Investment Income Calculation

Question:

It seems the program may be treating withdrawals from a TFSA as "income" for purposes of the OAS "clawback" test.

Answer:

No, TFSA investment income is never included in taxable income.

The OAS clawback is based on all income plus realized investment income. Investment income for the year shows on the cash flow table. The portion that is interest, dividends is taxed. But there is also realized income based on the selected 'Percentage of gains realized annually' in 'Economic Outlook' on the 'Forecast' page.

For example, assume all your non-registered assets are in fixed income that has a cost base of $250,000, a market value of $300,000 and you earn 4% per year.

Your market value is $312,000 at the end of the year, with interest of $12,000. If you sell and reinvest 20% of your portfolio each year, you will sell $60,000 of bonds and have a realized gain of $10,000. This amount is added to income to figure out the tax payable and assigned to the non-registered account.

This in turn affects the clawback on Old Age Security.

By default, this portfolio "churning" is 20%. You can control this (and set it to 0%) in the 'Advanced' section on the 'Economic Outlook' tab on the 'Forecast page'.

By: RetireWare / Equisoft On 9:50 PM

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CPP and Retired

Question:

When I run the simulation with the expected contribution years for the Canada Pension Plan, the results show a blank column for the CPP in the cash flow forecast.

Answer:

If you are retired and want to use a CPP based on contribution years, you must supply annual income in 'Financial Information'. In such a case, the annual earnings will only be used to estimate the CPP. Otherwise, the program has no way to calculate an estimate.

By: RetireWare / Equisoft On 9:50 PM

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Odds of success

Question:

When I run a Monte Carlo simulation, I get 92% success odds, but the assets at retirement show a shortfall.

When I look at the charts, it looks like there is/may be a slight shortfall near 85-90…

Why does this happen?

Answer:

Each capital market simulation looks at whether you have enough funds and income to pay your expenses for the rest of your life.

Suppose you have enough each year of retirement except that during the very last year at age 90 you are short by $10,000. I would consider this a success even though you are technically short by a small amount. After all, your selection of life expectancy is a best guess, or better, a safe guess.

There is an option in the Monte Carlo settings that allows you to count cases with small shortfalls as a success. You can modify the setting to only consider cases that have no shortfall, or select the amount you think is reasonable for your purposes.

If this does not explain your issue, I can have a look at your calculation if you give me permission to review your file.

By: RetireWare / Equisoft On 9:50 PM

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Calculation of Dividends

Question:

In 'Economic Outlook', what’s the difference between the Annual Expected Return and Dividend Yield in the “Economic Basis for Projections"? 

For example if I input 3% for Equities – Canada and an expected Dividend Yield of 3% does that mean a total expected annual return of 6%?

Answer:

The dividend yield will apply to assets invested in equities based on the asset allocation model in 'Asset Mix for Projections' (on the Options page). 

The dividend yield is on top of the appreciation of assets for each class of equities.

By: RetireWare / Equisoft On 9:49 PM

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Retirement Budget

Question:

 I now signed-up for your new web based application and my first impression is quite positive.  A couple of points though:

1) The software seems to ignore the post retirement budget data I’ve entered for my wife and I.  The budget statement is empty.

2) Can the interest rates be adjusted by the user or are they fixed.

Answer:

1. Have you selected both of your retirement income goals to be based on expenses in 'Retirement Income Target' in the Forecast page? Also, if you're not retired, the budget statement will be a pre-retirement budget. The post-retirement budget will show in the statement if you are currently retired.

2. If you have the DIY version, you can adjust the all rates and investment returns, and have expanded results with Monte Carlo simulations and risk analysis.

By: RetireWare / Equisoft On 9:48 PM

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Losing a Loved One

Not an appealing title

In order to add a little subtlety, I did not name this post "Death of a Spouse", but this is one of our post-retirement risks to plan for and manage: the risk of one spouse dying unexpectedly a few years into retirement.

We will look at ways to address this post-retirement challenge and prepare for the adverse financial consequences caused by the death of a spouse.

