With the COVID-19 crisis, the need for an emergency fund has become increasingly evident. Unemployment has hit some spectacularly high numbers, with as many 2mm jobs lost in April in Canada (source), and as many as as 1.5mm individuals in the US filing for unemployment benefits (source). Employment Insurance—in Canada at least—is not meant to replace your entire income, but merely to supplement it. And to complicate matters some folks only get the Canada Emergency Response Benefit which amounts to $500/week ($2,000/month). Recent indicators show that in some cities that $2,000 barely covers rent, and in Toronto it doesn’t even cover it based on numbers from rentals.ca, which peg the average rent at $2,103 in Toronto for June 2020 (see chart at end of article)
An emergency fund is one of the foundational blocks of a good financial plan. Our good friends at reddit tag it as the second thing you should do, after budgeting, and financial gurus such as Dave Ramsey set it as the first thing you should do (truthfully, Ramsey has it as the first and third things, the third being a bigger emergency fund). By now we’ve all heard the news of people being underwater, businesses suffering, and general anxiety of not knowing where your next paycheque is coming from. But if you have six months of expenses saved away, you can live virtually stress free for at least a few weeks while things settle down. Personally I follow the six month approach to an emergency fund, which is roughly 13 of my net paycheques, since I get paid bi-weekly (26 times per year). This means that if I am out of work, notwithstanding unemployment insurance, I have at least half a year of savings to draw down from.
But, just because you can’t touch the money, doesn’t mean you shouldn’t have it work for you.
Conventionally folks would stick the emergency fund in a High Interest Savings Account. Current rates (as of June 2020) have HISA rates between 1.69% and 2.00% according to our friends at ratehub.ca:
|Tangerine||2.80% (for first 165 days)|
The challenge is that if rates crumble, it won’t be long before HISA rates fall as well.
I’d like to lock in my interest rate, but at the same time, keep my emergency fund liquid. To accomplish this I reframed my emergency fund not as a 13-week buffer (~180 days), but as two 90-day buffers:
- Take half of my effective emergency fund (90 days worth of expenses), and invest it in a 90-day GIC.
- If something were to happen, I would have the remaining 90 days worth of emergency funds to leverage, and by the time those 90 days were up, the 90-day GIC would have matured.
This method allows me to lock in rates, not worry about rates falling, and most importantly: guaranty liquidity of my emergency funds.
I opted to open a 90-day GIC with EQ Bank because at the time it had the best 90 day rates available. The entire process took me about an hour (opening an account, transferring funds, and then purchasing a GIC). But that one hour of work netted me a little over $100 in interest from the GIC, which in my mind was worth the time and effort.
Onwards and upwards!
One of the greatest challenges of investing is keeping the long-term plan in sight. If you are like many investors who are on the FIRE path, then you are probably reading blogs on a regular basis, watching financial TV shows, listening to podcasts, etc., to keep abreast of things. Constantly submersing yourself in media is a recipe for the fear of missing out (or “FOMO” as the kids call it these days). However, keeping your long-term goal in view will help you to properly avoid these fears and keep you on the FIRE path.
Over the past few years I’ve seen a number of hot topics, and seen a lot of people make quick money. Two key areas that have constantly crossed my path have been bitcoin (or any coin or ICO based off of blockchain or some derivative), and marijuana stocks. I have read about many folks making tonnes of money off of bitcoin, and when I overheard someone who works at my local cafeteria talking about it—and how she leaves her computer on all the time to mine bitcoin—I knew that bitcoin had hit the mainstream.
Many of my friends also ask me about marijuana stocks. I personally know of at least one person who made over 100x her money by buying penny stocks in the marijuana sector a few years ago, and those stocks are north of $5.00. If you buy for $0.10 and sell for $5.00 you’ve made a 4,900% (yes, four thousand nine hundred percent). To rub salt in my FOMO wounds, she put the money in her tax-free account, which means she walked away with not having to pay any capital gains taxes.
My view is that folks who make tonnes of money off of early trends/hype such as bitcoin or marijuana are either incredibly patient, have a very strong stomach for the potential of losing money, or are incredibly stupid. Of course, one view is that you should always have “play money” for your investments. E.g. if you say that you’ll spend $100/year on any stock you want, you can probably have some fun playing with penny stocks or bitcoin. Heck, you may make a hell of a lot of money. However, for the most part I see a lot of people being sucked into hype because they do fear missing out on the next big thing, on the next “dot com” craze, or some other fad.
For myself, I have a long-term plan, and to support that goal I’ve got several goals and sub-goals, to help keep me on track. Of late, one of my tactical goals is to improve my asset mix. As I mentioned in my previous quarterly update, my focus over the next six months will be to increase my real estate exposure, which is just over 10%, a far cry from my nominal target of 20%. I consider myself disciplined in that I have an investment strategy at hand that forces me to avoid things like bitcoin and marijuana stocks (however, I have been toying lately with allocating 0.10% of my portfolio towards “fun stocks”, which would open me to up being able to invest in anything just for kicks).
However, even when ignoring hype stocks, by my listening to podcasts, reading, and compiling The Dividend Gangster dividend list, I have been exposed to several interesting companies. For example, one company which recently caught my eye is MTY Food Group Inc. (covered in my July 20, 2018 dividend update). The company recently agreed to purchase sweetFrog Premium Frozen Yogurt. The firm also has a fairly solid (albeit short) dividend history with some consistent increases, and depending on the valuation model it is may be considered undervalued. Seeing companies like this ignites a FOMO reaction, and makes me wonder if I should buy some shares of MTY to get in on the ground floor before it shoots up even higher in value, or makes its next dividend increase.
