Monday, 24 July 2017

Preparing for a Market Crash during Retirement Years

What is the best preparation for a stock market crash? Unless you have a crystal ball in front of you, I don’t believe anyone can predict when that will happen. I know for sure it will happen one day, just like the meteorologist that predicts rain will eventually get it right one day.

Since the last major correction that ended in March 9, 2009, the S&P 500 has climbed from 676.53 to almost 2,500 in July 2017, or almost 270%  in total returns, including dividends reinvested.  Average annual return is more than 30%. No wonder there are so many early people who have achieved Financial Independence by investing almost at the bottom of the market.  Conversely, people who withdrew their investments at the trough would not only have lost almost a third of their fortune, but also the opportunity cost of staying the course, and waiting for the market to recover, and finally profit from waiting.  This, my friend, is the essence of investing for the long-term.

Even though we are closer to a major market correction now than before, it is important to not time the market by making major moves with your investment strategy. Stick to an asset allocation strategy appropriate to your risk profile and your retirement timeline. My experience with overseeing the company pension plan assets tells me that this strategy works best over time. When the equity markets do well, the pension plan tends to underperform due to exposure in the fixed income. And vice versa, during the market crash in 2008, the pension plan was able to escape the worst due to investment in fixed income, which thrived due to shift to government bonds and lower interest rates.

Having said that, I am a little concerned that the current bull market may be slightly overextended due to the following reasons:

Central bankers are starting to raise interest rates beginning with the Federal Reserve Bank of the United States, and now the Bank of Canada. Despite benign inflation rates, I think it is time to unwind the balance sheet of debt.

There is a glut in oil supply. The Saudis are suffering, even though their cost of production is the lowest. Higher cost producing countries such as Canada, the U.S., Norway, will suffer the most.

The stock market has been on a tear for the past 8 years, which surpassed the longest bull market run on record.

Company earnings may be peaking. As measured by S&P 500 trailing P/E ratio, it is almost 27. Normal average is less than 20. Note however, that stock market’s performance is driven by future expectation, and not historical data.

Market is driven primarily by a handful of high tech companies, notably FANG (Facebook, Apple, Netflix and Google (Alphabet).  Emerging FANGS include Amazon, Microsoft, and Tesla. Leadership is definitely lacking. Just so you know, the S&P 500 is a weighted index, and the top 5 companies above comprised 20% of the market capitalization.

A lot of companies are shedding their workforce in order to meet the earnings estimates. Top line growth or sales or decreasing.

Global housing prices have reached an unaffordable level.  Look at the correction that the Toronto GTA market is experiencing now- down almost 18% from the peak in April 2017.

I am not a firm believer that politics drive stock market returns. There may be  few hiccups due to Trump’s presidency in the United States or even impact from terrorism, but markets usually shrug them off.

Here are some of the steps that I am taking to reduce my risk in the equity market:

Start buying precious metals, preferably physical gold. History has shown that the precious metal has a negative correlation to stock market performance. Gold prices were up 25% during the 2008 market correction. And to a lesser degree, gold stocks, too. I would say no more than 10% of your total portfolio should be allocated to precious metal.

Review your asset allocation. Stick to a more conservative portfolio by investing more in fixed income -government and high quality corporate bonds with staggered maturity dates to hedge against interest rate risks. . Even though the current yield is about 3%, it is better to preserve your principal rather than losing 30% in an equity market downturn. Plus, with interest rate rising, you should be able to get a 4% yield. Depending on your investment horizon, I would say no more than 40% should be invested in fixed income.

Keep at least 1 year of living expenses in cash. I have to say that I found this while reading some of the personal Finance blogs, and I must say that this is a great tip. Assuming you have $50,000 in either savings or fixed deposits.  This avoids the need to tap into your portfolio and sell the stocks while they are down due to a market correction.  Assume this is 5% of your total portfolio of $1 million.

Lastly, your equity selection should yield at least 3% in dividends. Including interest from fixed income above,  your $1 million portfolio should provide an estimated 3% return in cash or $30,000 - $160,000 dividends and $14,000 interest per year. Assuming you intend to harvest 3% of capital gains from your equities, which will provide another 3% or $12,000, your total portfolio should provide $40,000 a year in cash, which should be sufficient for a basic retirement lifestyle if you add in CPP and OAS (or even private pension plans) .

In summary, here is my ideal portfolio to ride through a market correction and basically a portfolio for all seasons:

For full disclosure purpose, I have initiated some of the steps above, but have yet to reach my targeted mix.