Unpredictable

Life expectancy tables tell us that women live longer than men on average. Life expectancy at birth in Canada in 2009 was 78.8 years for men and 83.3 years for women. The gap between men and women has narrowed over time from 7.4 years in 1979 to just 4.5 years in 2009. However, for a couple, it is very hard to predict which spouse will live longer. For more on life expectancy, read this blog post.

There are two cases to plan for: you die first and your spouse dies before you. Thinking that that the typically older male will pass away before a younger female spouse may leave him in a precarious position if the other possibility actually happens and no planning around it took place.

You have to look at the consequences of the early death for each spouse. How will each surviving spouse do, considering the many years he or she may live?

Impact on budget

Estimate the impact of one spouse's death on your post-retirement budget. In many cases, total expenses may reduce by as much as 25%, considering that while many costs such as housing, property taxes and transportation remain unchanged, others such as health care and personal expenses may reduce by half.

If the surviving spouse's budget reduces significantly and combined assets remain untouched, then it will have a positive impact on financial security.

Determine which income sources will be lost or reduced (such as CPP) when each spouse dies, and how any shortfall can be met going forward if required.

Downsizing and relocating are always options to consider to keep living costs in line with what you can afford. Smaller dwellings are also less work and cost less to maintain. If this make sense for you, you can assume in your planning that there will be a change in housing to less expensive dwellings. This will free up funds to invest and use for future retirement income. 

If you make a budget, differentiate between essential and discretionary expenses. Ensure you have enough guaranteed income to meet your budget for essential expenses whether one or both of you are alive.

Pensions

If you have a defined benefit pension plan, do not take a lump sum option when retiring or leaving your employment; only consider it if you are a long way from retirement. Select a "joint and last survivor" pension option at retirement. The lifetime income it will provide to your spouse is well worth the reduction applied to the pension.

The surviving spouse will become eligible to the deceased spouse's Canada Pension Plan survivor pension, which is 50% of the amount that was payable while alive. If you can afford to start the CPP (or a defined benefit pension) at a later age, the pension payable to you will be higher, and so will be the survivor pension.

Knowing the percentages of the initial pension payable to the survivor, you can assess if continuing income together with other available retirement funds are able to cover expenses for each surviving spouse.

Insurance

If you are insurable, having the right amount of life insurance is essential to ensure that neither suffers a financial setback. You can set up a policy to pay the face amount on either, the first, or the last death.

Insurance will be useful to cover any shortfall that may occur from lost income or assets after the death of one spouse.

Wills and estate planning

Having a will is a must to smooth out and speed up the transition at this difficult time. It can also minimize income tax to ensure assets are transferred efficiently to the other spouse.

Annuitize

Consider purchasing a joint annuity with a portion of your retirement savings. A joint and last survivor annuity will provide a survivor income to your spouse on death.

Annuitizing is also an option to consider for funds in a defined contribution pension plan or group RRSP at retirement.

Maximize assets

Here are a few strategies to increase the likelihood of leaving more funds on the table to pay ongoing expenses for the remainder of the surviving spouse's life.

Work longer

Work as long as you can, even on a part-time or contractual basis to reduce the period of time you'll need to rely solely on retirement savings.

Spend conservatively

Spend conservatively during the first few years of retirement and minimize your withdrawals. If you earn poor returns, low withdrawals will not deplete your assets as much and you'll be left with more money for the rest of your lives.

Invest wisely

Get knowledgeable about investing or get a professional to do this for you to maximize your investment returns.

Your should take on just enough risk to earn a decent return, while staying comfortable with your investment strategy. Savings accounts and money market funds earn less than the rate of inflation. So you are essentially losing money with these ultra safe investments.

Following a death

You can search Google for "Service Canada Following a Death" and you will find a helpful page on the Service Canada Website that shows you want to do to obtain a death certificate, cancel pension and benefits, Old Age Security, the Canada Pension Plan and tax-related payments.

It also points you to benefits you may be eligible to receive, such as survivor and death benefits and provides information on important financial matters to consider.

[Here's the link: http://www.servicecanada.gc.ca/eng/lifeevents/loss.shtml, use Google as suggested above if it goes stale.]

If it happens...