But it is times like this when discipline and keeping your eyes on the long-term goal—sticking to your plan—is most important. I could certainly go out and buy some MTY next week when I make my bi-weekly stock/ETF purchases, and buying it would certainly satisfy the itch of adding another company to my portfolio, and a potentially strong dividend player at that. When I look back at other companies I could have purchased “for a steal” (e.g. I was originally looking at Lassonde when it was $100/share, and it is now north of $200; or Canadian Tire at $90 and it is now north of $160) but didn’t bother, I am reminded of opportunities I missed out on. That said, purchasing common equity would push me further away from my tactical goal of re-balancing the portfolio by building my real estate exposure.
The simple reality is that capital (for most of us, that means plain old money) is a limited resource. To quote one of my professors, strategy is the “allocation of scarce resources”. Within that context, strategy in investing is the allocation of scarce capital, i.e. the money you have to spend. There is only so much money to go around. And when I view my portfolio in that context, the need to balance my portfolio to reduce overall risk by sticking to my target allocation outweighs the need to scratch the investing itch by finding a new company to add to my holdings.
So, when friends and peers ask me about a hype stock (bitcoin, marijuana), or even a non-hype stock (should I buy some BMO for my portfolio?), my first question back to them is, “What are your long-term goals?” If a stock—hype or otherwise—makes sense to add to a portfolio, by all means, do so. But only if it makes sense. Buying to follow the crowd because you’re sacred of not making the quick money is one of the furthest things form investing strategy I can think of.
Onwards and upwards!
Another year has passed, which means it is time to review The Great Pension Experiment to see how we are doing.
This will be my second year of results to review, and as such I’ve had some time to mull over exactly how we can measure performance, to see how the experiment is running. When I first discussed the experiment, I decided to undertake it because I thought I could do better than what my previous employer was offering me for a pension when I turned 65 years old. Based on my pension with that company, I would receive a monthly pension of $600, or an annualized pension of $7,200. I argued that I could take the lump sum that the company would give me if I cashed out my pension, and over time, end up with a portfolio that would pay me more than $600/month. To that end, there are a few key metrics to see how well we are doing.
First and foremost, I want to check my actual returns over the previous 12 months, and compare them to the annual returns of OPTrust. This is mainly a source of pride: I’d like to see if I, as a small time investor, can beat the performance of a pension fund with over $19 billion in assets, which pays money managers $45 million in investment administrative expenses (See Note 10b of their 2016 annual statements). As an aside, for the purposes of my own portfolio I use a October 31 year-end, since I started the portfolio in November 2015. OPTrust uses a calendar year-end — so I will be comparing my November 1 to October 31 results to their January 1 to December 31 results.
Second (and arguably the most important), we have to compare the monthly income my portfolio would give me, versus what my pension from the company would have given me. The best measure of this is to determine what the present value of the monthly pension from OPTrust would be, and compare that to the currently monthly income that my portfolio is giving me.
Finally, using Monte Carlo Analysis (MCA), we can run a model to see how well the current performance of my portfolio will project into the future. To do this, we will use actual returns up to the point of review (in this case, two years of actual returns), and then use MCA for the remaining years. For the experiment, the total duration (i.e. from when the portfolio started, to when I turn 65), is 26 years. Since we are two years into the portfolio, that means we have two years of actual returns, and will use MCA for the remaining 24 years. From there, we can see if the probability of beating $600/month in income at age 65 (i.e. what my company pension would have been) is still favourable.
So, how did we do for 2017?
The returns will be discussed in a subsequent section. For 2017, I pretty much left the portfolio on auto-pilot. Using synthetic drips, my brokerage continued to purchase shares for me whenever a dividend/distribution was issued. The composition of the portfolio is now:
All in, we picked up 12 shares of VCN.TO, 18 shares of VXC.TO, and 14 shares of VAB.TO. Because a synthetic drip cannot fully invest all proceeds, there has been a slow buildup of cash: in 2016 we had $106 in cash and we now have $370 in cash. When the cash account hits the $1,000 mark, I’ll redistribute it to one of the ETFs. There is little value in doing so right now with such a small amount: to do so would 2.7% going to transaction fees.
|Period Ending||Returns||OPTrust Returns||Beat (Miss) vs. OPTrust||Assertive Couch Potato Returns||Beat (Miss) vs. Couch Potato|
Total returns for the period ending October 31, 2017, were 12.05%. This yields a 18.53% return since inception, or an 8.87% return compounded annually over the past two years. Since The Great Pension Experiment is based on the Assertive Couch Potato portfolio, it is useful to compare my results to the Assertive Couch Potato, since that is effectively my benchmark. Ignoring transaction fees, the return on the Assertive Couch Potato was 10.6%. All in, I have beat the benchmark by 13.67%. Unfortunately OPTrust hasn’t yet published its 2017 results, so I do not yet know if I have beat them, but I will publish an update once their results are in.
