Thursday, May 29, 2008

Evidence of Inadequacy

Report on Business is reporting today the release of a new study by the C.D. Howe Institute calling for the creation of yet another government administered pension plan. The premise of the report's recommendation is that not enough Canadians have access to an employer sponsored pension plan and, of those who do not, many are not utilizing the savings vehicles in place to provide for post retirement income, such as RRSPs and the like. The position the report holds is that the managed money world (mutual funds, etc.) is fraught with high fees, which erode investors' returns, thus hampering their ability to accumulate sufficient retirement assets.

So, the moral of the story is that not enough people are saving money to fund their retirements. The C.D. Howe Institute obviously sees this as being detrimental to the future health of Canada's economic environment, and therefore is calling for government intervention.

Though I most certainly agree that not enough people are saving enough money for themselves, robbing from their future to finance their todays, I have a difficult time with accepting that the government should step in to save people from their own lack of foresight.

Do I believe that there are some outrageous fees out there? Yes. I think that there are a number of mutual fund companies that are charging fees that do not adequately reflect the value they're providing to individual investors. However, I do not believe that having the government step in and take over the business of managing retirement money for Canadians is an appropriate response to the issue. Perhaps enhancing the regulations on money managers with respect to how they levy fees might be a more measured and appropriate response.

How do you feel? Should the government be stepping in to save us all from ourselves, or does the responsibility for a happy retirement lie on the shoulders of the individual? I'd be interested to hear your comments.

Tuesday, May 20, 2008

Habits

Hi folks,

There are various different "levels" at which an advisor can assist the client. These can range all the way from the very basic "coaching" to help you develop habits, to the very involved process of estate planning.

In my experience thus far, most people who haven't before worked with an advisor are in the riskiest place of all, the "I don't have an emergency fund" place. Usually, when I encounter this circumstance, the first thing we'll do is get started on some type of a regular savings plan. Many advisors will, at this time, suggest that the client begin an RRSP and suggest using some specific mutual funds. This is where I differ.

The problem with the "I don't have an emergency fund" place is that the risk of needing to dip into that RRSP fund is huge. All it takes is a broken vehicle, a leaky roof, or a dead furnace to erase all that hard work. People will either dive deep into short term debt solutions such as credit cards or lines of credit, or redeem RRSP funds, often incurring sales fees and usually causing some serious tax inefficiency, not to mention the forever lost RRSP contribution room.

So, the risks are pretty high, as most people will at some point in their life encounter the broken vehicle or dead furnace problem.

As a risk management guy, I'm always looking at ways to reduce risk. The best solution I have seen for the beginning saver is to start by building good habits.

Good habits to build:

  • save some of every single paycheque
  • budget your cashflow and monitor your expenditures
  • limit the amount of impulse purchases to a fixed dollar amount per week or month
  • never ever touch saved money without due consideration as to the consequences of that action

That last point is essential, and here's why. I've worked with a number of younger families (30-45 years of age) who have made a HABIT of redeeming their RRSP funds or other long term savings to offset shortfalls in cashflow, to pay off credit cards, or to pay for trips or other big ticket items. The problem with this behaviour is that, psychologically, the individual has now crossed the "Do Not Touch This Money" line. That may sound like it's no big deal, but people tend to repeat the behaviour. This is what takes most people off track from reaching their financial goals, and what usually leaves them mired in the short term debt cycle.

So, learning good money habits is essential. In order to do this, the advisor must act as a coach, encouraging the client to save in low risk, low volatility, liquid vehicles such as high yield savings accounts or money market funds so as to build up an emergency reserve as a cushion. Then, only after the client has been able to develop saving as a habit, should we look at putting some of it away for longer term goals.

Have you ever redeemed money from your RRSP? When was the last time your credit card had a zero balance? Perhaps finding a good coach would be helpful.

Friday, May 16, 2008

Segregated Funds

Hello again,

The following message isn't for everyone.

An important aspect of planning your investments and your financial future is risk management. Of course, this is where a qualified professional can come in handy... Nonetheless, let's have a conversation about the stuff nobody wants to have a conversation about.

