The Reluctant Investor's Lifelong Portfolio - a Portfolio Inspired by, and for, Albert Einstein

"Everything should be made as simple as possible, but not simpler." Albert Einstein

In a 30 May 2014 post we defined what a portfolio for a reluctant investor should do, and reviewed several alternatives that don't quite do the best job. We've updated the subsequent June 2014 post to June 2025. Happily, what we said then has been proven by eleven more years still to work fine!
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This is what we propose, the Reluctant Investor's Lifelong Portfolio and Investing Plan

1) Portfolio structure: The portfolio will consist of two funds -

• iShares S&P/TSX Capped Composite Index ETF (trading under TSX symbol XIC) and 
• iShares Core High Quality Canadian Bond Index ETF (symbol: XQB). 
• At any time, the objective is to have half / 50% of the portfolio in each fund.

2) Account setup: Start with a TFSA. Open a TFSA account at a discount broker. If there is less in total to invest than $102,000, which is the cumulative maximum contribution limit up to and including to 2025 that can be invested in a TFSA, put it all in the TFSA. When there is more than $102k to invest put the excess into an RRSP (another account that will need to be opened at a discount broker), up to the cumualtive unused contribution limit shown on tax assessment letter from the Canada Revenue Agency that it sends out after you have filed your taxes every year. It there is more than the total limits of TFSA plus RRSP to invest, open a taxable account.

3) Initial allocation to target: Within each account, buy equal amounts of both XQB and XIC.

4) Automate investing: Set up automatic transfers to contribute to the TFSA/RRSP/taxable account if in savings mode. XQB has the wonderful feature of being part of the Pre-authorized cash contribution plan at iShares, which is free and automatic, so sign up for the amount going into XQB.  Unfortunately, XIC is not part of the PACC so purchases of XIC you will have to do yourself. Leave the money going into XIC in cash until there is at least $1000 to invest. Less than a $1000 for a trade and the commissions start to add up too much and hurt investment returns.

Similarly, during retirement withdrawal when regular amounts are to come out, sign up for the Systematic withdrawal plan for XQB (also not available for XIC). You will have to sell the appropriate amount to leave approximately half each in XIC and XQB.

Note: Not all brokers participate in the PACC and SWP. Check out here the in/out listing of brokers, along with details and forms for all the plans, including the DRIP. If the broker does not do the PACC and SWP, you must carry out buy and sell transactions yourself.

Sign up for the Dividend reinvestment plan (DRIP) for both XIC and XQB. That way, the regular cash distributions will not sit idle and will get reinvested automatically and for free in XIC and XQB.

5) Rebalance: Once a year, perhaps on a birthday to remember more easily, check the latest monthly market values of XIC and XQB holdings totalled across all accounts. If either is more than 5% away from the target 50%, sell the excess amount of the greater value ETF and buy that amount of the lesser. If less than $1000 is at stake to be re-allocated, don't bother, the cost of trading commissions is not worth it.

In the same manner, any large lump sum contributions or withdrawals can be used to even up the 50% allocation to each ETF.
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Historical Performance - To see what kind of performance the Reluctant Investor Portfolio would have provided, we again turn to the Stingy Investor Asset Mixer tool. XIC's performance matches exactly with the tool's TSX Composite, while XQB lines up fairly well with All Canadian Bonds. (Note: Stingy Investor has a model portfolio it calls the Simply Canadian ETF Portfolio which has almost the same composition as our Reluctant Investor, i.e. we did not invent the idea but we are promoting it with a different name to emphasize its potential usefulness.)

From 1980 to 2024 inclusive, our portfolio performed quite well. Compared to more complicated and sophisticated alternatives, the portfolio trades off some performance and some volatility to gain simplicity and convenience.

For a retiree withdrawing 4% a year the worst down year was 2008, when it incurred a 17% loss. The portfolio had fully recovered its loss within two years. Over the whole 45 year time span, despite constant yearly withdrawals, the portfolio gained an average of 4.2% compounded per year and it never dropped below its retirement start date value despite a number of down years (12 out of 45).