Returns aside, the monthly income of the portfolio is the real “meat” of the investment: since this is what is supposed to support me in retirement. To that end, the following graph highlights the salient points:
|Year||Present Value of
OPTrust Annual Income
|Annuity Income||Real Income|
For 2017, discounting back the OPTrust pension at 2%, the pension is worth $4,471/year or $373/month. The Great Pension Experiment is currently producing $1,590/year in real income (i.e. from dividends and/or distributions), or a hypothetical $3,069/year if we were to cash out the entire portfolio and buy a 4% annuity today. The real test of The Great Pension Experiment will be when one of the black lines crosses the red, since that will signal that The Great Pension Experiment is now generating income greater than the pension that OPTrust had offered me. It is much too soon to tell how well we are doing, but as long as the Real Income and/or Annuity Income are increasing over time, we should be okay.
Monte Carlo Analysis
Rerunning the Monte Carlo Analysis (MCA) using real returns for 2016 and 2017 still produces a favourable graph:
With the newest MCA completed, our probability of exceeding $600/month in income by 2041 is as follows:
So, while we had a dip last year, we’re back on track at a 93% probability of making our income targets.
All things considered, I would consider 2017 to be a good year for The Experiment. While I am still a far ways away from beating the pension that OPTrust would have given me (I’m about two-thirds there when using the Annuity Income projection, and about one-third there when using the Real Income value), I do have a very long time horizon: I still have in excess of 20 years to make this work! So for now, I will sit back and let the portfolio do its thing.
Onwards and upwards!
I spent Sunday helping out my brother in organizing his finances. He joined a major Canadian corporation a little over 11 months ago, and is approaching the point of vesting for his defined contribution pension plan. Within this context, vesting means that his employer will start matching any pension contributions he makes, subject to certain rules and maximums. This is a very common investment vehicle available to Canadians: many companies do not have Defined Benefit (DB) pension plans anymore, opting to provide Defined Contribution (DC) pensions instead. As an incentive for employees to save towards retirement, companies that offer DC plans often provide a “match”. A “match” is a provision wherein the employer will match any contributions an employee makes, subject to certain conditions. For example, one company I know of offers this match structure:
- Match 100% for the first 2% of contributions
- Match 50% for the next 2% of contributions
- Match 25% for the next 2% contributions
In the above, the “2% of contributions” means 2% of the employee’s salary. A more concrete example would be as follows: Assume an individual makes $40,000/year, and wishes to maximize her employer match. The numbers would add up like so:
Employee contribution %
Employee contribution $
Employer match %
Employer match $
As you can see above, the employee contributed $2,400 of their salary, but the employer contributed $1,400. This means that the employee received an instant 58% return for doing nothing! This is quite literally free money: your employer is giving you an instant top-up as incentive to save for your own retirement. Let’s take the example a little further: assume someone starts working at age 30, works for 35 years to age 65, and maximizes their contributions every year. Moreover, assume they get a 1% raise every year. If we plot this example over the duration of the person’s employment, the difference—while still a 58% gain—is even more pronounced.
By the end of 35 years, the employee would have contributed $103,000 on their own, if they had contributed 6% of their salary. But, thanks to the employer match, their effective contribution was $164,000! They have received an additional $61,000 all for doing nothing.
However, when an individual contributes to a plan such as the above, they don’t just save the money; they typically invest in mutual funds which are made available to them through the DC plan. We can modify the above graph to show the theoretical balance at retirement, assuming 2%, 4%, and 6% returns on the investments.
Again, there was a 58% gain when you compare the Employee only to the Employee and Employer Match:
Employee + Employer
The astonishing thing is that many people don’t take advantage of the employer match that is offered in their pension plans (here is an interesting read from the Financial Post). This means that there are people who are literally giving up free money. Often some people say that the reason they don’t do this is that they can’t afford to contribute money to their company sponsored pension plan, because that means that they will have less money paycheque to paycheque. To that, I have a couple of comments:
- If you are truly living paycheque to paycheque, then there are more systematic issues at hand that you need to look at; you really need to sit down and plan out a proper budget for yourself.
- You really can’t afford not to take advantage of a pension plan: if you don’t save now, then you will ultimately have to work longer later.
- Contributing to your pension plan is a tax-advantageous activity: meaning that if you wish to contribute $500 to your DC pension plan, your effective contribution is lower because your taxes will be lower; I will be writing about this in a future blog post.
So there really is no reason not to contribute. Imagine this: you are walking home and there is a fork in the road to go around a building. Both roads from the fork lead you to the same place at the opposite end of the building. From your vantage point, you can see a $20.00 bill lying on the ground up ahead on the road to the right, and on the road to the left, you can’t see any money lying around. Would you take the fork to the left? Of course not, you would be foolishly ignoring money that was just lying around. Your pension is the same: don’t take the road of no contributions, but take full advantage of the free money your employer is willing to give you.
Onwards and upwards!
I’ve come to the conclusion that I hate work.
Well, let me rephrase that. I don’t hate work. I actually like work. I like the people I work with. The work is somewhat interesting, and occasionally challenging. But, I hate the idea of the structured daily grind, the rat race, the nine-to-five, whatever you want to call it. I also have a lot of side projects I’d like to work on, but with the newest edition to our family, I never have time for side projects. I work all day, come home, handle nightly duties (feeding, bathing, housework, paperwork, etc.), crash, repeat. On weekends I try my best to give my partner some time off from babysitting, and the rest of the weekend I spend time taking care of other errands and what not. In short: I spend so much time supporting life, I don’t have a life.