Organize and gather personal records: birth and marriage certificates, certified copies of the death certificate. This will be required to establish ownership of the accounts and prove you are entitled to receive benefits.

Gather life insurance policies, investment account numbers, existing will, income tax and employee benefits information. Assess your financial situation by looking at total income and expenses, assets and liabilities, and insurance coverage.

File claims with insurance companies for individual life insurance policies, accidental death and dismemberment policies, travel, mortgage and credit life insurance policies.

Apply for the CPP death benefit of $2,500 and survivor pension. You also are eligible to transfer the balance in a RRSP or RRIF to your own account tax-free.

Make sure you have enough cash to meet your current expenses as well as funeral costs.
If you receive life insurance proceeds, use these funds to increase your cash reserves. Try to have at least six months' worth of living expenses in a bank account or money market fund.

You should put your name as the sole owner for real estate, vehicles and joint bank accounts.

Write a new will. Also look into a power of attorney for legal matters and health care in case you are unable to make your own decisions.

Probate is the legal process an estate goes through after a person's death. The process and requirements of probate differ for each province. Steps include confirming the legal status of the executor, notifying creditors and beneficiaries, settling the estate's debts and taxes, and finally transferring assets to beneficiaries and heirs.

Making a plan

Planning your retirement includes ongoing monitoring and making changes in light of changing circumstances.

As well, maintaining an updated retirement plan will make it easier to make the transition from a financial standpoint when it happens.

By: RetireWare / Equisoft On 10:28 AM

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The Stock Market Risk

Risky stocks

Stock market risk is the risk of the decrease in the market value of an investment.

In contrast to the sequence of returns risk, the risk that a market downturn reduces the capital base near the time of retirement, stock market risk is a period of poor performance in the stock market that results in investment returns lower than expected.

In both cases, the portfolio runs out of money sooner than expected, leaving little or no funds to pay living expenses. One measure of riskiness of a stock or portfolio is volatility -- how much the value deviates from its average over time. In statistical terms, it's the "standard deviation".

For example, we can calculate the average and the standard deviation of monthly investment returns
of a security over a number of years. The standard deviation gives a clue to the extent of the fluctuations for the security above and below its average.

The more wildly a portfolio fluctuates, the more likely the odds that it can irreversably deplete your assets.

Risk premium

In the stock market, there is a strong relationship between risk and return. In general, the greater the risk, the greater the return. Based on past volatility and the lack of guarantee of any equity investment, investors expect to be compensated duly for taking a greater level of risk. This compensation is called the risk premium.

Risk is therefore central to stock markets or investing because without risk there can be no gains. You need risk management strategies to minimize the risk and maximize the gain and meet your invetment return objectives.

Stocks and markets

In financial markets there are two major types of risk: the market risk and the specific risk. Market risk cannot be eliminated through diversification, though it can be hedged. Specific risk is tied directly to the  performance of a particular security and can be protected against through investment diversification. Sources of market risk include recessions, political turmoil, changes in interest rates and natural disasters.

Managing risk

There are a few strategies that you can use to mitigate the stock market risk.

Diversification irons out risks in a portfolio. Investing in a wide variety of stocks reduces risk compared to a poorly diversified portfolio. Diversification works if the securities in your portfolio are not perfectly correlated. When one asset or sector is faring poorly, the gains on other assets can make up for this loss.

Lack of diversification can give rise to a liquidity risk if significant assets are held in stocks that are traded in low volumes and they cannot be sold in a timely manner.

The percentage of assets held in equities should be in line with your risk tolerance level, time horizon and financial goals.

Even with a low tolerance, there is a need to maintain a share of assets in equities to boost potential investment returns. Common stocks have historically outperformed other investments over time, and are a necessary component of your portfolio.

You will experience low or negative investment returns on your stock returns from time to time. While these losses are painful, recoveries from market declines have been surprisingly quick in recent times. Selling to prevent losses from getting worse means that you may miss a recovery that boosts your account value. Holding good companies that are trading at a lower value are only a paper loss.