For a saver, the fact of making no withdrawals reduces the worst 2008 down to only 13% and there were only 9 down years in total. Recovery from down years never took longer than two years. The compound return was a healthy 9% a year.

Unfortunately the Stingy Investor tool does not include inflation data before 1980, so the period of high inflation, and its effects on real after-inflation returns, which is what really matters, cannot be examined. From 1980 to 2024, the real return of the Reluctant Investor Portfolio was 5.7% compounded during the savings no-withdrawal phase, with only 10 years out of 45 showing a decline that never took longer than two years till recovery from a decline. When the added stress on the portfolio of a 4% annual withdrawal was included, the portfolio still managed an average gain of 1.5% annually, but had 15 down years, and a decline of 22.2% starting in 2008 that still has not been recaptured.

Thus, though there is no absolute assurance of never taking a loss by selling out at any time we believe the Reluctant Investor's Lifelong Portfolio is a pretty good balance of the objectives. Overall, we believe the solution works pretty well, delivering 80% or more of the benefits of more time-consuming and complicated investing.

Such a portfolio has value. Not everyone can, or should be, an investor who spends time and effort on investing. That's why our post's title says the portfolio is both inspired by, and intended for, someone like Albert Einstein. After all, could anyone think that Einstein, or the world, would have been better off, if he had applied his time to investing at the expense of physics?

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.

Wind blows away capital, Solar burns it away, EVs run down the juice

 In his recent post on WUWT Why are Renewable Equipment Companies Such Poor Investments? Steve Goreham shows us that virtually no publicly traded companies making wind and solar equipment, electric vehicles, hydrogen battery cells or electrolyzers, or EV charging providers have been good investments. As a whole, based on the global Renewable Energy Industrial Index of the 30 largest global companies in the sector, investors would have made no money since 2006. Without the one giant blow-out winner - Tesla - there would have been big losses.

The reason he says is quite simply that none of these companies are financially viable profitable businesses. They have not been able to make money in general even with massive government subsidies. One commenter below the post notes the venerable Warren Buffett's pithy assessment of wind and solar: “without the subsidies and tax breaks, they just don’t make financial sense”. 

Goreham notes that the investor in the S&P 500, available through multiple low cost ETFs, would have quadrupled their capital. Therein lies the durable critical lesson for most of us small-guy investors. Recognizing that very few of us have the time, the smarts, the information or the interest to find the Tesla pot of gold, we are far better off to resist the latest investment fad and invest in broad whole of market ETFs. By their construction, indexes like the S&P 500 will incorporate winners like Tesla. Tesla is currently the 6th largest holding in that index. The many losers aren't there frittering away your capital at all. Sure, you won't be among the early now much richer investors in Tesla but you will be modestly richer and not poorer.

In Canada the current poster-boy glamour stock is Shopify. It has come from nowhere twenty years ago - the company did not even exist then. The company only went public in 2015. Yet it's now the second largest company by market cap in the dominant Canadian index, the S&P TSX60. Its stock price is extremely volatile and the PE ratio is an astronomical 97, i.e. it is priced for massive future growth. Want a piece of the action? Buy the stock directly itself ... or more cautiously, buy an index ETF like BlackRock's S&P TSX 60 (XIU) or Global X's offering (HXT). 

A Modest Proposal for preventing seniors in Canada from being a burden to their children or country ... 2024

It is a melancholy object spectacle to those, who walk through this great town Canadian cities, or travel in the country, when they see the streets, the roads homeless shelters, and cabin doors old age homes crowded with beggars government benefits dependants of the female two sexes, followed by three, four, one or six two pet dogs, all in rags second-hand shop hand-me-downs, and importuning every passenger for an alms handout. These mothers seniors, instead of being able to enjoy their retirement work for their honest livelihood, are forced to employ all their time in strolling to beg sustenance for from the public or their helpless infants struggling working children, or in low-paid menial jobs; ... who, as they grow up get older, either turn thieves benefits cheats, for want of work grocery money or leave their dear native country senses to fight vote for the pretender in Spain Ottawa, or sell themselves to the Barbadoes PornHub.