Monday, 17 July 2017

Options Trading

Stock Options in the forms of call and puts can be a great tool for risk mitigation. Call it a form of insurance. The auto or house premiums that you keep paying ensure that you are compensated in the event your car is involved in an accident or that your house catches fire.

Definition of option as follow from Investopedia

An option is a financial derivative that represents a contract sold by one party (the option writer) to another party (the option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).

Applying it to practice takes effort, patience and paying tuition fees upfront (i.e. pay the price initially and learn from mistake).  I find that my most successful options trades are not the one that are speculative in nature (i.e. banking that a stock is going to increase significantly by buying calls or thinking that a stock is going to tank by buying puts), but the option strategy that works best is writing covered calls.

Writing covered calls basically means that I own a stock, say 1,000 shares of TD Bank.  To further generate additional returns, I write a call for 10 contracts of TD Bank (1 contract = 100 shares) to sell at a strike price of $70 in 3 months (current price = $65 per share).  In return, I received a premium of $1,000 (or $1 X 10 contracts X 100 shares). 

My assumption is that since the stock has already appreciated 30%,   the stock has already reached its upside, and in the short term I assume that the stock will either decline or remain unchanged. If the share price stay below $70 for the next 3 months, the option will expire worthless. If the share price is above $70 prior to expiration, the buyer of the call will receive the shares at $70.  Regardless of the outcome, I still keep the premium, and therefore I am able to increase my return by another $1,000. There is obviously commissions involved.

In summary, there are various options that can be employed such as the basic buy or sell puts, writing calls and puts, to more exotic strategies such as straddles, collars, and etc. However, they can be quite costly for the inexperienced investor to participate in. 

Thursday, 13 July 2017

Funding Your Retirement

When planning for retirement, it is important to estimate where your sources of income are coming from.  You would also need to determine how much you expect to spend. Take a look ath list below, try to estimate how much you would get and need.
Sources of Income (assuming age 65 and above and maximum benefit as of July 1, 2017):
Canadian Pension Plan (CPP) per month:1,114
Old Age Security (OAS):                            584
   Total CPP and OAS                             1,700

Guaranteed Income Supplement (GIS) if applicable: 524.85 maximum
Defined Benefit (DB) Pension Plan if applicable
Dividend or interest income from investment portfolio
Part-time work if applicable

Monthly Expenses for 1 assuming frugal lifestyle:
Housing, transportation, food, clothing, and misc (basic lifestyle):            (1,700)
Add: another $800 for travel, dining and other lifestyle needs

If your sources of income exceeds your expenses, congratulations!

If your only sources of income consist of CPP and OAS (total $1,700), you may be able to still afford a minimalistic lifestyle (Expenses = $1,700).  I know I can live like a King! In addition, there are other social benefits that one can qualify at that income level, which would include GIS, hydro rebate, Ontario Trillium drugs and healthcare benefits and others.  

This just goes to show that you should not just blindly be led to believe that you need $1 million dollars in the bank to be able to afford to retire. But of course, we want to retire and travel the world, and live in luxury! This is when the extra planning and savings during your working years will pay off in the latter years. 

Saving an extra $100 per month for 40 years assuming a 5% annual return would provide $150,000. The same $150,000 when used to buy an annuity from a life insurance company would provide a monthly income of almost $700.

Alternatively, find a job with the government (local, provincial or federal), work for 30 years, and you can qualify for at least a  $4,000 a month pension for life! In order to receive $4,000 a month at retirement, one would have to save almost $800,000 lifetime and use the amount to buy an annuity to generate the same $4,000 income.  I know what I will do. Hope you do as well. Problem solved! And good luck getting the public servant job unless you know someone internally. 

Thursday, 6 July 2017

Another reason why you should opt for commuted value payment from Defined Benefit Pension plan

As I reiterated before, it is best to receive lump sum payment or commuted value (CV) from the defined benefit plan when you leave the company and invest in annuity. Note that there are some taxable events to consider. Sears Canada, which filed for bankruptcy protection, recently filed a motion with the courts to suspend certain monthly payments to its pension plan and post-retirement health and life insurance benefits, citing cash constraints. At stake is $3.7 million worth of cash payments to various DB plans, postretirement health and benefit plans.
Such issues are not uncommon. U.S. Steel Canada in Hamilton, Ontario filed similar motion with the courts to reduce pension and other benefit payments. Nortel Network, which has long been bankrupt, recently resolved its pension payment issue, resulting in a huge reduction of benefits to pensioners.
Just so you know, and I repeat, DB pension payments, despite being ‘guaranteed’ are not truly guaranteed.  If a company defaults on its payments to pensioners, the Pension Benefit Guaranty Fund (PBGF) essentially guarantees pension payment up to $1,500 (assuming the latest pension reform). If you are entitled to $5,000 a month payment, and the company that you worked work declared bankrupt, you may only get $1,500 from PBGF, thus losing $3,500.

