Blessed by the Potato

The Ontario Municipal Employees Retirement System (OMERS) is one of those big pension funds you hear about, providing sweet defined benefit pensions to government workers, and buying up companies and assets to help fund those pensions.

A reader asks:

Because I participate in an OMERS’ pension fund at work, I have the opportunity to invest in Additional Voluntary Contribution (AVC) within the same fund. This fund has been doing quite well so should I consider this?

The AVC is a neat option at OMERS: you can treat them like a mutual fund or ETF and invest in the same investment portfolio they’re using to try to meet their members’ pension obligations, on top of what they’re investing for you for your pension. It’s widely diversified with reasonably low overhead/MER-equivalent (~0.6%), and you can set it up to automatically take contributions straight from your paycheque. As a one-fund solution, you don’t have to see the performance of individual asset classes or worry about diversification and rebalancing decisions, you’ll just see the smoothed over-all performance.

I should note that this is not buying additional service or pension credits — it’s an investment managed by them, with no guarantees about what the funds will pay for in retirement (unlike the DB pension itself). The fact sheet also mentions limitations to the timing of withdrawals that limit the liquidity, which appears to limit you to only withdrawing in a 2-month window in the year, and then only 20% of what you have invested, which can really limit flexibility if these funds are for anything other than retirement.

Now, if anyone could waltz in and sign up to invest in the OMERS AVC, this would be a really interesting option to present alongside Tangerine, robo-advisors, and TD e-series. However, only people who are already OMERS members can do it. And that’s where my natural paranoia suggests this is not the way to go. OMERS has a great management team, the portfolio is diversified, and has competitive past performance relative to a passive index fund portfolio… but you’re already depending on them to come through for your DB pension, which is likely a big part of any member’s retirement plans. And as great a basket as it may be, you’ve already got a lot of eggs in that OMERS basket. In the unlikely event that they fall on their faces and have to trim DB benefits, you wouldn’t want the rest of your investment portfolio with them, too. And it adds one more thing to transfer (or think about transferring) if you get another job.

What do you think, would giving the AVC a pass be prudence or overly paranoid?

Edited to add: Over on Twitter, Sandi adds this:

I’d want to know what % future income relies on OMERS before cautioning against. (“It depends!!”)

And of course, that’s a good extra factor to consider. If you have 30 years of service with OMERS, your basket with them is going to be much bigger (and the over-exposure may be more of a concern) than if you have 5, and most of your retirement needs are funded elsewhere (where doubling up for some additional investments may not be a big concern).

In a widely seen CBC Marketplace report, the reporters spread the unhelpful tidbit that there’s a magical difference between the spelling of advisor and adviser. They say:

“Advisers” are regulated and have a legal responsibility to act in your best interest. “Advisors” are … not the same.

And since then I’ve seen that “tip” repeated many times when people are looking for advice: “go find an adviser” they may say, not having one themselves. However, it is missing the broader lesson and is unhelpful: job titles are misleading and unhelpful in the financial services industry. More importantly:

Advisor may not be regulated, but adviser is not used.

In what appears to be the original report kicking off the mini-controversy, of 121,932 registrants they looked at, only 17 across the country used the title of “Adviser”. Basically nobody uses that title, so when people repeat the “o” vs “e” issue and suggest that you go find an adviser — such a creature (effectively) does not exist! In an article at advisor.ca they did a check, and of 26 people who did use the term on their LinkedIn profiles, 24 did so in error; others may also use it under the aegis of another licensing body (such as insurance sales).

I’ve seen too many times people repeating the “o” vs “e” spelling difference as though it’s a helpful tip when looking for advice. It’s a distraction, nothing more. The real lesson is that most job titles (whether it’s advisor, vice president, or portfolio doctor) don’t actually tell you anything about whether the person you’re sitting across from is licensed to sell a particular product, experienced enough to provide you advice, or regulated to act only in your best interest. Indeed, some of the least regulated titles (like coach, planner, planning-farmboy, or instructor) may be the best people for you, who would put your needs ahead of any commission (’cause there isn’t one), even if there isn’t a regulatory framework and force of law to make it so.

