basis
Another way to look at the past distribution performance is to pretend we had invested a large lump sum ($100k) at the end of the year 2002 and simply collected the cash payouts. We ignore total return and do not calculate any re-investment of the distributions. The distributions are real cash in the investor's hand, net of any management and administrative fees. The chart below shows what would have happened.

The REIT fund XRE started well ahead of the pack and is still way ahead after 10 years but its lead has narrowed considerably. And it has lost ground to inflation (shown by the purple line), as has XBB, due to falling total distributions (NB again that we are only considering the cash distribution part not the total return of the fund where capital gains might have made up for the declining income). From second highest total cash received in 2003, the bond fund XBB would now trail all the equity funds

The erratic path of XEG might have caused many investors heartburn even though overall the net increase in distributions since 2003 has far outstripped inflation. The financials XFN and the mixed equity XIU have followed quite a parallel path, though XFN has inched ahead.

Why did REIT distributions fall so much?
The answer is that a few REITs with a heavy weight in XRE cut their distributions during the financial crisis, most notably H&R (HR.UN) and Chartwell (CSH.UN) while another, Dundee (D.UN) made no increase. All the other big REITs had increases, most of them quite healthy e.g. from 2003 to 2012 RioCan (REI.UN) +21% total increase in cash distributed, Canadian REIT (REF.UN) +20%, Calloway (CWT.UN) +35%, Cominar (CUF.UN) +25%, CAP REIT (CAR.UN) +2%, Boardwalk (BEI.UN) +52%. When we note that XRE contains only 14 REITs the influence of one or two holdings can be significant. Cuts in distributions are not typical of the sector. 

For investors looking at direct holding of REIT units instead of a fund, the past history is a reminder to closely consider the sustainability of the REIT payout - is the REIT distributing more cash than it earns? Chartwell is still having big problems with large net losses. H&R seems to have steadied the ship somewhat and has increased distributions since 2009 but the 2012 payout was still 10% below that of 2003 and it has more debt and lower return on equity than the other major REITs.

Will the equity ETFs continue to outgrow bond ETF cash distributions?
The investing landscape has been changing fast recently as interest rates, long kept at record low levels by central banks, have started to rise dramatically (see Bank of Canada's charts of various benchmark bond rates). As a result, bond prices have fallen and it is now much cheaper to buy into XBB. Anyone buying in at the current price (as of 26 June 2013) with a lump sum, such as we pretended to do in 2002 would get a 3.23% cash distribution yield from XBB according to its iShares webpage. By fluke, it so happens that XIU's current cash distribution is exactly the same 3.23%. 

As of June 26th, the investor would get exactly the same cash distribution from XIU and XBB. But as time passes, the cash distributions for each will change and diverge driven by different factors.
XBB distributions will evolve with interest rates
There has not been a huge absolute shift in interest rates - around 0.7 to 0.9% or so for medium to long term government bonds  - though the relative shift - about a 30% increase in the rate - in the last month has been dramatic. XBB's 2.7% yield to maturity is still below the cash distribution yield of 3.23% which means that if interest rates never changed again from today the existing bonds with higher coupon rates of bonds issued long ago at times of much higher interest rates, would eventually get replaced with lower coupon (around 2.7%) bonds and cash distributions would still fall. If interest rates keep rising, and it would not be too surprising if they do since we are still at the very low end of rates historically speaking e.g. see this Barry Ritholz chart for US rates going back to 1790 then after another 0.5% or so of rise, XBB distributions will level off. If interest rates rise above 3.23%, distributions will gradually start to rise as the higher coupon bonds gradually replace maturing lower coupon bonds. The slow downward creep of distributions that we see in our charts above would be become a slow upward creep.

XIU distributions will evolve with economic growth and earnings growth
Equity ETF distributions are driven by the dividends paid by companies held within the funds. There is good historical evidence, some of which we linked to in our first post back in January, that dividends on broad market indexes do rise over time and do also handily outstrip inflation. Unless economic growth stops entirely, companies no longer grow earnings and dividends cannot grow too, we do not believe cash distributions of funds like XIU will stop rising. For example, Thornburg Capital's The Benefits of Dividend Paying Stocks shows much the same exercise as our pretend investment of $100k in 2002 but for the USA's S&P 500 going back to 1970. The results in their chart, copied below, look very similar overall, though we notice that there was a much bigger hit to dividends from the 2008 financial crisis. The results of sectors may vary but the overall market should grow over the years.

Bottom Line: Equities, especially broad-based ETFs such as XIU (and there are multiple others from other providers such as BMO, Powershares, Vanguard) present the income-seeking investor with an attractive combination of cash distribution stability and long term growth.