Now, don’t get me wrong.. This is all natural for me, at this stage in my life. A new family, a steady job, paying off car, house, condo, etc., all means that I have to make some sacrifices. Unfortunately, those sacrifices are things like pulling together a portfolio to participate in the annual Contact Festival, finish work on PART so that it is in a state that can be used by the public (truth be told I’ve used it for managing my investment portfolio for a few years now, and it works great), and some other side projects..
And for those reasons, I hate work.
So, what to do?
I’ve been crunching numbers, and mulling over what would be realistic goals, and pulling together my vision for my financial future. To that end:
- Retire from full-time work in 9 years, working at most 6 months out of the year
- Have an average before-tax salary of $100,000
There, one vision, two goals. As I said, I don’t mind work, but I want time to do my own things. And having six months of free time every year, will certainly afford me with the time to work on those things. The assumptions baked into the above:
- The $100,000 average before-tax salary will naturally adjust by inflation
- Any debt load I have in 9 years will be covered b the $100,000 salary, with enough to have a comfortable lifestyle
To accomplish those goals s going to take some fancy financial engineering. One of the biggest logistical challenges is that the bulk of my investments are tied up in either my LIRA or my RRSP; this means that any income and/or gains from those investments will not be available to satisfy goal #2. My non-RRSP/LIRA funds are relatively minimal at the moment: the past few years I have shifted many investments (primarily US companies) into my RRSP to take advantage of the zero withholding tax Canadians have when they hold US investments in registered accounts.
So, I am essentially starting from ground zero. If we do some quick back of the envelope math, to generate $100,000 in income at an average yield of 4% (a number I literally pulled out of the air, but it is fairly trivial to find reliable ETFs and/or individual companies to pay an average 4% yield) would require $2.5million in capital: $2,500,000 x 4% = $100,000.
Luckily the entire $100,000 does not have to come from investments. Up until recently I was a Project Management Consultant, and as such I still have my corporation. If I were to go back to project management consulting, it would be a fairly easy task to pick up at least one six month contract per year. If we do some more back of the envelope math, even at a very low hourly rate of $70/hour (which is the low-end of project management consulting rates in Toronto, in the finance sector), working six month yields:
|Days per Week||5|
|Weeks per Year||26|
|Hours per Day||7.5|
|Less CPP Contributions||$969.15|
A prudent decision would be to take out the $50,000 salary I need and leave the other $17,280.85 in the corporation “for a rainy day”; an added bonus!
So of our $100,000 target, there is now $50,000 remaining. Looking at the March results, I am currently generating approximately $1,000 net annual passive income that is not locked into a registered account; this leaves $49,000. Generating that much passive income is not an impossible task, but it is a daunting one: how to generate $49,000 in annualized income in 9 years? This is a classical risk-reward problem: the more risk you take on, the higher your potential reward.
If we use the benchmark Canadian Couch Potato Returns from the Couch Potato website, the balanced portfolio has a 10 year CAGR of 5.38%. $49,000 in passive income at 4% yield is $1,225,000 in capital required. At 5.38% CAGR, that means we need $765,000 today, so that it compounds at 5.38% over nine years to result in capital of $1,225,000. Regrettably, I do not have $765,000 lying around.
Some other considerations:
- I am gainfully employed at the moment at a major Canadian company; assuming I continue to be employed, my salary will go up each year (which I can redirect to investing), and I can continue to participate in the company’s employee share ownership plan.
- The plan gives me an instant 50% through the company’s match (i.e. for ever $1.00 the company kicks in $0.50), so I am making huge gains.
- Who knows where the housing market will be in 9 years? We may sell off our property and become renters: even after paying rent, $100,000 in pre-tax income will be more than enough, assuming that the relationship between $100,000 in pre-tax income and rents remains constant. I.e. if I were making $100,000 right now, I could still afford to rent. Assuming that the $100,000 inflation-adjusted in 9 years is enough to cover rent inflation-adjusted in 9 years, I would still be okay
So while I do not have the capital now, there are options available such that in 9 years I can fulfill my vision.
What are your thoughts? Knowing you require $49,000 annual income in 9 years time, what would you do?
..but I’m not worried.
I recently published an analysis of Magna International, and concluded that the stock was very undervalued, to the tune of 26%. Following my own advice, I picked up 100 shares in my Tax Free Savings Account on Thursday February 23, 2017. Following that, on Friday February 24, 2017 the TSX composite was down 1.57%, its biggest drop in 5 months. I had picked up Magna for an average cost per share of C$59.95 including commissions, and on Friday it had closed at C$56.43/share, a 5.87% drop in a single day; this equating to a C$352 cash loss in 24 hours.
At the same time, Magna announced its fiscal 2016 results, some highlights of which include:
- Record 2016 sales up 13%, well above 4% growth in global light vehicle production
- Record 2016 diluted earnings per share from operations increased 9%
- Record 2016 cash generated from operating activities of $3.4 billion, up 45%
- Returned $1.3 billion to shareholders in 2016
To sweeten the news, the dividend was hiked to U$0.275/share, up from U$0.25/share, a 10% increase.
