Risking Less and Prospering using Real Return Bonds? [RRBs]

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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by SQRT »

@Quebec. Thanks for summarizing the book. Your personal response seems well thought out and reasonable. Impressive.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by longinvest »

Quebec wrote:* Added later: this should have been phrased better. There is inflation protection in my DB plan, but only beyond 3%. For milder inflation, pension indexation depends upon the financial health of the plan, and this clause has been suspended for over 10 years, so I'm not counting on it.
Quebec,

I guess you are aware of the new provincial law that affects municipal pensions, suspending inflation indexing when the plan is not in good shape. See the following link (in French):
- http://www.rrq.gouv.qc.ca/fr/programmes ... raite.aspx
The government might have also adopted other laws or might be in the process of adopting new ones for the pensions of other sectors (government, private) suspending inflation indexing in case of pension plan deficits. I don't have references, but I remember hearing about it.

So, I wouldn't count much on any inflation indexing promise given the existing example of the government overriding pension plan inflation-indexing promises by simply adopting a new law. Most DB pension plans are in the red and the government is likely to act to prevent a large group of plans from going bankrupt. I think that there's a good likelihood that many DB pension plans are not currently sustainable, indexed or not to inflation.

Actually, it's the Nortel example that frightens me the most (unless one has a government-backed pension). There is simply no protection against a DB pension plan failure in the province of Quebec. If one's DB pension plan fails, one is left on his own. There's not even an equivalent, for DB pensions, to the partial* protection of Assuris for annuities.

* I say partial because Assuris could fail (no government backing) in a really bad scenario, and because the protection has limits.

I would estimate the future cash flows of a (non-indexed) pension by multiplying the promised annual nominal pension amount by the plan's solvency ratio (when less than 100%). For example, if the plan has a solvency ratio of 80% and the pension is $12,000, then I would estimate the future pension as $12,000 X 0.8 = $9,600. But, this leaves the cash flow completely vulnerable to a possibility of high future inflation, significantly reducing its purchase power. I haven't yet figured out how to deal with that as a member of a non-indexed DB pension plan. I can't opt out of the plan, and I can't commute its value unless I quit my job (which I like more than I dislike its pension plan) before age 55.

I really dislike nominal DB pensions and annuities; they fail to protect us at the exact point in time when we need them most: in very old age due to unexpected longevity, when most of our other ressources are likely to be depleted or near depletion.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by AltaRed »

Non-indexed DB pensions are indeed vulnerable to inflation. Most folk don't worry much about that when they are working, but once one is retired and the same deposit is made year after year, it will (should) start to become noticeable. I am more than 10 years into my non-indexed DB pension and while I have not noticed any decreasing purchasing power, that is partly because CPI has been inocuous for some time and partly because it has been slow creep. I cannot imagine what the impact would have felt like in a 10%/yr inflation scenario. Am I lucky so far? Probably yes. Will I continue to be lucky? Talk to me in 20 years.

The way I plan for it is simply to recognize I will have to tap into more capital over time, but also believing that my fixed and dividend income streams from my nominal investments will increase too should inflation rear its ugly head.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by Quebec »

longinvest wrote:Quebec,

I guess you are aware of the new provincial law that affects municipal pensions, suspending inflation indexing when the plan is not in good shape.
My DB plan has not suffered such a faith so far, so for now I'm still counting on the partial protection against inflation (indexing is CPI minus 3%). Our regular contributions rates have been increased recently, and there is talk of additional special contributions to resorb the (rather large) funding deficit. I can only base my planning on the current rules, and will revise it if rules change. I am aware that rules can change at any time, and the following measures are being taken, partly as a result of this uncertainty:
- we're maxing out RRSPs and TFSAs
- the mortgage will be fully paid at age 55
- early retirement at 55 is a nice goal to have, but we can of course work longer if needed or desired. In my case this would have a rather large effect on the initial pension amount, because the plan punishes early retirement. The slope of increasing pension versus time is quite steep between ages 55 and 63
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by longinvest »

AltaRed wrote:The way I plan for it is simply to recognize I will have to tap into more capital over time, but also believing that my fixed and dividend income streams from my nominal investments will increase too should inflation rear its ugly head.
When looking at the problem from Bodie's point of view, where I want to assure a safe minimum basic income, believing that income from nominal bonds and stocks will increase sufficiently to cover the increasing deficit of a nominal pension does not cut it. There is simply no such promise written on my stock certificates and my nominal bonds. As for an inflation-indexed bond, it makes precise inflation-indexed payment promises between now and its maturity, but this does not tell me anything about future reinvestment real yields between now and my unknown date of death.

