retirement | Financial Crooks

Like many Canadians, part of our retirement income will come, we hope!, from a defined contribution pension plan. This is the type of plan where you choose what to invest in, hope it earns profits, and hope that by the time you retire there’s enough money in the plan to pay you something monthly. It is not the kind most people want, which is a defined benefit plan, which is (almost) guaranteed to pay you something monthly. It’s up to us (and you if you have one) to make sure our defined contribution pension is invested the best way possible and that’s what makes the plan a pain.

Lack of Fixed Income Choices in DC Plan Frustrates

While some plans swamp employees with too many choices to invest in, others, like ours, offer too few.

For example, here’s what we can invest in for the fixed income category:

a mid-to-long term bond fund managed by a major financial firm
a money market fund managed rather poorly by another major financial firm

Yep. That’s it.

Short Term to Maturity Bond Funds are Better Right Now

If you’ve read anything about the future of the bond market, you’ll know it’s at risk of a major drop. As interest rates climb, the rates offered on new bond issues will also climb. That will make existing bonds with lower rates undesirable. To bolster demand, the owners will have to cut the price they are trying to sell them for to offset the lower interest paid.

Say I have a $10,000 originally-20-year bond paying 1.5% a year that has 5 years left on it before it matures. New 20-year-bonds appear on the market offering 2.5% a year. That new bond pays about $100 a year more interest than the old bond. To find a buyer for the old bond, I would likely have to reduce my price from $10,000 to $9500 or less (5 years remaining x $100 per year) to find an interested buyer.

The interest paid on bonds has not increased by much yet. But it still may be necessary to offer a reduced price when selling old bonds just because the buyer thinks the interest rates will be rising. Unfair but true.

That’s why many people suggest going with short term-to-maturity bonds right now. Buyers are less likely to be worried that interest rates will climb high quickly in a short time. Therefore you might be able to persuade them to buy your bonds without offering much of a discount. and you could always just hold the bonds to maturity and re-invest at a higher rate when they mature.

So why does our DC pension plan not offer us a bond fund with a short average term to maturity?!

Even our bond fund manager is painfully aware of the risk right now. I’ve noticed if you look in the details about what the fund holds that they are playing some interesting paper games to try to reduce risk. They will do things like buy some 40-year term-to-maturity bonds at a ridiculously low interest rate to counterbalance buying a lot of very short term bonds. The result is that they can stay within their fund’s defined required range of age to maturity with less risk than if they invested solely in mid- to long-term range bonds.

Money Market Funds are Risky

Some people mistakenly assume a money market fund is like a bank account. You put your money in, earn some interest, and it’s all waiting for you when you want it out.

Wrong.

Money market funds invest in things like commercial paper. In theory, this is fairly safe and the funds are fairly low risk. They are not NO risk though.

In fact in the 2008-2009 financial fiasco huge amounts of commercial paper went bad. You can read up on it online in articles like When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007–2009.

Money Market Funds Preparing for “Negative Earnings”

“Negative earnings” is what you and I call losing money!

In a January 2013 article by Bloomberg, for example, it explains how some big investment houses are resetting the rules for their money market funds to allow them to drop in value below their nominal (usually $10) value per unit. The article RBS Changing Money-Market Funds to Accommodate Negative Yields.

Firms that are doing this include

JPMorgan Chase & Co. (JPM)
Morgan Stanley
RBS Asset Management Ltd.
and various European fund providers

The move is driven by the fact that funds have been experiencing losses and ***are expected to have further losses.*** They want to be able to give you back less money than you paid when you bought the fund. That doesn’t sound much like a bank account to me. (Unless you had one in Cyprus.)

By the way, do you think the average pension plan member knows about all of this? This is why I think DC Pension Plans are a real danger.

Why Our Defined Contribution Plan Doesn’t Offer Truly Safe Fixed Income Choices

Some DC Plans allow members to invest in GICs. These guaranteed investment certificates ensure your principal is safe and offer a very low, but safe, payment of interest.

Our plan does not offer GICs. If I understand correctly it’s because people would put too much money into low interest GICs. Then, by the time they want to retire, there would not be enough money in their DC plan to buy an annuity to get a reasonable monthly cheque.

That tells me two things:

people are scared of losing what little money they have in their pension plan
the company hasn’t considered ways to offer GICs while managing risk

I think they should offer some truly safe investment like GICs but limit the total amount of the pension plan that can be invested in that category. The limit should change depending on how close a person is to retirement.

Pension Planning is Easier if You Have a RRSP and a DC Pension Plan

Things are a bit easier for us than for some members of our DC Pension plan. We have RRSPs in addition to our work savings. So we balance across the two plans. We can, for example, buy GICs or deposit cash in a CDIC-insured daily interest savings account within our RRSP. Then we can keep our DC pension plan earnings in the stock market, if we wish.

Many people are not that fortunate, however. Lots of employees do not have a RRSP or a TFSA for a variety of financial reasons, some good, most sad. What are they supposed to do?