What are some of the risks you'll face as you work toward executing your financial strategies? Here are a few to consider:

- you get sick, can't work, and therefore have no income
- you die
- you divorce, your spouse takes half of everything, alimony and/or child support take a large chunk of your income
- you get fired, laid off, downsized.
- a fire or other natural disaster destroys your home and everything in it.
- your business fails
- you get sued

I'm sure there are more, but I'm not trying to freak you out or otherwise depress you. What I'm trying to do is to demonstrate that, irrespective of all of the hard work we do to earn an income and save some money, there are going to be times when events conspire to ruin good people.

So, what can be done? Briefly, get some insurance. In most of the situations mentioned above (except the marital ones, those issues are outside of my purview of expertise), different types of insurance can help offset the risk.

Did you know that there was a way to protect your investments in the event that your business fails or you get sued? There is. Use segregated funds.

Segregated funds work very similarly to mutual funds, except that they are an insurance product. Essentially, you, the insurance contract owner, owns the insurance contract. The insurance contract has contractual claim to the investment assets.

The brilliant part of this arrangement for the contract holder is that, because its an insurance contract, its governed by insurance legislation. Because of that, it cannot be seized by creditors*.

So, if you get sued or become insolvent, your segregated funds should be safe, whereas had your portfolio been constructed exclusively of mutual funds, stocks, bonds and real estate, all of your assets would be at risk.

Another little known benefit of segregated funds is that, because they are an insurance product, they are paid out upon death directly to the beneficiary and therefore circumvent probate. For most, this is likely a non-issue. However, probated wills are public documents, viewable by anyone. Did you know that? Some people would prefer some discretion in certain circumstances (sensitive family issues, mistresses, general privacy concerns, etc.) and would benefit from having some of there assets in an insurance vehicle such as segregated funds.

Now, with all that said, I'm not here to tell you that segregated funds are the end all be all of investing, because they're not. I've spent a lot of time searching for good ones, and there aren't many. Also, they tend to be more expensive to own, as there are certain guarantees inherent in them that standard mutual funds don't have, such as guarantee of principal. So, they're not for everyone all the time, but they can fill a niche for some folks such as business owners and professionals which other products simply cannot.

* - According to the Canadian Life and Health Insurance Association:

• Potential creditor protection
When the contract’s named beneficiary is a spouse, child, grandchild or parent of the insured person (or, in Quebec, the contract owner), when the beneficiary is designated irrevocably or, in some provinces, where the contract is registered (for example, as an RRSP), creditors cannot seize a segregated fund contract if the contract owner declares bankruptcy or fails to pay his or her debts, as long as he or she has not entered into the contract for the primary purpose of shielding assets from creditors. In some instances, courts of law have deemed the purchase of segregated fund contracts while the creditor was insolvent as an attempt to shield assets, and disallowed the creditor protection.
**(from the CLHIA Guide to Segregated Fund Contracts)

Wednesday, May 14, 2008

Life Insurance... do you need it?

I've been licensed to sell life insurance for over two years now and I'm here to tell you, nobody wants to buy life insurance. My theory is that people simply do not want to admit their own mortality. They would rather just not think about it. So, when I come along and suggest that we discuss the possible consequences of dying, I hear things like, "Oh, I don't believe in insurance," or, "no, I'm not interested."

The unfortunate fact is it's my responsibility to my clients to point out where their financial risks are, and then educate them as to how they may reduce or eliminate those risks. And, that's really all insurance is for - to help people manage or eliminate certain financial risks.

So, back to the question - do you need life insurance? In order to answer that question, first something needs to be made clear... life insurance is not for you - life insurance is for the people you leave behind. Therefore the question becomes, if you die, will the people that you leave behind suffer financially in some way?

There are a few ways to look at this issue. First and foremost one must assess what actual costs their death will incur. Usually then, we're talking about final expenses such as funeral costs, fees paid to your executor to manage your estate, a burial plot, and things of that nature. But, we're also talking about estate taxes which can turn out to be fairly significant if, for example, you own a cottage or some other valuable assets.

Secondly, we must consider something else of considerable significance: lost wages. Does your family count on your income in order to maintain their standard of living? If so, all that money that you won't earn needs to be taken into account.

So, now that we've determined that there may be a need, we need to start classifying the risks. We need to split them up into the "if you die" category, and the "when you die" category. For example, though your family may count on your income now, you do plan to retire at some point. So, that is not going to be a permanent need. Rather, that risk could be offset with a temporary product. In other words, if you die before you retire, that could create a financial issue for your family.