When taking into account that a spouse OAS vanishes on death, that the CPP/QPP survivor pension is capped, and that divorce could always happen, I am increasingly thinking that the only safe minimum income one can robustly count on is OAS + CPP/QPP pensions delayed to age 70, along with a bridging RRB ladder (early retirement) or GIC ladder (retirement at 65) between the day of retirement and age 70. Anything else carries more risk, in our Canadian landscape. Given the average CPP monthly pension of 642.45 at 65 and the maximum OAS pension, we're talking of an average inflation-indexed $19,000 OAS+CPP pension starting at age 70 (assuming retirement at 65)*. This is below the level of poverty. A perfect employment history at maximum pensionable earnings would raise this to a maximum inflation-indexed $26,000 OAS+CPP pension starting at age 70 (assuming retirement at 65)**. This is still pretty low, even for a bare essentials budget.

* One would need to supplement that with a $95,000 pool of money at retirement, $76,000 of which would be invested into a non-rolling 4-year GIC ladder.
** One would need to supplement that with a $130,000 pool of money at retirement, $104,000 of which would be invested into a non-rolling 4-year GIC ladder.

This is not to say that this minimum income is completely riskless: there's always the remote (but possible) risk of the government selectively defaulting on RRBs or changing the rules of OAS and CPP/QPP.

One would have hoped for a pension to provide for the missing gap to an acceptable minimum income level, but the lack of inflation indexing is worrisome in old age. Maybe CPI-indexed annuities would provide a solution for this, yet I don't know if they still exist; Standard Life which was the only insurance company offering them has been acquired by Manulife. Worse, Assuris only insures a pension payment up to a nominal $2,000 (monthly). Above this amount, one could take up to a 15% hair cut each time the paying insurer defaults. So, even if the initial annuity amount was below $2,000, inflation indexing could bring the amount above $2,000 and expose the annuity to a hair cut.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by gobsmack »

I understand the concern but I still think that a diversified portfolio that is generating a decent amount of income from investments abroad (stocks and/or bonds) should, for the most part, provide an adequate level of protection. It may not be the ideal solution but I think it is probably good enough.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by longinvest »

Quebec wrote:
longinvest wrote:Quebec,

I guess you are aware of the new provincial law that affects municipal pensions, suspending inflation indexing when the plan is not in good shape.
My DB plan has not suffered such a faith so far, so for now I'm still counting on the partial protection against inflation (indexing is CPI minus 3%). Our regular contributions rates have been increased recently, and there is talk of additional special contributions to resorb the (rather large) funding deficit. I can only base my planning on the current rules, and will revise it if rules change. I am aware that rules can change at any time, and the following measures are being taken, partly as a result of this uncertainty:
- we're maxing out RRSPs and TFSAs
- the mortgage will be fully paid at age 55
- early retirement at 55 is a nice goal to have, but we can of course work longer if needed or desired. In my case this would have a rather large effect on the initial pension amount, because the plan punishes early retirement. The slope of increasing pension versus time is quite steep between ages 55 and 63
This seems reasonable to me, but I would lean on the safe side and make my worst-case calculations using the following assumptions:
  • I would cut the starting pension amount by the solvency deficit (which assumes plan termination) instead of the more optimistic funding deficit (which assumes on-going plan contributions by new employees).
  • I would assume an annual (1/1.03 - 1) loss of power purchase.
On the more positive side, your inflation-3% pension is quite valuable. You could estimate an upperbound on longevity, such as age 115 or 120, and assume an ongoing possibility to invest into a TFSA into something that will yield at least the rate of inflation (a 0% real yield). This way, you could virtually convert your inflation-3% pension into a fully inflation-indexed one. Here's a small example (converting a 10-year inflation-3% pension into a 10-year inflation-indexed pension) in constant dollars:

Code: Select all

Year		Real pension	contribution(withdrawal)
Year 1	$10,000.00	$1,213.89
Year 2	$9,708.74	$922.63
Year 3	$9,425.96	$639.85
Year 4	$9,151.42	$365.31
Year 5	$8,884.87	$98.76
Year 6	$8,626.09	-$160.02
Year 7	$8,374.84	-$411.27
Year 8	$8,130.92	-$655.19
Year 9	$7,894.09	-$892.02
Year 10	$7,664.17	-$1,121.94
Total	$87,861.09	$0.00
Average	$8,786.11	

In other words, the inflation-3% $10,000 10-year pension is equivalent to an inflation-indexed $8,786.11 10-year pension, assuming that you invest any excess into a 0% real-yield investment and you fund pension deficits from it.
Last edited by longinvest on 13 Nov 2016 11:51, edited 1 time in total.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by longinvest »

gobsmack wrote:I understand the concern but I still think that a diversified portfolio that is generating a decent amount of income from investments abroad (stocks and/or bonds) should, for the most part, provide an adequate level of protection. It may not be the ideal solution but I think it is probably good enough.
Oh, yes. Actually, one could always be super pessimistic and assume that a widely diversified portfolio will only deliver a 0% long-term real return (or even a slightly negative long-term return). With a big enough portfolio, this will still provide, when combined with OAS and CPP/QPP, more than the required minimum income.

It's just annoying that one is still forced to make assumptions about it. It is by no way as easy as Bodie would let us believe to actually assure a basic minimum income, not even using RRBs, pensions, and annuities in addition to OAS and CPP/QPP.

I'm not changing my portfolio as a result of reading his book (other than it finally prompted me to further diversify my bonds by including RRBs). I'm confident I'll have way enough above my minimal required basic income (using my diversified portfolio, nominal pension, and OAS/QPP).

What I really liked, though, is that it provided me with a clear way to think about a fundamental aspect of risk: having a minimum of money available at the time it is needed.

That is not to say that Bodie's proposed method to fund retirement is perfect (to his defense, he doesn't claim so): a 30-year RRB ladder is actually quite risky, because the money could not be available at the time it is needed. How? Simply because of a change of plan. Example: Between ages 35 and 64, build a liability-matched RRB ladder. Retire at age 65. At age 66, learn that one has cancer and 2 years to live. The average maturity of the ladder, at age 66 is 14 years. This could expose the retiree to quite a loss, in real dollars, if real rates had just gone up.
Last edited by longinvest on 13 Nov 2016 12:00, edited 2 times in total.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by AltaRed »

gobsmack wrote:I understand the concern but I still think that a diversified portfolio that is generating a decent amount of income from investments abroad (stocks and/or bonds) should, for the most part, provide an adequate level of protection. It may not be the ideal solution but I think it is probably good enough.
As do I understand longinvest's concern, but I have never planned on such 'certainty'. 10+ years plus into retirement (including a post-retirement divorce and the 2008-2009 debacle), I have been stick handling good enough with OAS/CPP/DB and investment income. I am also of the view that my spending needs (or perhaps more accurately, desires) will diminish with time, and I can always downsize (or liquidate) my principal residence as well. Excessive (hyper) inflation will always be a potential dark cloud on the horizon but so will a violent home invasion, earthquake, premature health crisis, auto/air crash, etc.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

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longinvest wrote:a 30-year RRB ladder is actually quite risky, because the money could not be available at the time it is needed. How? Simply because of a change of plan. Example: Between ages 35 and 64, build a liability-matched RRB ladder. Retire at age 65. At age 66, learn that one has cancer and 2 years to live. The average maturity of the ladder, at age 66 is 14 years. This could expose the retiree to quite a loss, in real dollars, if real rates had just gone up.
Suppose at age 66 I learned I had only two years to live. Why would I want to sell off my securities, such as RRBs?

First, upon death, there is a deemed disposition (apart from spousal rollovers in RRSPs). But that doesn't mean I have to sell the assets, merely pay tax on them. The tax is a proportion of the asset value (registered) or capital gain (non-taxable). So if the value of the asset has dropped, so has the tax payable. So I don't see this as a big deal.