Keeping Aware of How a DC Pension is Invested Is Work

To keep up to date on the types of fixed income investments offered in our DC pension plan is work.

In the olden days this work was done for employees by a financial specialist who would make investment choices for the entire company within the defined benefit pension plan. Now, each employee must do this work himself or herself. It’s a waste of time and energy. And frankly many of the employees lack the skills to do the research and make good choices. It’s worrying and it’s a pain.

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Does your DC pension plan offer good choices for fixed income investing? Please share your experiences with a comment.

Annuities can provide a steady reliable source of income for someone who is not working perhaps due to retirement. Basically, you buy an annuity and it pays you a set amount on an agreed schedule for an agreed length of time. When that time is up, the original principal invested stays with the annuity’s issuer. Often the length of time is until the buyer dies. But what if you want the steady reliable payments but you don’t want to permanently hand over your principal? Is there some way to buy that?

A Reasonable Facsimile for an Annuity

So far I haven’t found any product that is the same as an annuity but that doesn’t use up your principal. I have found what advertisers used to call a “reasonable facsimile” though. It looks a bit like an annuity and works a bit like an annuity but it isn’t one.

For this to Work You Should Act as if You’re Buying a Vacation

If you’d asked me ten years ago if I had any stocks I would have said no. Then, after thinking for two or three minutes I might have corrected myself and said “well actually yes I do. But not real stocks.”

My confusion would have stemmed from the way I acquired those two stocks. Many, many, many years ago, I bought stock in my employer when it was privatized. As a then resident of Alberta, I also bought a small amount of Alberta Government Telephones when it privatized. (You may know it better by its current incarnation “Telus.”) In both cases when I bought the stocks I never expected to sell them again. They were impulse buys and I thought of them the same as if I had spent money on a vacation. It seemed like a good way to spend the money at the time and I’ve never thought much about it ever since.

If you are seriously interested in this “facsimile” of an annuity, you’d have to do the same thing. You’d have to consider the money you spent as being “almost” as gone as if you’d bought a true annuity. You’d have to go in with the possibility that you might never see or touch that money again.

You’d Also Have to Be Prepared for a Possible Drop or End to your Payments

If you buy an annuity from a well-respected source, part of the payment is insured. If the company issuing the annuity goes bankrupt you’re guaranteed to get at least a portion of your regular payments.

If you buy an annuity from a fly-by-night source, however, you might lose the whole thing if the issuer goes bankrupt.

Some people still choose this second option, especially if the proposed annuity payment is much higher than a well-insured one.

If you’re going to buy into this “facsimile” annuity you’d also have to be prepared that the payments could drop or could stop. How likely it is for the payments to be at risk depends on from which issuer you choose to buy your payments.

Have You Guessed the Nature of the Facsimile Annuity Yet?

Yes, the reasonable facsimile is a collection of dividend paying stocks.

Your principal might be recoverable unlike with a true annuity because you might be able to sell your stocks to get back all or part of your principal.

Your payments would not be guaranteed to stay the same or to continue because some companies do cut their dividend payments and some do stop paying dividends.

The risk of a dividend being cut or stopped can be estimated for a stock if you look at its dividend history and its current and announced company plans. Some companies are well aware that their investor-base is people who need steady, reliable income. If their business plan tends to produce steady reliable profits they usually plan on maintaining their historical approach to paying dividends.

Why I Forgot I Own Two Stocks

This brings me back to the two stocks I owned and actually forgot about. One of the stocks plummeted to half its value within a couple of years of when I bought it. From that point forward, I never included it in any estimates of my net worth. The other was such a small amount of stock it would be like counting the contents of my childhood piggy bank.

While I forgot about these stocks as “investments” or “capital gains plays” I never forgot they pay dividends. In fact, out of curiousity I recently worked out the yield for these stocks based on what I paid to acquire them all those years ago. (I didn’t factor in inflation or the lost time-value of that money. I kept it simple and just divided how much I get per year now by how much I paid in cash back then. This is not good math. It was just fun.)

The shares are now yielding 8% and 18% per year on their initial investment. That’s substantially better than the current yield for someone buying the same stocks today. Which is good because the increase is supposed to help cover some of the rate of inflation. (In fact when I compared it against the CPI increases for those years, the increase has been higher than inflation.)

Both stocks have also enjoyed large capital gains over the years. But since I have never sold the stocks and since I act like the money I paid for them is long gone, that’s not actually relevant. If I’m still holding them when I die, though, my survivors may be pleased. They could donate some of the shares to charity and use the tax credit to help offset some income taxes on the rest of my estate.

How Can I Pick the Stocks to Buy for my Facsimile Annuity?

Ah, now there’s a difficult question. I’ll have to get back to you on that with another post. In general, though, you’d be looking for a stock that has

paid a dividend for many years without interruption
is a business that tends to have a steady profit, such as a utility, financial or telecomm business
preferably has increased the dividend steadily to keep up somewhat with inflation
does not jeopardize its own survival just to pay a large dividend