FYI, the $1,500 a month that you finally receive after months or years waiting are also essentially a return of principle in most cases. Recall that you have been contributing approximately 5% of your pay into the pension plan each year. Assuming your average pay over the years was $100,000 and you have worked 40 years, and the rate of return was 6%, you would have accumulated almost $800,000 by the time you retired. And if you have invested $800,000 purchasing an annuity with an insurer, you would have received a monthly income of $4,000 a month - GUARANTEED. This is because ASSURIS ,which acts as an insurance fund, guarantees the higher of $2,000 of the amount or 85% of the promised benefits. 

Wednesday, 5 July 2017

Defined Contribution (DC) Pension Plan

For the unfortunate majority of workers who do not participate in company sponsored Defined Benefit (DB) pension plans, but instead contribute to DC plan instead, below are a couple of watch-outs. The typical DC plan includes a 50% matching contribution from the Employer up to 5% of salary (or 2.5% Employer + 5% Employee).  This is great because you get to double your money from get go.  However, unlike a traditional DB plan where future benefits are promised, you have to roll the dice with a DC Plan and select your own investments, ranging from targeted benefit investments to various equity and fixed income funds. And the biggest drawback is that future benefits are not certain despite the constant belief that the stock markets have always provided an average return of 10% or so. Tell that to the folks who suffered a 30% haircut in 2008 during the U.S. credit crisis when they were about to retire.

What I wanted to discuss further is actually the Management fees, or also known as MER, IMF and a host of other names. These are fees charged by the investment managers to operate the fund, regardless of whether the fund returns are positive or negative. The fees can range from a low of 0.1% to more than 2%. 

What I finally realized from looking at the fund prospectus is that in a typical DC Plan, the average fund in a DC plan is higher by at least 0.3% compared to a similar Exchange Traded Fund (ETF) as illustrated below. This, despite the promise that there are savings to be generated. The truth of the matter is that there are other fees tacked on to the MER besides the typical MER in a similar ETF.  I am not exactly sure what these fees are, but will try to find out.

On many  occasions, one can even leave the funds in the DC Plan when one retires.  But if I can make a suggestion, you would be best served if you move the money to a self- managed ETF. For a $1 million portfolio below, there are savings of at least $3,500 per year pre-tax by doing so. It may appear insignificant at first, but the amount adds up if you consider the fact that you will live an additional 20-25 years to live assuming you retire at the age of 65.

DC Plan
Savings in Fees
TSX Composite Index (70%)
Management Expense Ratio (MER)

Canadian Corporate Bonds Index (%)
Management Expense Ratio (MER)

Assume 70% Equity/30% Bonds
Management Expense Ratio (MER)

  Difference in Fees on a $1M portfolio
     Assume 20% tax on $60,000 income, annual pre-tax income on savings in fees
ETF - Exchange Traded Funds, managed by individuals, commissions may apply
DC Plan - Company sponsored, management and OTHER fees (MER) paid by employees

Thursday, 29 June 2017

Pension and Insurance Revisited

For those lucky enough eligible to receive benefits from a Defined Benefit pension plan,  a decision will sometimes have to be made to either receive monthly pension payments or commuted value/lump sum payments (CV).

Let me summarize for you the pros and cons as I see it.

Pros of receiving monthly pension payments

Certainty of payments each month.

Amount guaranteed by PBGF up to a maximum of $1,500 with the new proposal in Ontario.


Payment stops when the pension dies unless the Joint and Survivorship (J&S) option is selected (in which case the surviving spouse continues to receive pension payment at a lower amount).

Selecting the J&S option also means a reduction of almost 30% in pension payment in some cases.

PBGF guarantees a maximum of $1,500 in pension payment. If the pension plan performs poorly and  the company is not able to fund the pension plan, any benefits above $1,500 may not be paid.

Once the pensioner dies, and if there is no J&S option available, no further payments will be made.