Second, my executor and heirs might want to sell off my securities and invest in something else. That's their choice. But they will be making it, knowing that they could have continued with the RRBs to maturity and not incur any loss at all.

Third, my heirs might need money for some other purpose, e.g. buying a house or paying for university, and so must realize the loss. But they are still getting some money twelve years before they expect it. How is this a negative for them (setting aside their grief)?

Fourth, I might want to spend more while I am still alive, thereby having to realize the loss now. But I would still be spreading the remainder over two years rather than fourteen (or thirty). I can still go on a heck of a spending spree.

Okay, early death is an extreme scenario. I might want extra money for a variety of reasons. Unless these are urgent, I can wait until my RRBs recover (market timing, I know) or perhaps revise my plans more comprehensively. Remember, here I am at age 66 with a situation I have planned for. In any such plan it is wise to contemplate alternatives and either make explicit provisions for them, or at least have a contingency plan.

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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by AltaRed »

ghariton wrote:First, upon death, there is a deemed disposition (apart from spousal rollovers in RRSPs). But that doesn't mean I have to sell the assets, merely pay tax on them. The tax is a proportion of the asset value (registered) or capital gain (non-taxable). So if the value of the asset has dropped, so has the tax payable. So I don't see this as a big deal.
One niggly point. That is true except in the case of an election to roll taxable investment ACBs over to a surviving spouse. That said, I agree with your synopsis that the risk of 'capital' losses post-death is not really relevant.

Off-topic: If I was executor of a last-to-die estate, I'd turn the then investment portfolio into capital preservation mode ASAP. There is more executor risk from beneficiaries in an estate losing additional capital value versus not making meaningful investment returns.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

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ghariton wrote:
longinvest wrote:a 30-year RRB ladder is actually quite risky, because the money could not be available at the time it is needed. How? Simply because of a change of plan. Example: Between ages 35 and 64, build a liability-matched RRB ladder. Retire at age 65. At age 66, learn that one has cancer and 2 years to live. The average maturity of the ladder, at age 66 is 14 years. This could expose the retiree to quite a loss, in real dollars, if real rates had just gone up.
Suppose at age 66 I learned I had only two years to live. Why would I want to sell off my securities, such as RRBs?

First, upon death, there is a deemed disposition (apart from spousal rollovers in RRSPs). But that doesn't mean I have to sell the assets, merely pay tax on them. The tax is a proportion of the asset value (registered) or capital gain (non-taxable). So if the value of the asset has dropped, so has the tax payable. So I don't see this as a big deal.

Second, my executor and heirs might want to sell off my securities and invest in something else. That's their choice. But they will be making it, knowing that they could have continued with the RRBs to maturity and not incur any loss at all.

Third, my heirs might need money for some other purpose, e.g. buying a house or paying for university, and so must realize the loss. But they are still getting some money twelve years before they expect it. How is this a negative for them (setting aside their grief)?

Fourth, I might want to spend more while I am still alive, thereby having to realize the loss now. But I would still be spreading the remainder over two years rather than fourteen (or thirty). I can still go on a heck of a spending spree.

Okay, early death is an extreme scenario. I might want extra money for a variety of reasons. Unless these are urgent, I can wait until my RRBs recover (market timing, I know) or perhaps revise my plans more comprehensively. Remember, here I am at age 66 with a situation I have planned for. In any such plan it is wise to contemplate alternatives and either make explicit provisions for them, or at least have a contingency plan.
George,

I didn't explain myself clearly. I was simply trying to illustrate that even if RRBs are the safest investments around, there is still a possibility that money wouldn't be fully available at the exact time it is needed* (as opposed to the time it was expected to be needed), just because of uncertainty in one's life. Just to complete my (flawed) example, just imagine that one would need a big part of the capital to pay for bleeding-edge treatments in the US or elsewhere outside of Canada, just to extend life to 2 years, with no bequest motives.

* In reference to the new perspective I've learned on risk from reading Bodie's book.

I was in no way trying to say the RRBs are not safe, or that using an RRB ladder is not safe, in general. I really messed up my example. Sorry for that.