To sum things up:
- The market dropped 1.57% in a single day
- My investment lost 5.87% in a single day
- Magna had a record year
- Magna increased its dividend 10%
Days like this only go to emphasise the importance of a long-term view. The market will always go up and down, and there is really no way to time things out (I’ll ignore the technicians in the audience). If I had a crystal ball, I would have waited 24 hours before pulling the trigger on my trade, and by now I would have been up 2.23% week-over-week, instead of down 1.54% week-over-week. Alas, I’m a Dividend Gangster, not a Dividend Clairvoyant. My original investment thesis stated that:
- Magna had a strong dividend history (26.97% CAGR over the past 6 years, when measured in USD Dollars. When measured in CAD dollars the dividend is a little wonkier (in the favour of Canadians) as it has to take into account currency fluctuations)
- Magna was undervalued to the tune of 26%
With the 10% increase, Magna is continuing to maintain the course of a strong dividend player. Even though the price dropped (like a rock!), it is still undervalued, and still has plenty of upside before reaching its Graham number.
Now, a novice investor might have panicked on the Friday when the market dropped, and sold off on the Monday. Let’s take a look at the stock performance over the past few days, and see where we’ve landed:
|Date||Price (CAD$)||Gain (Loss) for the Day||Gain (Loss) Since February 23|
If a novice had sold immediately after the drop on Feb 24 (i.e. they sold on Monday Feb 27), they would have lost 3.41%, or $2.02. If they had held until today (Mar 3), they would only be down 1.93% or $1.14. How would they know when to sell? How would they know why to sell? The short answer is: they wouldn’t! And that is what differentiates an investor from a trader. The former does not panic at the drop in price in the short term. Guess what happened between February 23, 2017, and February 24, 2017?
- The price dropped 4.68%
- EPS rose 12.02%
- Book value rose 7.19%
- The dividend rose 10.00%
- The dividend payout ratio increased from 17.23% to 17.82%
So except for the dividend payout ratio, some of the key per share metrics improved, and the price dropped. If the EPS went up, and the dividend went up, and the book value went up, and the share price went down, that screams “buying opportunity”! However, the general trend of the market on that one day pushed most stock prices down, including Magna. If anything, I wish I had some additional capital kicking around: I would have doubled down on my position in a heartbeat.
As investors, more importantly, as dividend investors, we have to keep our eye on our 3-year, 5-year, 10-year, and 20-year goals… A minor blip in stock price shouldn’t shake us, it should drive us to invest more of our capital. The classic quote from Baron Rothschild is to “[b]uy when there’s blood on the streets, even if the blood is your own.” Now, I didn’t have blood of my own that day (because I was investing in my TFSA, if I had leveraged my line of credit, the interest to purchase the stocks would not be tax-deductible)… But nonetheless, while a market downturn is bloody, but it is also an opportunity.
Onwards and Upwards!
- Fundamental figures are in US currency
- Share prices are in Canadian currency
- My ACB was C$59.95, which was based on an intra-day price; the values listed in the historic pricing table are the CAD close price
This is part 3 of a 3 part series I have entitled "The Great Pension Experiment", which details my analysis on what to do with a defined benefit pension plan payout. The first two parts may be found here: Part I, Part II.
It has been one year since I started off on The Great Pension Experiment. I feel that this is a useful experiment because it leverages real world results in a closed environment. Because the funds are in a LIRA, I am unable to add or withdrawal funds, so any losses must be recouped “internally” by better investments.
In Part II I made the claim that, based on the Assertive Couch Potato Portfolio, over a 25 year time horizon I would be able to grow the portfolio to a point where I would be able to generate over $600/month in passive income, assuming a 4.00% yield. It has been 12 months since that claim, so lets see how we’ve done after one year.
When the portfolio was first opened, I set it up with a blend of 25% fixed income, 25% Canadian Equities, and 50% of non-Canadian Equities:
Originally I had intended on re-balancing the portfolio semi-annually (i.e. every six months), and in retrospect, this was a stupid idea. Cash was building up in the portfolio slowly, but sitting there idle until I had a chance to re-balance. Due to the already high number of shares, any dividends and/or distributions from the holdings would be in excess of the current price of those shares. Because of this, I should have been using synthetic drips right from the start! Accordingly, in September 2016 I set up my brokerage to re-invest any dividends received directly into additional shares. This ensures that money is not sitting idle, and because the investments are via synthetic drip, I receive additional shares commission free.
That said, as of October 2016 (one year), the portfolio sits at:
For the year ending October 31, 2016, I received $1,485.24 in dividends/distributions ($123.77/month). The portfolio as a whole has grown from an initial investment of $64,723.32 in cash to $68,468.29, which represents a 5.648% total return. This is actually pretty impressive, since the first half of the fiscal year (From November 2015-April 2016), the portfolio was in negative territory:
|Period Ending||Open NAV||Close NAV||Return %||TTM Return %|
I had bought into the portfolio at a peak in 2015, and the market had a clawback shortly after. As a result, the portfolio lost money for the first six months. I did take the opportunity during that period to top off the VXC shares whilst I had some excess cash from distributions, which in retrospect was a wise choice. Buying when the market is in a downturn helps to dollar cost average down, ultimately increasing future returns.
The portfolio is more or less at the target weighting if you round to the nearest whole number, and because of this I see no need to buy or sell additional shares at this time. Hypothetically, if the portfolio were to keep this pace for another 24 years, even at a 5.000% return we would generate approximately $736/month in passive income. So based on simple extrapolation (i.e. assuming constant returns for the next 24 years), we are right on track.
That said, I am going to ignore the portfolio for another six months, and will revisit in May of 2017 to see if any rebalancing is required. Until then, the next update will not be until December 2017. Here’s hoping that the portfolio continues to provide excellent returns at that time.
Onwards and upwards!
This is part 2 in a 3 part series I have entitled “The Great Pension Experiment”. This will detail my analysis on what to do with a defined benefit pension plan payout, after leaving my previous employer.