A very common question people ask is “Am I on track to retire?” It’s usually a good starting place for an engagement with a planner, especially if you’re within a decade or so of your planned retirement date. That plan is going to come with a lot of good discussions of your goals, some contingency plans, how you use your money, etc., etc. It’s also going to cost a few thousand dollars for the support and those conversations (and I’m deliberately avoiding saying “for the plan” as though the document in isolation is valuable outside of the process).

But for some of us, we just want to get a ballpark idea of whether we’re on track or not, and we want to do it ourselves with a whiteboard and spreadsheet. So here’s how I think about approaching the problem:

1. Define your goals
2. Add up your resources
3. Project forward to see what might happen
4. Analyze
5. Repeat/Try to break it

Now each of those phases can be more work than the few words make it sound: even “just” defining your goals can be a lengthy conversation about what you want the rest of your life to look like. There is definitely room there for a planner or coach to provide a lot of value in the process, but you can get a large part of the way there yourself.

Unfortunately, the process isn’t going to return a really clean yes or no answer. Instead we’re going to get shades of “maybe, if” or “probably, I think.”

Define Your Goals

Part of defining your goals is the straightforward part: figuring out the kind of lifestyle you want in retirement, and then translating that into a dollar amount for your spreadsheet. But it also involves thinking about trade-offs: would you be ok with a more variable income/spending profile, or do you want a steady stream of retirement income? Will your spending decline as you age (less travel?), stay fairly level (with inflation adjustments) or increase (more health/support needs)?

And when thinking about the future, how much lifestyle inflation will you face? Back in grad school, I was pretty sure I would be perfectly content retiring to a nice, quiet one-bedroom apartment somewhere and would only need $30,000/yr or so. Needless to say, my target has risen over the years, and now I use a figure that assumes a little more lifestyle inflation.

There can be a lot of moving parts that can quickly overwhelm a simple DIY approach.

But for the sake of example, let’s say that Elrond Example has had those conversations, and boiled it down to three numbers: he wants to have at least $40,000/yr in retirement income, but would like to aim for $55,000/yr, and Elrond would like that retirement to start at age 65 (assuming he’s 40 now). I also have to be careful to understand how I’ve framed these numbers. For example, if I figure that Elrond makes $70,000/yr pre-tax now, and in retirement will have a few fewer expenses and won’t have to save $7,000/yr anymore, I get to $55,000/yr pre-tax — Elrond will still be taxed on that income and have a perfectly fine retirement, so I can use pre-tax numbers in my later calculations. But if I mean after-tax dollars, as in the amount he can actually spend, I’ll have to account for the taxes. Or, maybe using a different method I can figure that he’ll want $45,000/yr after-tax to spend in 2017 dollars (with a floor of $34,000/yr). Various tools and methods will use different amounts.

Either way will work for you, you just have to be clear with yourself what it is you’re doing. Same for inflation: it’s easiest IMHO to think about real dollars: when retirement actually comes Elrond may be spending $100,000/yr in 2040 dollars, but I can think of that more easily as $45,000 in 2017 dollars — but I will have to adjust my rates of return to be real rates of return (i.e., subtracting out inflation).

One last number to consider is how long you’ll need this support to last. Living to age 95 is a decent rule-of-thumb to use.

Add Up Your Resources

I’m not going to have to fully fund my retirement goals on my own — I’m going to have CPP, OAS, and possibly a pension to help out. Enumerating how much support I get from those guaranteed sources may go a long way towards setting my mind at ease. If reliable, inflation-adjusted income from secure sources like a defined benefit pension, CPP, OAS covers a large portion of my spending needs, I’m automatically going to be closer to being on track. What’s your ratio of spending needs to secure retirement income look like?

I also need to figure out where I stand already in terms of how much I already have invested.

For the sake of the example, let’s say that Elrond can count on the maximum OAS support (in 2017 dollars that’s just over $7,000/yr), and that I’ve used the CPP calculator to estimate Elrond’s CPP income at $8,000/yr in 2017 dollars. Elrond also has a small defined benefit pension. He looks up the statement, which tells me that at age 65, with a bunch of assumptions, he’ll be eligible for $15,000/yr in (pre-tax, real) pension income.