Just to be clear: A liability matched RRB ladder is the safest way to fill the gap between retirement and the delayed start of OAS+CPP/QPP payments at age 70. It is also the safest way to assure a higher floor (than the above) by planning a (partially rolling) RRB ladder (assuming a 0% reinvestment real-yield floor) that extends into very old age, beyond the most optimistic longevity assumption. But, in that case, I had to make assumptions (which I didn't need to do for the retirement to age 70 gap).

Is that better?
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

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longinvest wrote: there is still a possibility that money wouldn't be fully available at the exact time it is needed* (as opposed to the time it was expected to be needed), just because of uncertainty in one's life.
Agreed.

Back to diversification as the other main risk reducer (not risk eliminator). I would not recommend a 100% RRB portfolio to anyone. I certainly don't hold one.

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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

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In an earlier post, Quebec has already summarized the most interesting parts of the book.

So, assuming that we agree with Bodie's description of risk as being the possibility of not meeting our future minimal needs, how do we build a portfolio?

Bodie's solution

In Risk Less and Prosper, Bodie suggests to build two distinct portfolios. One portfolio composed on inflation-indexed bonds to meet our future minimal needs with a near 100% certainty, and a second portfolio to meet our wants. I'll respectively call these portfolios needs-portfolio and wants-portfolio.

Bodie says that it's the investor's objective risk capacity which dictates how much of his investments should go into the needs-portfolio. As for the more subjective (emotional) risk tolerance of the investor, he says that it could be used to determine the composition of the wants-portfolio.

Criticism

Personally, I think that Bodie's proposed approach is a pretty naive implementation to meet his requirement of eliminating the risk of not meeting future minimal needs. Yes, it does the work and it is guaranteed to succeed (as much as such thing is possible, in real life). But it is likely to be one of the most expensive approaches to assure that future minimal needs are met.

In the book, Bodie seems to assume that his readers are either extremely risk averse, or that they know very little about markets and investing. While he takes the time to dispel myths about how to interpret "stocks for the long run" in an individual's life*, he doesn't put any emphasis on the fundamental and logical relation between risk and reward.

* Actually, it seems that both Bodie and Siegel pretty much agree (more than they disagree) on the subject; they just frame it differently, and many investors just misinterpret what they are saying. Here's the transcript of a very enlightening debate between the two: The Great Debate (Bodie vs Siegel). Both had Paul Samuelson as Ph.D. mentor.

Added: It should be noted that, while using a separate portfolio of laddered RRBs is not economically necessary, it might fulfill psychological needs, allowing investors to avoid panic during a crisis. This is a perfectly legitimate justification for using a separate needs-portfolio. But, not all investors need as much psychological protection.

Theory Reminder

So, let's try to consider the problem from an investing adult point of view. Even if I considered that I had two distinct portfolios, that would just be mental accounting. In reality, I would just have a single portfolio containing inflation-indexed bonds and other assets.

Let's push this reasoning further. Let's say that an investor determined that he needed to invest $10,000 per year into inflation indexed bonds from now until retirement to meet, along with OAS+CPP, his future minimal needs. Let's also say that every year, he was able to save and invest a total of $25,000 dollars. Why would he need to put $10,000 into RRBs? That would be equivalent to say that, in the worst case, there was a possibility that his additional $15,000 yearly investments could possibly go to $0!

I don't know about others, but I have a lot of trouble picturing a $15,000 yearly investments into a portfolio diversified across the total nominal Canadian bond market, the total Canadian stock market, and the total set of developed and emerging international stock markets just going to $0 or near $0 in inflation-adjusted terms on the day of retirement. That would probably be due to an alien invasion or some major cataclysm destroying Canada as we know it. RRBs would most probably be of no help, in that situation!

As investing adults, we know that it would be illogical to expect RRBs to be the asset that delivers the highest returns (in general). Logic tells us that riskier assets must return more than RRBs often enough, otherwise investors would shun these other assets and put their money into the safer RRBs, causing the prices of these riskier assets to fall until they get cheap enough that they'll start returning more than RRBs. It just cannot be otherwise. It might take a long time for asset prices to adjust, as investors could take many years to realize that assets are incorrectly priced, but it must happen often enough.

When we look at the history of stock and bond markets across the world, we see this risk/reward relation over long stretches of time, yet as Bodie says, the risk of stocks and nominal bonds is real. Markets can take a long time to correct asset prices.