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.

Copyright 2015 Jean Lespérance All Rights Reserved

Monday 6 July 2015

Is it Worthwhile to Wait for Higher Interest Rates to Buy an Annuity?

Payouts on annuities are at all-time lows these days. The same lump sum payment buys a much smaller lifetime income than it did ten or fifteen years ago. The main culprit is the steady fall in interest rates in the last few decades. Money that the insurance companies receive from investors and then invest themselves in highly secure bonds to back up the annuities yield a lot less so the insurance companies can offer less.

That situation may cause some people to wait for higher interest rates to get a higher payout on an annuity. How worthwhile is this? In our last post on annuity buying tips, Annuitize now, or wait?, in tip #7 we concluded that the basic answer is that if you need to start taking income, it doesn't make sense to wait. It is tough to beat the return required to beat the annuity. But that assumed that interest rates stay as they are. Suppose they rise, as has been expected for years now, though it has not happened yet.

Annuity payout rates will rise much more slowly than interest rates
Using the actual data from 2000 to 2013 on the Individual Finance and Insurance Decisions Centre in the Payout Annuity Index, we can see the steady drop in actual payouts on annuities as interest rates fell from around 6% on Government of Canada 10-year bonds to the 1.77% available as of 26 June 2015. Payouts on the way down can give us a good rough idea of what would happen on the way up. We found the payout for every 0.25% or so interest rate level and came up with the following graph.

The annuity payout rate is simply the yearly income you get divided by the lump sum you pay over to the insurance company, e.g. on 26 June 2015, a 65 year old male RRIF single sex priced monthly income annuity averaged over the five highest insurance company quotations for a $100,000 lump sum came to $6,150 income per year, a 6.15% payout. In contrast the payout rate on 19 July 2000 when the 6% GOC rate prevailed was 8.83%, or $8,830. That's a substantial $2,700 more income per year.
(click on image to enlarge)

The graph shows how gradual the change in annuity payouts is compared to interest rates. A 4% difference in interest rates from 2% to 6% - a three times increase - produces only half that amount of change in payout, just over 2.3% from 6.5% to 8.8%.

Mortality credits, the return from people dying younger to those dying older, strongly influences the gentle slope of the graph points. As we noted in our previous post, interest return drives only part of the annuity income. Mortality credits are another large chunk. The 1.7% difference in payout rate between ages 65 and 75 also shows the powerful effect of mortality credits. It is much more worthwhile to look at getting older as a source of higher income than rising interest rates. And unlike interest rates, we definitely know which direction we are going in terms of age!

Continued rising life expectancy means the slope will be more gradual than the historical graph
The above graph over-states the steepness of the slope of changes to the annuity payout rate in response to interest rates. The reason is that life expectancy has continued to increase in the 15 years since 2000. The extra three or so years gained in longevity since 2000 means the insurance companies have to pay out for longer and so they offer lower monthly income. In addition, the insurance companies know about the actuarial projections which forecast a continuation of rising life expectancy. Since the oldest data and the higher interest rates are at the right end of the graph, that's where the greatest change in life expectancy has occurred and the payouts would be most reduced. The slope of the line is consequently reduced.

The relative attractiveness of annuities is greater at low interest rates than high interest rates
The higher are interest rates, the greater is the interest rate component of the annuity return versus the mortality credit component. The following chart shows the compression of the gap between annuity payout rates and interest rates / GOC 10 year bond rates the higher the GOC 10 rate.
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At the highest interest rates, other safe investments like the GOC 10s are much more competitive with annuity payouts. The payout rate for a 65 year old man when GOC 10 interest rates were 6% was only 8.8%, a gap of only 2.8% but the gap today at current 1.77% GOC 10 interest rates is 4.4%.

The investment funds that will be used to buy the annuity may be reduced by rising interest rates
If you as the investor waiting to buy an annuity hold a diversified portfolio of stocks and bonds, consider the reaction of those holdings to a rise in interest rates. For bonds, the answer is straightforward. They will fall in value. Investopedia explains how this works. The Duration metric indicates the sensitivity of a bond or bond fund to interest rate changes - e.g. as of 6 July 2015, the broad market Canadian bond ETF from BlackRock, the iShares Canadian Universe Bond Index ETF (TSX symbol: XBB) has a duration of 7.35 years. Thus, if interest rates were to rise 1%, XBB's value would fall about 7.35%. $100k of annuity money would drop to about $92,650. To recover that capital loss in XBB would require staying invested for the 7.35 year Duration (we described how this works in this post).  Meantime, for the annuity, that interest rate rise, judging roughly by the graph above, might bring about a 0.5 to 0.6% higher income payout. That's a much smaller gain than the XBB loss. In addition, XBB's return, aka yield, is only 1.65% net of fund expenses (1.98% portfolio yield minus 0.33% MER).