On the other hand, one may be able to choose to receive CV, which is layman terms means a lump sum payment based on the present value of pension benefits earned,  

Summary and recommendation

My suggestion, being both a CFP and a qualified Life Insurance professional, is to purchase a whole life insurance policy that can be fully paid off in 10 to 20 years as soon as one can walk if one opts to receive monthly pension benefits without the J&S option.  The advantage is that the monthly pension payment is 30% more than the pension with J&S option, and even if one passes on, the surviving spouse/beneficiary receives the insurance proceeds tax-free. 

Based on some quick math, a 10-year $100,000 whole life policy probably cost $1,600 a year for a 21 year old and will be paid off in 10 years.   A 30% reduction on monthly pension payments based on a $2,000 monthly pension  is  about a $600 reduction. As such, the breakeven point is about 2-3 years. Again, in layman terms, if you had purchased the insurance policy way back, you can have the assurance that after 2-3 years, you will come up ahead by not opting for the J&S option.

Pros of receiving CV

Depending on the monthly benefits one is entitled to and his age , the pensioner may be able to transfer a portion or all of the CV to a Locked In Retirement Account or Life Income Fund.  This will be suitable to someone who can make his own investment decision on what to invest it.  More importantly, one can preserve the principal unlike a monthly pension payment that will stop when one dies (assuming no J&S option  is selected)

The typical amount is based on the Income Tax Act, but is generally based on the Annual Benefit multipled by a factor of 10 and above.  For instance, if one is entitled to $20,000 of annual pension benefit, one can transfer up to $200,000 to a LIRA based on a multiplier of 10,  The remaining CV balance, if over $200,000, will be taxable.

In addition, if the whole amount is transferred to purchase an annuity, the whole amount will be taxed free. The advantage is that annuity payment received from insurance companies are guaranteed up to $2,000 per month or 85% of the monthly benefit, whichever is higher.  If you were to ask me, I would rather trust the insurance company over the company paying the pension since PBGF only guarantees payment up to $1,500, which is up from $1,000 .

As indicated above, only a portion of the CV can be transferred in most cases, and the balance is taxable at the marginal tax rate. 

Summary and recommendation

Again, my suggestion, being both a CFP and a qualified Life Insurance professional, I would recommend that one should always purchase whole life insurance policy as young as possible, and pay off the policy as soon as possible. The benefit is that the policy can be used to provide reassurance to your dependents in the initial years, while serving as an estate preservation tool at your latter years.

Secondly, do seriously consider the CV option even though there are some tax consequences because of the principal preservation nature as the amount you can move tax free to a LIRA is under your control as   it can be used to generate investment income and possibly growth., while still maintaining the principal amount. 

Thursday, 22 June 2017

Minimum Wage in Ontario

While I appreciate the Ontario Liberal’s Party intention to increase the standard of living for lower income wage earners by increasing the minimum wage to $15 an hour effective January 1, 2019, I can’t help but wonder if the plan is going to succeed, never mind the hundreds of thousands of dollars wasted invested paying consultants to justify the idea in the first place.  

Don’t get me wrong. I am all for paying someone a decent wage, but this is the incorrect approach.

By increasing the minimum wage, you must also increase wages at all levels to keep pace. Otherwise, it creates a disincentive. Take for example, wages for a lifeguard. Depending on which city or private facility you work for, the current wage starts at $13 an hour. Do you know the amount of time and investment required to qualify as a lifeguard, and the requirement to maintaining your qualifications through continuing certifications?  I know that for a fact because both my daughters used to be lifeguards, but stopped as soon as they went to university and found better paying positions. This is also why there is a shortage of qualified lifeguards because of the disparity in pay to the minimum wage standards, which have risen considerably over the years, while the pay scale for lifeguards has stagnated.  

Who wants to spend all the money to be a lifeguard when you can make more money working at McDonald’s?  Guess what, you may not even get a minimum wage job at McDonald’s that easily. Just take a look at the number of self-ordering kiosks that have sprung up lately.  

In addition, small business owners and retailers suffer the most as they will not be able to pass on the increased cost of payroll to consumers easily. To make ends meet, they must reduce the number of hours or eliminate workers. The business owners are the true risk takers, and if Ontario wants to continue to encourage entrepreneurship, increasing minimum wage to such levels will be counter-intuitive.

The only way to increase one’s standard of living is not by waiting for handouts. One must upgrade one’s education, skills and be relevant in this changing world. The gap between the haves and have nots have widened.  But sadly, our government policies have not kept pace.  Life is tough, suck it up!  

Preparing for a Market Crash during Retirement Years

What is the best preparation for a stock market crash? Unless you have a crystal ball in front of you, I don’t believe anyone can predict wh...