The fundamental source of uncertainty causing this risk is that we don't know, at any point in time, whether a risky asset is properly priced. If we could know with certainty the correct price of a risky asset, it wouldn't be risky to invest into it; this asset would behave like an RRB held to maturity, delivering the exact cash flow we expect in inflation-adjusted dollars. The market would price this asset similarly to an RRB.

A Better Solution?

So, now that we've remembered the basics of investing theory, how should we proceed? I think that it would be reasonable to invest into a traditional balanced portfolio containing a certain allocation to RRBs. There is no reason to isolate RRBs and not let them participate into portfolio rebalancing*. I think that it is a good idea to consider Bodie's minimum needs requirements as a gauge to determine the objective risk capacity of the investor.

* [Added:] Actually, there are psychological reasons to keep RRBs separate (and possibly organized into a liability matched ladder), to help some investors sleep well at night during crises.

OK, I'll admit that Bodie is probably right that an investor who is barely saving enough to meet his future minimal needs (and can't save more or retire later) would have almost no choice but to put it all into RRBs properly matched with liabilities in a ladder. We're talking of someone in Jim Otar's red zone, here. (See Otar's Unveiling the Retirement Myth book).

But for the typical FWF member, I don't think that Bodie's ratio of RRBs within a portfolio is warranted. I think that it would be OK for an investor to realistically* estimate the worst-case scenario for a chosen portfolio, and proceed with the chosen portfolio as long as the worst-case estimate reveals that future minimal needs will be provided for (through natural portfolio cash flows and by selling assets).

* Being realistic in assessing the worst-case scenario is crucial. It's not the time to hope for the best in this step.

So, it is possible to choose within a wide variety of portfolios while sticking to Bodie's definition of risk. The more one saves relative to one's basic needs, the more one has flexibility to invest into various portfolios.

Would a traditional 60/40 stocks/bonds portfolio work? Would a dividend portfolio work? Would a [fill in the blank] portfolio work? It depends on its estimated worst-case scenario: Will it meet future minimal needs? If not, add RRBs until it does. It's as simple as that.

[added:] When selecting a portfolio (or two distinct needs-portfolio and wants-portfolio) and an investment policy, it is also important to ask the question: "Will I stick to my portfolio and investment policy in the midst of a really bad crisis?". If the answer is "no", one should change the portfolio or policy now, before the crisis happens!

We've been traditionally taught that once we estimate how much we want to accumulate for retirement, we should estimate the required rate of return then select the investment mix that will deliver this return. That's what some authors call the need to take risk.

Our new approach, based on Bodie's definition of risk, contrasts with the traditional approach to investing; it eliminates the concept of needing to take risk. Instead, it first asks the investor to determine his future minimal needs to draw the line on risk. An investor willing to take risk must first develop the capacity to take risk, either by saving more than strictly necessary, by lowering his future minimal needs, or by planning to retire later.

When reading other books, something always seemed wrong to me when I read that one should to take more risk if one's current savings were insufficient to meet one's objectives. It seemed like hoping that risk would not show up. That's like saying that if you think that you'll be late, you should go faster than the posted speed limit in order to get to your destination on time, ignoring the risk of having an accident or of having a cop giving you a ticket and, as a result, still get late. Sometimes, the right thing to do is just to call and say you'll be late. It is even better to simply leave earlier.

Anyway, that's what I think. What's your opinion?
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by ghariton »

I think that you are leaving out, or at least not giving proper weight to, the psychological aspect of investing.

Humans are prone to panic. This is not just in finance, of course. Just look at the scares around food, or health treatments, or election results. But financial matters seem to touch us very deeply. For example, I can't move my daughter away from a 100% fixed income portfolio, because she is appalled by ANY decrease in her holdings.

So, although a two-portfolio approach may not make much sense economically, I think that it does have psychological attraction. It allows some of us to master our fears in severe downturns, and stay the course, knowing that we will not be eating dog food, no matter how badly markets behave.

In my own case, economic logic suggests that I should be 100% equities, with perhaps three months' worth of living expenses in liquid fixed income. That's the logical approach. But, having lived through three major downturns now, I know that I would worry too much when the fourth one comes, if I were 100% equities. Having "enough" RRBs allowed me to go through the 2008 episode with equanimity.