Elrond can also look at his investment statements to see that he has $60,000 in TFSA, $20,000 in RRSP, and $20,000 invested in a non-registered account, all invested in a “balanced” portfolio. He’s also saving (on top of his pension) $7,000/yr.

I’m not necessarily looking for a net worth statement here. For example, I wouldn’t subtract a mortgage from the amount invested, as I’m already accounting for that in the cash flow: the amount Elrond has to save for retirement is after the mortgage payment is made, and the debt will be paid off several years before his planned retirement age.

Project Forward to See What Might Happen

Once you have your needs and your resources, you can start to play with a variety of tools to see what will happen and try to approach an answer about whether you’re on track. If you’ve got time and an inordinate amount of patience, you can do it all by hand on paper.

If today my example person Elrond has $100,000 in total nominal investments and I assume a 4.5% real return (net of fees), then next year Elrond will have $104,500, plus another $7,000 that he has saved. I can keep projecting forward like that up until retirement (though I’d likely track each account separately, as each dollar in an RRSP is not the same as on in a TFSA).

Then when he hits retirement, I can use a rule of thumb like the ~4% figure for a sustainable withdrawal rate to see if the portfolio will last, or I can model drawing it down based on a more conservative asset mix.

Then I can do it again using different assumptions about whether Elrond might not hit his savings goals in a few hard years, or if returns are different. We’ll come back to the point about using different assumptions.

Analyze

Now I’ve done a lot of work and really want to know, am I on track?

Well, a quick analysis says that Elrond is at least not in serious trouble: in this example, he had such modest needs (income floor of $40,000/yr / spending floor of $34,000/yr) and enough guaranteed support (CPP, OAS, defined-benefit pension, total of $30,000/yr) that he doesn’t need to draw much from his portfolio. Using a 3.5% version of the 4% rule-of-thumb (to be conservative about rates of return and the effect of real-world investment fees), he only needs a portfolio of $285,715 to support his minimum spending, and in my projections his TFSA alone would get him there.

What about his more ideal target retirement lifestyle? Using the same very simplistic method, he’d need a portfolio of $714,285 to cover the $25,000/yr beyond any guaranteed sources of income, but my simple math and assumed rate of return only puts him at $613,000 by age 65. That’s pretty close, especially with all the assumptions involved, and maybe I was being a bit conservative with my rates of return, so maybe he is on track? Hmm, he’d have to save an extra $2,250/yr to hit that number, which is a pretty big change to his budget… Perhaps I can be a bit more aggressive because the bulk of his investments will be in his TFSA in this example, which won’t have a tax drag… and we quickly see how a black-and-white answer is hard to come to.

Repeat/Try to Break It

Sometimes we just want to be reassured. But often it’s more useful to be better prepared. So try a couple of different assumptions in your planning and see if you’re still ok with the answer — if not, you may have to start adjusting your course (or expectations) now.

A big thing to consider is the rates of return you use: there’s a lot of uncertainty in what your investments might return, and it ties deeply into the core of your saving/investing projections. Professional planners will sometimes use Monte Carlo software that will run thousands of simulations of future scenarios to try to see how robust your plan is. IMHO, when you still have over a decade before retirement, that can be overkill, but you definitely want to look at at least a few scenarios with your straight-line/constant return tools (best guess, good, bad) to see if you need to be more conservative.

When you get closer to retirement, things like sequence of returns risk will be important to consider, and that’s why paying a planner to help can really be worth it. But from afar a bad sequence with decent average returns is still a “bad scenario” that can be approximated as a scenario with just an overall lower straight-line return.

For this example, I used the Ballparkinator (click here to download the spreadsheet with the numbers for this specific example), which lets me get a quick look at a few simplified retirement scenarios in one go (though the straight-line methods are a bit optimistic when looking at when the money runs out).

I can see that Elrond Example can meet his floor spending even under a fairly poor worst-case scenario (0% real bond yields, 2% real equity returns, and paying e-series rates of investment fees). Even if he has to retire 3 years earlier than planned for health reasons (assuming a modest decrease to his pension and CPP benefits), under our base case returns he’s in good shape on his current path to at least meet his minimum spending needs.