I am a big fan of Monte Carlo analysis (MCA). In a nutshell, when performing an MCA we run a test a fixed number of times, using a controlled set of inputs, and observe the results.
I had mentioned on my previous entry that I felt I could do better than the $600 per month defined benefit pension that OPTrust was offering after I left the company. But, how would I quantify this?
I wanted my LIRA to be as simple as possible, to run virtually effortless. Because of this, I elected to use one of the Couch Potato model portfolios, specifically the one using ETFs. Within these options, given my 25+ year time horizon, I elected to use the Assertive Portfolio, which has the following composition:
- 25% of the Vanguard Canadian Aggregate Bond Fund ETF, VAB
- 25% of the Vanguard FTSE Canada All Cap Index ETF, VCN
- 50% of the Vanguard FTSE All-World ex Canada ETF, VXC
The weighted average expense ratio of this portfolio is 0.18% as of November 2016, and the returns are pretty impressive:
- 1-year return: 7.20%
- 3-year return: 12.61%
- 5-year return: 8.91%
- 10-year return: 6.24%
- 20-year return: 7.10%
- Lowest 1-year return (2008-03 to 2009-02): -24.95% (2008 financial crisis)
To perform my analysis, I elected to take the lump sum from OPTrust, and run an MCA on it to see what the projected monthly income would be in 25 years, if I had used the Assertive Portfolio. To do this, I ran 100,000 iterations on 25 years of growth in the portfolio, using randomized returns. Here is an example of one set of returns:
|Year||Start Value||% Gain||End Value||Implied Annual Income||Implied Monthly Income|
In the above, the % gain is a random gain for the portfolio based on an average return of 8.29%, and a standard deviation of 7.96%. The implied annual income assumes I could take the ending value of the portfolio, and buy an annuity or other similar (set of) instrument(s) to generate 4% of annual income. I believe 4% annual income, if you are not concerned with growth, is incredibly doable in the market.
But wait, where did that 8.29% average return, and 7.96% standard deviation come from? And what do they mean?
If you take 15 years of returns for the couch potato model portfolio, and do some statistical analysis on that data, you will end up with an average daily return of 0.032%, which equates to an average annual return of 8.287%. Moreover, those same daily returns have a standard deviation of 0.503%, which is 7.959% annualized. (For annualizing, I assume there are 250 active trading days in the year: 52 weeks @ 5 days/week, less 10 days for various holidays). Now, because the model portfolio asks for VAB, VCN, and VXC, and those ETFs are relatively new, I used iShares Core S&P/TSX Capped Composite Index ETF (XIC), iShares Canadian Universe Bond Index ETF (XBB), iShares MSCI World Index ETF (XWD), and iShares Core S&P 500 Index ETF (CAD- Hedged) (XSP) as proxies:
- For the period of October 29, 2009 to December 31, 2015, I used a blend of 25% XIC, 25% XBB, and 50% XWD.
- For the period of April 15, 2002 to October 28, 2009, I used a blend of 25% XIC, 25% XBB, and 50% XSP.
The ETFs listed are iShares ETFs. The XWD is the equivalent to VXC, but prior to October 29, 2009, there were no ETFs I could find that were all-world excluding Canada ETFs. Moreover, the period I chose covers the tail end of the dot-com bubble, as well as the massive 2008 financial crisis. Doing this provides more real world examples. In fact, looking at the above table you can see that in this iteration, in years 18 and 20 the sample has massive declines of -14% and -8% respectively! I feel this is an accurate representation of what could happen.
The average and standard deviation play into each iteration of 25 years. In the table above, the “% Gain” column will be, on average, 8.29%, and vary with the standard deviation of 7.96%.
Now, if we pull this all together:
- Create the table above 100,000 times
- Take the final 25 year implied monthly income from each iteration
- Plot a histogram
We get the following:
The above histogram shows that we have a 16% probability of having total monthly income less than or equal to $786. Put another way: we have an 84% probability of having implied monthly income greater than $786. If we take this a little further, we have an approximately 7% probability of making at most $600, or a 93% probability of making at least $600.00. But wait, OPTrust’s defined benefit income would be $600/month. I have only a 7% chance of not beating OPTrust’s defined benefit pension! Screw you OPTrust, I’ll take my chances.
So, based on my Monte Carlo analysis, using 13 years of historical returns on a portfolio of 25% Canadian Equities, 50% non-Canadian Equities, and 25% Canadian Fixed Income, I took the plunge to invest all of my money from OPTrust into my LIRA, using the couch potato portfolio. That was almost a year ago. In my next post, I’ll speak to the first year of actual results.
Onward and upward!
This is part 1 in a 3 part series I have entitled "The Great Pension Experiment". This will detail my analysis on what to do with a defined benefit pension plan payout, after leaving my previous employer.
Up until 2015, I worked for the OPSEU Pension Trust, a major pension plan in Ontario, and had the benefit of a “golden pension”, or a Defined Benefit Pension. These pensions are considered the gold standard in the pension industry because the total payment that one receives upon retirement is guaranteed, regardless of what happens in the markets.
However, towards the end of my tenure at the company, a new CEO came in, and there were a number of changes with upper management. As a result of these changes, there was a large amount of restructuring as the company made attempts to streamline processes and change the long term strategic goals and organization of the firm. As with any restructuring, there are causalities, and my department was no different: my entire department was explained away, and I left the organization.