There are many shorter Duration, less interest-sensitive funds around, such as BlackRock's ETF with trading symbol XSB, but returns are even lower, such as the 0.8% net of expenses for XSB.

Stocks are usually also hurt by rising interest rates, especially in the short term, though in the long term, the businesses do adjust and stocks do ok. The price reaction of stocks and stock funds is much less predictable and more variable than for bonds, as we previously described. The investor is left with considerable uncertainty and the annuity purchase becomes very dependent on market conditions for the best annuity purchase timing.

Perhaps the best alternative waiting time investment is cash, whose value is completely insensitive and oblivious to interest rate changes. A High Interest Savings Account today can earn up to 1.95% (though the deposit protection may be less than the best, which is CDIC's). HISAs at major institutions with CDIC deposit insurance coverage currently earn about 1.0%. Nevertheless, while interest rates are steady, the opportunity cost metric Implied Longevity Yield, which we described last post, handily beats that return.

How long can you wait?
The final element to think about is how patient you can manage to be. In our previous post on which bond ETFs are most susceptible to interest rate changes, we wrote "Interest rates will inevitably rise when conditions improve, the only question being how soon that will happen. Be ready!". That was in 2010 - almost five years ago! It's a long time to hold one's breath. In the interim, the annuity payout rate for a female single life 10-year guaranteed RRIF-funded annuity fell from 6.7% to 5.7% as interest rates fell, instead of going up.

In short, waiting for rising interest rates likely is not worth it. Waiting while you get older is a better way to think about it.  But if you need to draw income and you can cover you can cover basic needs with an annuity even at today's low rates, it's likely not worth waiting at all.

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.

Copyright 2015 Jean Lespérance All Rights Reserved

Sunday 21 June 2015

Buying a Life Annuity - Tips

When buying a Life Annuity it is especially important to get the best deal since it is a one-time decision that lasts a lifetime. Here are some points to consider in making the purchase.

1) Shop around, use a broker
Make sure you cover all the life insurance companies that sell annuities. As the listing of current rates on the Globe and Mail annuity table and our comparison table below show, the company offering the highest income usually differs according to your sex and age. The highest quoting company also change constantly. The best way to shop around is by using a good broker who deals with all the companies, such as LifeAnnuities.com (Ivon Hughes) and Canadian Annuity Broker Services (John Beaton).

There is a wide range between the highest and the lowest income quotes - anywhere from 3% to almost 30%. The range widens the longer the deferral period between purchase and income start date e.g. hi-lo quotes in our table below on the eight and a half year deferral to age 71 for a 62 year old span more than 20% for all types of life annuities for both men and women.

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2) Mind which account you use to buy the annuity
Men should buy with RRSP/RRIF funds first, and locked-in funds (LIRA/LIF/LRIF) funds second, for pension money regulated in all provinces except Quebec and Newfoundland & Labrador. Women should do the opposite and buy with locked-in funds first and RRSP/RRIF funds second.
That will obtain the most annuity income for both men and women. The reason is legislated mandatory unisex rates, which came into effect during the 1980s and which apply to all locked in pension money but not to RRSP/RRRIF funds. Under unisex rates, insurance companies are not allowed to price annuities differently for men and women, which would entail paying higher amounts to men and lower amounts to women in recognition of the fact that men die sooner than women and thus do not collect their lifetime annuity for as long.

The result, as our table shows, is that unisex-rated income lies somewhere in between the single sex-priced income for men and women, anywhere from 3% to 8% above - for women - or below - for men - the single sex income level. Men lose and women gain with unisex. Quebec still requires, and Newfoundland & Labrador still allows, single-sex annuity pricing in locked-in accounts. Standard Life has created a detailed table on pension legislation, part of which covers sex discrimination provisions across Canadian jurisdictions.

Most online sources of current annuity quotes seem to publish only the single-sex prices so getting unisex quotes for locked-in money will require contacting a broker.

3) Men - Unlock to get more income
Men should take advantage of unlocking privileges to be able to use single-sex pricing. Locked-in pension savings may be moved to unlocked accounts, like an RRSP or RRIF under certain conditions, including becoming non-resident, financial hardship, small remaining balances and reduced life expectancy as TaxTips.ca explains on Unlocking Your Locked-in Pension Accounts. The most generous provisions are under Federal (see FAQ here), Alberta and Manitoba jurisdictions, which allow a one-time unlocking of up to 50% of account value upon moving the funds from a LIRA or LRSP into a LIF or LRIF. Once inside the RRSP/RRIF the funds can be used to buy higher income single-sex annuities instead of unisex annuities. The same amount of original locked-in money will buy higher income.