I think it is agreed by all parties, that this prodigious number of children old people in grabbing at the arms, or on the backs, or at the heels of their mothers daughters, and frequently of their fathers sons is, in the present deplorable state of the kingdom, a very great additional grievance; and therefore whoever could find out a fair, cheap, and easy method of making these children parents sound useful members of the commonwealth, would deserve so well of the publick, as to have his statue set up (in place of that cancelled founding Prime Minister of Canada) for a preserver of the nation.

But my intention is very far from being confined to provide only for the children of professed beggars: it is of a much greater extent, and shall take in the whole number of infants adults at a certain age, who are born of parents in effect as little able to support them, as those who demand our charity in the streets.

As to my own part, having turned my thoughts written for many years upon this important subject, and maturely weighed the several schemes of our projectors, I have always found them grossly mistaken in their computation. It is true, a child person just dropped from its dam employer may be supported by her/his milk savings for a solar year, with little other nourishment income.  It is exactly at one 66 years old that I propose to provide for them in such a manner, as, instead of being a charge upon their parents children, or the parish state, or wanting food and raiment for the rest of their lives, they shall, on the contrary, contribute to the feeding, and partly to the clothing  well-being of many thousands millions. 

I shall now therefore humbly propose my own thoughts, which I hope will not be liable to the least objection.

The authorities, having in their wisdom determined that ending life is an honourable, sensible and even laudable action, not merely before it has properly started, but additionally at any time and age before natural causes bring about this inevitable final event and taking into account the considered and wise opinion of the better class members of society who have carefully deliberated these matters over many years in Davos that there are far too many humans on the earth with consequent mounting damage to our dear mother earth, rapid and decisive action suggests itself imperatively.

I grant that our wise and beneficent national government has with great foresight installed a very active and successful policy to assist people to die whenever the fancy strikes them. Indeed we observe its success with the rapidly growing numbers of casualties right across this bountiful but over-populated land. Reports from the far-flung corners of Canada bring news of the enthusiasm with which the undertaking is being encouraged to all and sundry by the diligent public employees we are all so fortunate to have in our service. Sadly, the fundamental idea is correct but requires a minor adjustment to achieve the perfection that the most intelligent minds can discern. 

I shall return to my proposal shortly but I beg the reader's indulgence to detour through a significant problem for older people that this proposal resolves most satisfactorily. I speak of retirement income and the problem for most private individuals who do not work in the public service, for whom this problem does not exist due to their perpetual inflation-matching pensions, that one cannot know if money will run out before one dies and how much to spend each year in consequence. This pernicious and mentally debilitating guessing game leads many to constrain their spending and restrict their enjoyment of life after retirement. I am confident the reader would agree that no one would deny that this situation needs to be addressed. Millions of Canadians facing this Gordian knot will be eternally grateful for a practical, effective solution, particularly if it costs them nothing.

By now, the astute reader may have divined the essence of my modest proposal, which is none other than to make the MAID program mandatory at age 66. 

The brilliance of this scheme becomes apparent on examining the multitude of its benefits and the absence of disadvantages. 

First, consider the public good. There is consensus - 97% of scientists agree - that the world human population is unsustainably high. Survival of the planet requires a cull of humans, though morality dictates this must be done humanely according to strict principles of equity and fairness. A fringe minority of malcontents might object that they wish to opt out but how can we tolerate such people when the fate of the planet is at stake and the overwhelming majority supports the view that over-population is an existential threat. MAID+ will significantly contribute to fighting climate change. 

In any case, well-crafted blanket positive messaging, with the central idea of "do your bit as a citizen", along with monetary incentive programs, for example a $50,000 cash bonus paid at age 65 to fund an enjoyable final year of life, would get people on board such that opposition would be sufficiently marginalised as to be of no consequence.