In other words, you should follow the trend of the market and recognize that short term trends are "noise" and what really matters are long term trends. However, it is also possible that you will experience a long period of stock market losses. So as you get older, you should be careful to limit your stock market exposure and gradually reduce it to a level that cannot adversely impact your financial security.

A related approach to diversification is holding investments that have a low correlation or are negatively correlated to each other. This is less effective today as markets across the world tend to be highly correlated and stocks and bonds have a low correlation.

If performance is lower than expected, then lowering spending may be the only option if a phased or postponed retirement is not possible.

Transferring risk

There are ways to transfer the stock market risk. A annuity is an obvious solution, but the income it provides may create issues for managing other risks, such as the long-term care risk (insufficient income to pay rising health care costs) and inflation risk (if the annuity income does not have automatic increases to maintain purchasing power). Inflation and annuities are discussed in greater detail in this blog post.

The stock market risk can also be removed by investing in financial products that hold stocks, but guarantee against the loss of principal, such as segregated funds or index-linked  notes. Again, fees and loss of liquidity have to be carefully considered when assessing the benefits of these investments.

What's in store for the future

With low economic growth, high government debt and low interest rates, many have a pessimistic view for the stock markets. What can we expect when formulating expectations for future stock returns?

Vanguard Research published an excellent study entitled "Forecasting stock returns: What signals matter, and what do they say now?" (October 2012).

The Vanguard research looked at U.S. stock returns since 1926 to assess the predictive power of more than a dozen metrics. They found that many commonly cited metrics have had very weak and erratic correlations with actual subsequent returns, even at long investment horizons.

Their research has shown that forecasting stock returns is difficult for the long-term and impossible in the short term. Over a long time horizons, few metrics have predictive ability. While valuations (price/earnings ratios) have been the most useful measure, they have performed modestly, leaving nearly 60% of the variation in long-term returns unexplained.

The study indicates that using the current valuation metrics points to a positive outlook for the stock market over the next ten years. However, it cautions that investing must account for the fact that the future is difficult to predict, meaning that investors should not rely on point forecasts from a forecasting model but instead turn their attention to the distribution of potential future outcomes.

The study concludes:

"A focus on the distribution of possible outcomes highlights the benefits and trade-offs of changing a stock allocation: Stocks have a higher average expected return than many less-risky asset classes, but with a much wider distribution, or level of risk. Diversifying equities with an allocation to fixed income assets can be an attractive option for those investors interested in mitigating the tails in this wide distribution, and thereby treating the future with the humility it deserves."

Planning for uncertainty

A study by Russell Investments entitled "Adaptive Investing: A responsive approach to managing retirement assets" suggests that the risk to manage is running out of money, not volatility. It is possible that a higher volatility portfolio could actually reduce the chance of an investor running out of money.

The authors suggest planning for 10 years at a time and plan to have enough money to purchase an annuity at the end of the ten year period. The portfolio must supply cash flows for an uncertain period, we may not live as long as expected, or live much longer. So it is impossible to have a plan that is cast in stone forever. The plan must be flexible enough to account for changes in circumstances such as health, expenses, interests and marital status.

This can be achieved by having a retirement plan that is monitored and revised periodically.

By modeling retirement cash flows, we can see evaluate the risk of a shortfall.

The key metrics to monitor are:

• Funded ratio: the ratio of assets over liabilities; it shows whether assets exceed the value of liabilities today.
• Probability of success: the probability that assets will be greater than liabilities at a future date.
• Magnitude of failure (or expected surplus): the average size of the shortfall (or excess) at the end of ten years in unsuccessful scenarios.

If adequately funded, i.e. a funded ratio around 100%, you can test to see if an increase in exposure to equity risk improves the funded ratio.

If the plan is underfunded, i.e. a funded ratio lower than 100%, the investor has a lower capacity for market risk. It then becomes a gamble to shoot for higher short-term investment returns by taking more risk.

However, if an underfunded plan has a significant probability of success, then increasing market risk could be a good strategy. But if the probability is lower, the optimal approach may be revising the spending plan rather than counting on strong returns.

Lowering planned spending will immediately reduce the liabilities of the plan and improve the funded ratio.

By: RetireWare / Equisoft On 9:54 PM

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