However, he’s not guaranteed to be on track for his more ideal retirement: sure, he’ll get there with a rosy scenario where his bonds have a 2% real return and his equities an 8% real return (before fees), which has happened in some points in the past, but even in our base case scenario he’ll run out of money before turning 95 in this example.

Again, a strict yes/no answer is hard: with a relatively optimistic outlook for investment returns over the next few decades, sure, he’s well on track; even with a fairly realistic base case he’ll have money for his ideal retirement goals for longer than he’s likely to live (sometime into his 80’s). But he’s not so solidly there that he can afford to retire any earlier if his ability to work fails a few years early, and a bad few decades for his investments could also put a crimp on his retirement plans. Though he may never see a birthday cake adorned with 90 candles, he wants to prepare for that opportunity.

It’s also hard to come up with an exact amount extra he needs to save. To get his base case scenario to give us 95 as an age where he runs out of money, we have to increase his savings from $7,000/yr to $8,250/yr. But even at that higher savings rate, he can barely cope with an early exit from the workforce at 61 (with associated decreases in CPP and pension income), and an exit at 60 would compromise his minimum spending target, even under the base case investment returns. Is that enough of a cushion?

And there’s no realistic way for Elrond to support his ideal retirement spending level even after worst-case investing returns. How conservative is too conservative?

We can also try a different way of analyzing the numbers. At the bottom of the Ballparkinator is the so-called “backwards method”, which uses a set sustainable withdrawal rate (variations on the 4% “rule”) plus any gaps in spending to see how big a nest egg Elrond needs at the beginning of retirement, then figures out how much he needs to save each year to get to a nest egg that size based on the various real return rates (note that this ignores taxes). If Elrond wants to be somewhat conservative and use 3.6% as his sustainable withdrawal rate, then under the base case scenario, he needs to bump his current savings rate of $7,000/yr up to over $9,500/yr. While under the best case scenario, he’s saving more than he needs (a nice problem to have), it’s not possible for him to save enough to meet his ideal spending needs under the worst-case investment returns scenario. But, using this method and his minimum spending needs, he is saving more than the tool returns for worst-case scenario.

So looking at it from several angles and with a few different assumptions, Elrond appears to be most of the way towards being on-track for retirement. Even if a few things go wrong, he will quite likely still be able to meet his minimum retirement income goals. His ideal retirement is possible for the track he’s on if things go well (he can continue to work to his target age without having to take time off from savings due to an emergency or leaving the workforce early, decent investment returns, etc.). But he may want to re-examine his plan to see if he should start envisioning something a touch more modest (but still well above his minimum), or start finding a way to save and invest more.

And of course, there are other possibilities too. In this example, we used the “balanced” portfolio for Elrond, which in the spreadsheet is a simple 50-50 mix of fixed income and equities. If we believe that equities will have a higher return over the next 25 years, and if Elrond has the personality for more investing risk (certainly he has the time horizon), then moving to a higher equity weighting (like the age-10 rule-of-thumb from the investing course) may also help him achieve his goals — but this is not a solution to take lightly, and it’s all too easy to just be more optimistic on your future rate of return assumptions to magically get back on track.

Summary

There’s no simple formula for answering the very simple question of “am I on track?” There’s lots of uncertainty between now and retirement, from what your investment returns will be to how much you’ll be able to save or even how much you’ll want to spend. But if you can meet your minimum needs even under a “bad” scenario and get into a happy range for your spending with a more realistic base case scenario, then you’re probably on the right track.

And as you get within a decade or so of retirement, it can be worth meeting with a planner to examine these questions in more detail and discuss the trade-offs involved.

I’ve seen multiple versions of the same question chain, which starts easy enough: basically in investing isn’t performance after fees what really matters?

Yes, what you really care about at the end of the day is your performance after fees.

So then isn’t it worth paying a higher MER for Fund X when it out-performed the index last year/over the last 5 years?

