vendredi 22 juin 2018

Financial illiteracy

Photo by Roman Mager on Unsplash

In the recent study from CIA, there was some disturbing news on how weak the financial literacy was in Canada. In order to fight the good fight here's a few points that everyone should be aware of :

  • The cost of an annuity is near its expected terms * amount. 
  • Inflation have a dramatic effect even in these low inflation times.

Annuity Puzzle
If ever you want to guess the value of a pension annuity, multiply the annuity by 11-15. In the study, they've asked a 1,000 person to how much would they willing to pay for a 100$ monthly annuity. Based on the above, that would be 13,200$ to 18,000 (100$*12*11 to 100$*12*15). 660 persons in the study responded that it should be below 3,000$ ! I understand that they do not have great publicity, but that's a high discrepancy. The risk of the insurer not able to honor the annuity is slim. Many laws, oversight agency, reserve and insurance exist in order for the insurer to honor their policy contract. 

The magic number out there if you are to personnaly manage our withdrawal is 25(4% rule)! Based on Accumulation-Dynamic Decumulation you can get away with 20-16.7 (5%-6%) if you are able to bear some fluctuation and not perfect inflation protection. That would mean a value of 20,040$, 24,000$, 30,000$. Over 84% reported that they would not accept to pay more than 9,000$! 

Please be aware, having constant payment until your death have a substantial cost. Probably more than you believe to be, but mostly not because of "insurance profits and margin". 

Inflation exist!
As the saying goes : A dollar today is worth more than a dollar later. However, the reverse is also true, A dollar later is worth less than a year later. Would you believe that 310 persons would rather have a pension of 2,358$ steady (not indexed for inflation) than 2,358$ indexed for inflation. This is like free money at no cost that would not get picked! 

While more understandable, 540 persons would rather get 1,966$ steady income than 2,358$, even though that at 1-3% inflation the indexed pension would surpass the steady one before 10 years in. In the grand scheme that leaving some money on the table, but at least you get to use it when you are younger. 

On the other hand after the research showed the participant of the amazing power of inlation, 40% would rather get 1,551$ indexed for inflation than 2,358$ steady pension. This would break even around 20 years in retirement. 

If we look at this through the lense of the 4% rule, it's amazing that it get so much traction as inflation is so missundertood among the population. Without fear of inflation, you can get away with a safe withdrawal rate (at 60% equity allocation) of 4.6%. Said differently, you would need 14% less funds to retire. With Accumulation Dynamic Decumulation with a 6,5% withdrawal rate, you need a 49% less funds to retire. That means a year or a decade of earlier retirement. Not too shaby if you do not believe in inflation. 

mardi 12 juin 2018

Risk Shared Pension Plan

One of the latest creation in Pension Plan scheme is the Risk Shared Pension Plan(Shared Plans). In many ways, it's superior to the traditional DB and DC. In my mind it solves the great dilemma between offering an adequate pension for retiree and remove the risk of future expense and contribution volatility. In short it offer reasonable secure pension, stable and sustainable contribution requirement.

I believe that the objective of a pension plan should be to provide an adequate pension and funding it appropriately. For this end, Shared Plans provides an expected pension upfront to the member. Funding is made on current contributions. No one is behind to guarantee payment. If funding become insufficient, than benefits are cuts. To avoid the cuts, the current employee and sponsor can poney up more funds voluntary. The benefits are calculated in advance so that 97.5% of the time, there should not be any reduction of benefits.

A pension plan should aim to have stable contribution funding, be sustainable and be secure. These features makes the design to be more stable, contribution are known in advance. The sponsor is not required to pay more or less due to market return. Since DC sponsor(EE+ER) do not contributes more or less due to market return, why should the DB sponsor should? The design is substainable. If the fund disappear for whatever reason the outflows will be adjusted. The design is more secure.

For those who have DC account the principal problem is that employee have just about no clue on if it will be enough at retirement. Those who contribute often contribute not enough and do not adjust up their contribution. I believe that we cannot/should not expect that a person with no financial education be able to make financial decision without expert helps. Currently DC general philosophy is that the member knows best. DC guideline are for the plan to suggest to get help. Shared Plan instead provides a guideline for what their current contribution will be able to provide as a pension. If there's a short fall in contribution, warning bell activate to review the plan (either increase contribution or decrease pension). The employer of DC and Shared Plan are equally happy not to have to fund future funding issue.

For those lucky few who have DB, the employee often feel confident that his pension is known in advance and well funded. On the funding side, it is not the whole truth. The Employer must fund it. The guarantee is as strong as the company behind it and the current funding. Sears employee were angry to see their benefits cuts by 20% due to the company going down. Instead a Shared Plan would have seen that their pension to be cut far in advance and thus with lower pay cut.

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