Due to pension law in Canada, when an employee leaves a company, they are given three options with the money that is with the company for their future pension:
- Leave the money with the company, and at age 65, start taking a pension.
- Transfer the money with the company to your new employer’s pension plan. In this way, any deductions which were taken off of your paycheque whilst with employed with the former company, would carry forward with you to your new company. The caveat to this is that it is not the actual deductions which would transfer, but the commuted value of those deductions.
- Transfer the commuted value of your pension to a Locked In Retirement Account.
Before continuing with the background information, it would help to get some terminology out of the way..
The commuted value of a pension is an actuarial calculation which states what the total value of your pension in the future is worth today. To give a very simple example, assume you received a pension of $1,200/year ($100/month) starting at age 65, and given your actuarial profile, you would live to the age of 85. Given that, the total payments you would receive would be:
But, that $24,000 is the value of the pension as you receive in the future; to be accurate, you have to discount that back to the present day. If we extend our example to assume that we have a discount rate of 5.25%, and we are currently 50 years old, this means that the first annual pension payment of $1,200 (i.e. when you turn 65) has to be discounted back 15 years at the discount rate of 5.25%, or . The next payment would have to be discounted 16 years, or . If we do this for all of our payments to age 85 (our assumed death age), then the present value of the pension is then:
And if we do the math on this, we find that our $1,200 annual pension at age 65 is worth $7,353.54 in today’s dollars.
The example above is very simple, and a more true calculation would discount each (monthly) payment by the discount rate. Also, the assumption that the pension would last for 20 years is based on a number of actuarial tables, etc. But at the end of the day, the commuted value is the present day value of all future pension payments.
The other item to discuss is the Locked In Retirement Account, or "LIRA" for short. A LIRA functions much like an RRSP, with the following key differences:
- Under normal circumstances, funds in the LIRA are locked in until either your retirement age, or some other specified age as specified by the province the LIRA is registered in. For my purposes, I am basing my calculations assuming the LIRA is locked in to age 65.
- Under normal circumstances, money added to a LIRA can come only from another LIRA, or registered pension. You cannot add money to a LIRA at a time of your choosing as you would with an RRSP.
- Depending on the circumstances, you may be able to transfer your LIRA to your pension plan with another employer in the future.
Put another way: when you open the LIRA, any and all money is inaccessible until the prescribed age of withdrawal, or if available to you, you transfer the funds to another registered pension plan. If the market goes south and your LIRA loses 90% in value, you cannot add money to bring it "back up". Similarly, if it grows in value over time, you cannot withdrawal that money until some time in the future.
For my own personal situation, after leaving my previous employer I elected to incorporate myself and become an independent consultant. This mean that Option 2 was not possible, as I would no longer be employed by a company with a pension plan to transfer the funds into. The other options would be Option 1, leave my money with OPTrust, and Option 3, transfer it to a LIRA.
The formula for OPTrust when calculating the defined benefit pension is:
Based on my years of service, and average salary, the pension I could have expected to receive at age 65 would be approximately $600/month, or $7,200/year. But, that is $7,200/year in 28 years 26 years!! The Bank of Canada has an inflation target of 2.00% annually. If we discount back the pension offered by my previous employer at the inflation target of 2.00%, that would equate to $426.67/month $352.12/month in today’s dollars. I’ll be honest: I think I can do much better than that.
That said, because the pension offered by OPTrust would be worth relatively little in the future, and because I did not have an employer to transfer my pension to, I went with Option 3. The second part of this series will outline the quantitative analysis I performed to come to this conclusion.
Edit – January 2, 2018
I realized that there was an error in my above calculations. Since the pension kicks in at age 65, when I wrote that post there were 26 years remaining, not 28. Moreover, there was an error in my original worksheet. The discounted monthly pension is actually $352.12, not $426.67, in today’s dollars (well, at that time!). Fortunately, this error is in my favour: the $352.12 threshold is even more attainable than the $426.67 threshold.
Dividend Reinvestment Plan investing, or “DRIP” investing, is a very cost efficient way of making passive gains in your portfolio. I have been a big fan of this type of investing for years, as it completely removes two types of investment friction: rounding friction, and commission friction. Well, the second one is a bit of a lie: you are exposed to some commission friction, but it is minimal in the grand scheme of things. But, before I get ahead of myself, I’ll explain what DRIP investing entails.
At its core, a company which offers a DRIP allows the shareholder to re-invest dividends issued by the company directly back into additional shares in the company. So if the share price is $5.00, and you received $10.00 in dividends, you will receive 2 shares. In addition to this core functionality, there may be additional benefits and/or constraints:
|Item||Description||Potential Benefts||Potential Constraints|
|DRIP Enrollment||The process of enrolling in the DRIP||May have a minimum number of shares required, e.g. you may need 100 shares to even sign up for the DRIP.|
|OCP/SPP||Optional Cash Purchase or Share Purchase Plan. This is the ability for you to buy additional shares directly from the company.||May offer a discount on additional shares, e.g. 2% off of the current share price.||
|Automatic Contributions||Automatically debit from your bank account on a periodic basis. This allows you to slowly build your position over time, virtually effort-free on your part.||Same as OCP/SPP||Same as OCP/SPP|
So, how does this all work?