And that’s where the arguments start. If you had a time machine, sure, go back and invest in Fund X. Or just buy that one stock that did the best over that time period and do even better. Or see some dinosaurs — it’s your time machine, do what you like. But starting from today and going into the uncertain future there’s no way to say whether Fund X will continue to out-perform net of fees without that time machine. You have to choose where to put your money without the benefit of knowing in advance which fund is going to earn its fees and then some. Then seeing that most actively managed funds don’t beat the benchmark, you can at least control your costs and invest in a low-cost index fund, which is going to do better than most of the other choices you could have made.

But that explanation doesn’t always resonate, so let’s try a different approach.

There’s a clever little expression that I like: on the internet, nobody knows you’re a dog.

And then there’s this interesting little human interest story: a cat won an investing contest. A mash-up of the two gets us this catchier bit of advice: in investing, nobody knows you’re a cat.

The manager your favourite mutual fund pays may pick great investments and out-perform the market, even net of fees. And that may be because your manager has great skill and discipline, and is able to continue to beat the market… or it may be because of dumb luck.

It’s extremely difficult for an outsider to tell the difference in a world where cats can beat professionals, a world where even highly paid, ostensibly skilled managers mostly under-perform. So yes, at the end of the day all that really matters is performance after fees, but without a time machine the best chance for getting that is to minimize your fees.

A major problem with human decision-making is that we have to do it with incomplete and conflicting information. It’s hard. And there’s a lot of uncertainty and randomness involved — moreso in some areas than others — so it’s hard to fine-tune our decision-making through trial-and-error. In some cases, we may only get one shot at a decision.

A lot of the time we have to weigh the probabilities of different (often conflicting) opinions and bits of evidence. We can take a sort of Bayesian approach, even without getting into the math: based on what we know already, we think some bits of information informing our opinion are likely to be true and helpful, and others are not likely to be true and helpful. For example, if I’m trying to pick where to go for dinner when I’m out of town for a conference, I could ask a few people for their suggestions. I’m going to put more weight on the advice of my friend Alex who has similar tastes to me than I would on the hotel concierge (a complete unknown who may be getting kickbacks to point guests to a restaurant) or my friend Ahab, who cares more about how food is sourced or presented than how it tastes. I’m also going to have a huge prior probability of choosing a pizza place, so it would take a very strong recommendation to move my decision to say a greasy spoon.

In investing, I might put some high probability on the likelihood that the income statement and balance sheet are right, and some low probability that someone ranting on Twitter or on a blog is right, then come to a decision as to whether or not to invest in a company.

The next trick then in your probabilistic model of the world is when do you shift your decision? There’s a lot of good stuff to read out there on the foibles of human decision-making, how we’ll stick to a decision far longer than we should, etc. So try to consciously consider from time to time what new evidence would make you change your mind or your weightings of the probabilities. Granted, most of what comes out in the investing world is non-actionable noise: some analyst somewhere changing a price target or opinion on a stock is not necessarily a reason to change your mind on what the balance sheet is telling you or to sell — and I fully encourage you to get into the habit of ignoring most of that. But maybe something else might come along to outweigh your prior decision: firing the CEO (especially if your thesis revolves around betting the jockey not the horse), or missing targets, or the ascendance of a competitor.

Allegations of fraud, for example, can (and should!) shake your faith in a decision based on book value (because if the financial statements are fraudulent anyway, then any information you got from reading them is worthless for making an investment decision).

I think the Home Capital (HCG) case and the OSC disclosure is a timely example of this in action. For years I have been biased to the short side: I’m a real estate bear to begin with, I’ve heard of some shady lending practices (and conversely, have trouble finding evidence of people who likely shouldn’t ever get a mortgage not being able to find some way to close a deal), but HCG kept making money and writing more mortgages and going up.

Then in 2015 the company disclosed its problems with fraud in their mortgage channel, and the disclosure was quite late, with insider selling associated, and heavily spun to be dismissive (for example, the company framed the number of loans as being less than 5%, but that was comparing the flow in 2014 to the total stock – of that year’s originations, the loans in question were something more like 10%, which really does sound material). Those were red flags to me, and though I wasn’t brave enough to short at the time, I certainly wasn’t going to buy the dip.