However, items such as final expenses and estate taxes will be an issue no matter when you pass away. So, those are better managed with a permanent insurance product. We could say that when you die, there will be costs that must be paid in some way, and insurance might provide that cash for you.

Ultimately, determining your insurance needs is a rather involved process that requires a considerable amount of thought and consideration. Of course, always be sure to deal with a qualified professional who is prepared to take the time to get to know your specific circumstances.

It seems to me as though there is something inherent in the insurance buying process that forces us to acknowledge our mortality and admit to ourselves that death is inevitable. Understandably, this is never easy. But, I'm here to tell you that there is a certain degree of relaxation and reassurance that happens once you've been through the process of dealing with this stuff. And, if there are people that count on you to provide for them, then getting adequate insurance is simply the responsible thing to do.

The Four Steps to Wise Investing

Investing money isn't as complicated as it seems, but it does require some consideration, planning, and strategy. There are four steps that are the foundation of any good investment strategy.

Risk Tolerance

Understanding your tolerance for volatility in the value of your investments is critical. Ask yourself, can I handle a 10% decline in the value of my investments? How about 20%? 40%?

Something that I’ve learned is that tolerance for risk tends to go up when people understand why things go up and down. So, I’d suggest that you don’t pay too close of attention to the day to day movements in price. Instead, spend your time learning more about why things go up and down.

Time Horizon

Knowing how long you plan to invest for is essential as well. Once you have identified your time horizon, you can determine the appropriate type of investment vehicle. For example, equity cycles take at least 7 – 10 years, and therefore should be avoided as a short term investment. Investing in equities for a short term horizon runs the risk of needing the money when the value is depressed, which of course is contrary to the goal. Conversely, fixed income investments such as GICs, bonds, and Real Estate Investment Trusts tend to pay out a steady stream of income, though don’t tend to produce wild swings in their value like stocks will. Because of that, they are more suitable for shorter time horizons.

A very good way to approach the time horizon issue is to spend some time thinking and prioritizing your financial goals. For example, if you’re wanting to replace your car in 5 years, go on a vacation in 2 years, and retire in 20 years, you should consider having different “pools” of investment money for each of these goals.

Asset Allocation

Asset allocation refers to the way different classes of assets relate to each other in your investment portfolio. It is your asset

allocation that will determine what type of return you are able to achieve over the long term. There are essentially 2 primary asset classes that the novice investor should consider using: equity (stocks) and fixed income (or bonds, etc). I refer to these classes as ownership (equity) and loanership (fixed income)

Equity (stocks) – when investing in equity, you become a part owner of a company. As such, you have an opportunity to participate in the profits and growth of that company over time.

Fixed Income (bonds, GICs, etc.) – when you invest in fixed income products, you are essentially investing in debt. Mortgage funds and real estate investment trusts are other examples of fixed income products. These are methods of pooling money together for the purpose of lending it out. The return on these products is usually in the form of an income stream.

As mentioned previously, the relative ratio of these two asset classes in your portfolio will determine the overall volatility and return of the portfolio. So, investors with a short time horizon or a low tolerance for risk should have more fixed income products, and investors with long time horizons and a higher tolerance for risk should have more equity products.

Rebalancing

Rebalancing refers to maintaining a particular balance of individual investments in your portfolio. Because different investments will move in different ways at different times, the particular weighting that you might like each to have in your portfolio might change over time as some go up and some go down.


So, let’s imagine that you’ve decided that your portfolio should have 25% weightings each in US Stock, European Stock, Asian Stock, and Global Bonds:


Now, let’s imagine that one year later, their relative performance looks like this:



As you can see, in order for us to take this back to the original balance at 25% each, we will have to sell the Asia and US stock to buy more of the Euro stock and Global bond. This forces us to maintain our discipline in sticking to our original investment policy of 25% weightings, as well as forces us to sell high and buy low. Equity and Fixed Income tend to perform in cycles. By maintaining your discipline in rebalancing, you take advantage of that cyclical pattern.

In conclusion, if we are to follow these 4 steps rigorously, it takes the guesswork and uncertainty out of our investment strategy, and gives us a fixed benchmark to work from.