Fairness is ensured automatically by the proposed rule that everyone reaching age 66 is subject to what we modestly shall call MAID+. Equity is ensured as well when we recognize that the bulk of people who will be affected, at least in the initial ramping up period, are the coddled old toxic white population. These same old people do not work and do not contribute economically to society. They merely consume vastly disproportionate resources of the medical system. Fewer people also means less carbon emissions, an existential threat to the planet, not merely by their use of fossils fueling their lifestyle, but also from the mere breathing out of CO2. The 20th century witnessed a number of brutal messy pilot projects for the mass culling of humans. The public need not worry. Carrying out MAID+ gently and humanely is ensured by the advances in medical technology that now provide society with utterly painless and instantaneous cessation of life, as amply demonstrated by the growing success of MAID. 

We note that the historical injustice that the early recipients of Canada Pension Plan have been receiving much more than their fair share at the expense of younger generations will be corrected. The free riders will be gone. MAID+ will enhance social equity and peace.

The effect on public finances, recently endangered by ballooning federal debt, will be massively beneficial during the initial transition period of the policy. Consider that upon death all a person's assets are considered to have been sold from a tax viewpoint and capital gains become payable. All registered savings plans are deemed to be liquidated and the money taken into income. Those billions of immediate taxes will eliminate the deficit and balance the budget, as the Prime Minister himself presciently predicted some years ago. Readers may be assured that the Prime Minister has not contributed to this modest proposal though some may harbour suspicions.

In addition, consider the inevitable massive savings to healthcare spending by the elimination of a population that occasions a hugely disproportionate share of provincial medical budgets as bodies and minds deteriorate.

Next, consider the individual's perspective. The enormous intractable financial planning problem of how many years to plan and how much to set aside for retirement income is instantly resolved. It's exactly one year after 65. Financial planning becomes easy, alleviating the individual's worry altogether. All the intricate legal arrangements can be planned and carried out precisely at the right time. Whether it is to have a blow-out party year to spend it all living like the King, the Prime Minister or the Governor General, or to set aside money for children and grand-children, all the corrosive uncertainty disappears. The pernicious long term erosion of spending power by the recent high inflation disappears as well. Children will be freed both from the concern that mum and dad will either foolishly fritter away their inheritance or that they will become a financial burden. MAID+ will improve relations between seniors and their adult children.

All an individual's worries about declining physical and mental health as he or she ages will instantly vanish. The dreary years of diminishing capacity and debilitating chronic diseases will be gone. Human suffering will be much reduced, an undeniable benefit. Children will be freed from the significant time and monetary burden of caring for elderly parents and be able instead to be more productive for the nation's economy.

After all, I am not so violently bent upon my own opinion, as to reject any offer, proposed by wise men, which shall be found equally innocent, cheap, easy, and effectual. But before something of that kind shall be advanced in contradiction to my scheme, and offering a better, I desire the author or authors will be pleased maturely to consider, as things now stand, how they will be able to find food and raiment for millions of useless mouths and backs.

I profess in the sincerity of my heart, that I have not the least personal interest in endeavouring to promote this necessary work, having no other motive than the publick good of my country, by advancing our trade economy and public finances, providing for infants seniors, relieving the poor, helping to save the planet and giving some pleasure to the rich. I have no children living parents, by which I can propose to get inherit a single penny; the youngest being nine years old, and my wife past child-bearing and, my modest proposal being adopted, my residence will be relocated to another country, having attained 66 years and being desirous of saving the government the cost of MAID+ for myself.

Published this Father's Day 2024 in memory of my father who passed away a few years ago at the age of 96 years 359 days having fought for every second of life. 

This text is my creation only in keeping with the principles of Harvard's Claudine Gay school of scholarship. To forestall accusations of plagiarism, any resemblance to any writings of Jonathan Swift are purely accidental.

 

PS I fear this post is too close to the truth to be proper satire. cf https://www.conservativewoman.co.uk/horrific-rise-of-canadas-euthanasia-industry-is-a-warning-to-us-all/

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. 

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.

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

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.

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