With DRIP investing, you normally have a share of stock in certificated form. Classically, this would mean that you have a physical paper certificate for the company in which you are investing. Today, there are alternatives such as the Direct Registration Sytsem (DRS), but the core of the matter is that the share(s) of the company are registered directly in your name. This differs from a typical stock trade through a brokerage where shares are held in street name (more info may also be found here), where the shares are actually in the name of your broker/agent, and not yourself.
This is important, because once an investment is certificated, you can start participating in the DRIP. You cannot participate in the DRIP if the shares are in street form.
Once you have your certificated share, enroling in the DRIP is as easy as filling out the requisite paperwork.
So, how is this a good thing?
As I mentioned above, one form of friction that DRIP investing eliminates is rounding friction. Recap the example ealier:
[i]f the share price is $5.00, and you received $10.00 in dividends, you will receive 2 shares.
I had picked those numbers for convenience, as they gave us a whole number of shares to re-purchase. However, what if the share price was $7.50, and you received $5.00 in dividends? With a normal brokerage, you would receive $5.00 in cash, and no shares, since the share price is greater than the received dividend. With a DRIP however, you can receive fractional shares. So your $5.00 in dividends will purchase you 2/3 of a share (since $5.00 is 2/3 of $7.50).
Let’s look at OCPs. If you have an extra $100 lying around one day, you might decide to purchase some stocks. Moreover, let’s say you own Telus (T.TO) in your DRIP. The current market price (as of business day close on Sep 9, 2016) is $42.03. If you were to buy shares at a typical broker, assuming $9.95 commission, you could only buy 2 shares, and be left with $5.99 in your pocket ($100.00 less $9.95, and purchasing two whole shares at $42.03). But, because Telus offer OCP/SPP, and no commissions, you can buy 2.379252 shares!
These fracitonal elements are important, because you can now take advantage of true compounding. As an example, let’s use Telus again, with the following assumptions:
- Share price grows at 3%/year
- The dividend grows at a rate of $5%/year
At a regular brokerage, after 5 years, here is what you have:
|#||Numbe of Shares||Period Dividend||Dividends Received||Share Price||Dividend Bank||Shares Purchased||Dividend Bank (end)||Net Value|
In the above, the “Dividend Bank” is where you would store all dividends received until you had enough to purchase one share, and “Dividend Bank (end)” is the money left over in the dividend bank after buying a share. But, as you can see above, we were never able to purchase any shares! This is because it would take us forever to save up enough of the dividend income to buy a share, plus we have to save up enough to cover the commissions as well.
Using a DRIP, with the same growth assumptions, here is what you have:
|#||Numbe of Shares||Period Dividend||Dividends Received||Share Price||Shares Purchased||Net Value||% Gain from Without DRIP|
Where the “% Gain from Without DRIP” is the relative difference between a brokerage-based portfolio and our DRIP. Looking at the above, by using the DRIP, over our 5 year example time horizon we have gained 3.42%, all for doing nothing. And, if you throw OCPs into the mix (e.g. setting up regular contributions), your holdings grow even quicker.
Not all companies offer DRIPs. In Canada, two of the major providers are Computershare Canada and CST (the CST link takes you directly to their DRIP page). But even for those companies that offer DRIPs, not all DRIPs are created equal. Not all companies offer OCP/SPP. Some charge for DRIP, OCP/SPP, and/or withdrawals to/from the plan, and some have minimum balance requirements. That said, when I am looking for a company to DRIP with, other than my regular stock analysis, I look for those who offer and OCP/SPP, and as an added bonus, regular automated contributions by deducting from my bank account. Moreover, those that offer discounts on OCP/DRIP (e.g. Emera which offers up to a 5% discount on DRIP) are even better.
And OCP/SPP is key. The reason being, if you have only one share to start, it will take you forever to get to the point where you can take advantage of material growth through DRIPping.
How does one get started?
You only need one share to start a DRIP, and then you can use an OCP/SPP purchase to purchase any additional shares as needed. You can leverage places such as The DRiP Investing Research Centre‘s Share Exchange board to find individuals who are selling individual shares, or you can even post a message asking for a particular share. Typically individuals selling on these forums ask for a $10.00 convenience fee. This is pretty much in line with most discount brokerages, and since you can easily recoup this cost through the DRIP process itself, it is a small price to pay. Alternatively, you can purchase shares through a regular (discount) brokerage, and then ask the brokerage to withdrawal your shares in certificate form. DRIP Primer has a great list of brokerages, and the fees to do so.
One final thing to mention is synthetic DRIPs. With a synthetic DRIP, a brokerage will buy you any whole shares that it can when the dividend is issued, and any money remaining is given to you as cash. Looking back to Telus, if the share price were $42.03, the dividend were $0.46/share, and you had 100 shares, you would receive $46.00 in dividends. Your brokerge would take this $46.00, purchase one share, and leave the balance ($3.94) in your account as cash. The advantage to this is that the brokerage does not charge you a fee (i.e. commission) for the purchase. The disadvantage is that you cannot take advantage of the fractional shares as with a true DRIP; i.e. you are still subject to rounding friction.
- DRIPs offer a great way to build compounding returns, through re-investing dividends and purchasing fractional shares
- Often, companies offer discounts on DRIP and OCP/SPP, but not all DRIPs are created equal; some have better features than others
- DRIPping does not save you from doing your research: as with all investments, only invest in companies after doing a thorough analysis
And some good resources:
- DRIP Primer list of discount brokerages
- The DRiP Investing Resource Centre boards
- List of Canadian DRIPs from DRIPPrimer