But I could see the holding long case being potentially forgivable: maybe you saw real estate continuing on its tear (which it did), which washes away many sins of underwriting; maybe you figured it was a contained, one-time issue that was fully in the open and priced in to the stock.

Short sellers like Marc Cohodes were, however, alleging that management had still not fully disclosed the problems — that the focus on the 2014 originations was missing that the problem could have been bigger (what were those brokers doing in 2012 and 2013?), or that the problems in the company were larger than a few third-party mortgage brokers. Cohodes likes to use clever names: “the Queen Street Cowboys” for the OSC, or “the Potato Chip Queen” for Bonita Then. So in his tweets you may have seen “Project Trillium” referenced and figured that it was just another cute name he made up — after all, I tried several times to find out what the heck it was and there was nothing indexed in Google on it (other than Cohode’s tweets). Last fall was the first time I saw anything more than a tweet in this BNN piece.

But then the OSC statement of allegations came out, and there it was: a reference to Project Trillium, confirming that that was the name of the Home Capital internal investigation into the mortgage fraud issue. And not just that, but that there were “serious systemic underwriting control deficiencies” (which had not yet been disclosed by management). In all the ink spilled over the bank run and collapse in Home Capital’s share price, not many (props to Macleans) picked up on that tidbit. Yet that’s the kind of new evidence that should make an investor immediately re-assess their probability weightings of the evidence – clearly the shorts did know something more than the longs. Sure, it’s not as big a deal as if the allegations were that the books were being cooked, but there are concerns when management is not being forthcoming and transparent about issues — and repeatedly hiding behind their freedom to interpret what is “material”.

With the short lens on, you can start to find things that aren’t total red flags on their own, but look a bit suspicious in light of a company that’s not being transparent (or even actively hiding things wherever possible): like the “other operating expenses” line. Before the issues in 2014, that was broken into subcategories; in 2015 it’s all consolidated and increases from $70M to $90M, then to $123M in 2016. Or the news that HCG partners with a company started owned by the founder’s kids (without disclosing it as a related party transaction, again using the shield of a “not material” interpretation) to do 1st & 2nd mortgage package deals, seen as a way to side-step mortgage rules around borrowed down payments.

In 2015 you may have put a low weight on the opinions of a short-seller like Marc Cohodes in your decision about what to do with HCG. As Marc’s track record as a short of Canadian names has become quite impressive over the past few years (Valeant, Concordia, Home Capital Group to name a few), and as it became clear that he likely knows more about this company than many of the longs speaking on TV, you should probably have increased your weighting of his opinion in your decision of whether or not to own the stock (especially if you were relying on the opinion of talking heads on TV who were on the long side).

This was an interesting case for me to think about, because it was not as cut and dry as Enron or Sino-Forest, where the companies themselves were broken. AFAIK, no one has said that HCG is a complete sham, but the weakness of their controls could be a big issue if the housing market turns, and the number of fraudulent loans (or the slowdown in future business to prevent it from happening again) could be larger than previously indicated. Their lack of transparency is another issue, which IMHO is what underlies the bank run — banks are built on trust and HCG lost that. It’s also likely why they haven’t solved their liquidity issue by just selling loans: they had to massively over-collateralize the HOOPP loan, which on top of the other issues suggests that no one should be paying anywhere near par for mortgages they’ve written (and it only takes about an 8% discount to wipe out the equity thanks to the power of leverage).

So whether your decision is to buy an investment or something totally different, what evidence and opinion did you consider when making the decision? How did you decide how much weight to give one piece of evidence over another? What new evidence would it take for you to change your mind?

Full disclosure: I did purchase a small number of puts on HCG (i.e., I am effectively short).

Footnote: This decision under uncertainty stuff helps show why active investing is so hard. For 99.9% of investors out there, you should probably use a passive index investing strategy rather than messing around with individual stocks — and I just so happen to have an online course that will help teach you how to do that! While I did eventually take a position here, it is very small and could more properly be considered entertainment/gambling money rather than part of my long-term portfolio, which is mostly passive ETFs.