4) Check out a short guarantee period
Choosing a guaranteed payment period of 5 or 10 years may offer higher income than a no guarantee period. This is a bit of a surprise. It would normally be expected that when the deal is that the insurance company stops paying out an annuity immediately upon the annuitant's death instead of guaranteeing to continue paying (into the estate after death), it would offer higher income. But due to the segmentation of the annuity market and the choice of some providers to offer only products with or without the guarantee, it seems to happen regularly that the highest income comes with a guarantee. For example, in the upper left area of our table, the unisex rate offered by Equitable Life with a 10-year guarantee is $5796 per year while the best no-guarantee rate is from Desjardins at $5760. The Equitable annuity would ensure getting back at least $57,960 of the $100k premium. It's an easy choice to buy from Equitable instead of Desjardins. Checking both guarantee and no-guarantee options at the time of purchase is worth it.

5) Check out the return of premium option 
Choosing the option that offers return of premium (to your estate) when you die before the income start date may offer higher income than no return of premium. Again, it is a quirk of the market segmentation but in many of the quotes in our table as highlighted in red text and numbers, the income from return of premium insurers was higher than the no-return offers. This is especially valuable for the long-deferred-annuities, where the income may start eight years or more down the road. Dying before the income start date without receiving a penny for the large premium handed over would be galling. Of course, the insurance company does not lose out by making the guarantee since it only hands back the premium whose value diminishes from inflation and in the meantime it is able to use the capital to invest and gain returns for itself.

6) Index income to offset inflation?
Indexation of income to try to match inflation seems to be of dubious value. Our first table above shows much lower income compared to non-indexed annuities from annuities indexed to rise by 2% a year to match the current best guess rate of many economists, which also happens to be the official target rate of the Bank of Canada.

To judge whether this is worth it, we calculated how long it would take for the indexed income to reach the same level as the non-indexed annuity. As our second table shows, it takes eleven years, till age 73, before the 2% indexed annuity reaches equality for a man buying today aged 62. With rising age of annuity purchase the levelling off happens sooner and sooner but then you have many fewer years of life expectancy to worry about inflation eating away at purchasing power. We believe RetailInvestor.org's method for offsetting actual inflation, in which you set aside and reinvest a portion of the annuity income each year, offers a better solution. Instead of a one-time forever guess at inflation, you reinvest depending on actual inflation.
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7) Annuitize now, or wait?
It's almost surely not worth waiting to annuitize if you have retired and need to start taking income. Whether to wait or not is a trade-off between the investment return from a portfolio less withdrawals and the certain, steady income from an annuity. Annuity expert Professor Moshe Milevsky of York University has developed a formula to guide the choice. The formula is called Implied Longevity Yield (ILY). It measures what rate of return a portfolio or other investment would have to achieve to beat the annuity while withdrawing the same income as the annuity. ILY takes into account the fact that deferring purchase means you will be able to pay less later for the same annuity income because your remaining life expectancy will be lower. ILY also assumes interest rates remain the same as today. Below is a table of ILY calculations from CANNEX.com as of June 2015.
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Even at relatively young ages in the 60s, it is hard to beat an annuity. Certainly, investments with the same rock solid triple A equivalent rating, like term deposits or Government of Canada bonds, can provide nowhere near the same return. Even broadly diversified portfolios of stocks and bonds, which can and do fluctuate and have no guarantee of producing a return, would be hard pressed to beat the ILYs in the above table. These days especially, expected future portfolio returns are likely to be muted compared to historical actuals i.e. not likely to exceed the ILYs of age 70+. We must remember that if interest rates were to move up and more attractive returns from investments were to be available, the annuity payouts would rise too and thus the ILY as well. Back in June 2000 interest rates were much higher - Government of Canada 10-Year bonds yielded 5.9%, but the ILY for a 65 year-old male at 6.9% and a 65 year old female at 6.4% both beat that per Milevsky's IFID research centre table.

The underlying reason why life annuities will always be very competitive with any type of portfolio investments is that annuities have the additional source of return from the forefeited funds of those annuitants who die sooner than expected, the so-called mortality credits. The following chart from Sun Life in the document Payout Annuity - Overcoming Objections. shows how large the mortality credits, which it calls insurance credits, become the older you get.
(click to enlarge)

Unfortunately, the latest ILY figures are available only from CANNEX and thus by contacting an insurance broker. RetailInvestor.org shows on this webpage how to do a simplified "good enough" approximation.

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.

Copyright 2015 Jean Lespérance All Rights Reserved