Okay, just how much RRBs do I need to feel secure? Bodie's approach, and my own, is to be able to fund a very basic standard of living with them. For me, "basic" is very low -- utilities, food, clothing, and vet bills for the dogs. As time goes on and my wife and I age, the amount of fixed income needed for this declines. That means that the amount of RRBs I need to hold declines as well. Fortunately, this happens automatically. Since RRBs are premium bonds these days, every coupon payment is partly a return of capital, and so a decline in my allocation to fixed income. When my 2021 RRBs mature, I will take the occasion to further reduce my FI by doing only a partial rollover.

This is a very different approach than the traditional asset allocation based on percentages. As my portfolio grows (and it is still growing), why should that lead to increases in fixed income? My basic needs aren't going up -- the amount required to fund them is going down (fewer years to live). Or at least, the amount that I feel comfortable with is declining.

Of course, there is considerable merit in the argument you make, that as my portfolio grows, the size of the losses I should be willing to absorb should grow too. After all, if I lose 50% of a $2 million all-equity portfolio, I am still as secure as if I had a 100% fixed income portfolio of $1 million. (All figures are illustrative :wink:) But that ignores the psychology. A 50% loss may lead me to do foolish things with the remaining money. (In my case in 2000, it led me to try to catch falling knives.)

So yes, I could count on the equity part of my portfolio to sustain me in my need-to-have expenditures. But I just feel better this way. I compensate by having a very Spartan set of needs, as I've pointed out above.

______________________________________________________________________________________

The mystery for me is not the role of RRBs in constructing my portfolio. Rather, it is what possible use long term nominal bonds might be. They certainly don't make me feel any safer, given their lack of inflation protection. And while they do protect me against the short term volatility in equity markets, that volatility doesn't particularly bother me (provided I have my safe RRBs). Their returns are definitely below the expected returns on equities, so I can't be holding them to help grow my portfolio. And while nominal bond returns are higher than those on RRBs, the difference isn't that big. If we ever do get high inflation, nominal bonds may prove more volatile than even equities -- which is exactly the time when I don't need highly volatile securities.

__________________________________________________________________________________________________

Finally, as everyone knows*, higher risks are rewarded by higher returns, and if an investment like RRBs have very low risk then the probably have low returns as well. Well, yes. I'm fully conscious that I'm buying insurance against unanticipated inflation, that such insurance has a cost, and that the cost manifests itself in lower returns. That's a price I'm willing to pay. Others, who are less bothered by the risk of unanticipated inflation, will find the price of the insurance too high. Good. That means that they aren't driving up the insurance premium, leaving me with a (relative) bargain.

*There is a body of literature, often referred to by NormR on this forum, which challenges that link. In particular, historically, the highest volatility equities have delivered below-average returns. I call this the lottery ticket effect -- the investor is purchasing hope for a change in lifestyle, in addition to a future income stream.


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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by longinvest »

George,
ghariton wrote:I think that you are leaving out, or at least not giving proper weight to, the psychological aspect of investing.
OK, that's a fair criticism. Note, though, that I did not say that Bodie's approach did not work; I said that it is likely to be one of the most expensive approaches.

I have nothing against expensive things. I do buy some, in select areas of my life, to enjoy them. I just think that in Risk Less and Prosper, Bodie could have presented a wider number of investing approaches and discussed their emotional impact.
ghariton wrote:Humans are prone to panic. This is not just in finance, of course. Just look at the scares around food, or health treatments, or election results. But financial matters seem to touch us very deeply. For example, I can't move my daughter away from a 100% fixed income portfolio, because she is appalled by ANY decrease in her holdings.
So, 100% fixed income (including an RRB ladder not marked to maket) is effectively the right choice for her.

While I didn't put the emphasis on bond-only portfolios, I stated the criterion for "Would a [fill in the blank] portfolio work?". The blank could be filled as: "Would a 100% fixed income portfolio work?". The answer is: "Will it meet future minimal needs? If not, add RRBs until it does."

So, even your daughter's portfolio fits within the proposed portfolio construction model.
ghariton wrote:So, although a two-portfolio approach may not make much sense economically, I think that it does have psychological attraction. It allows some of us to master our fears in severe downturns, and stay the course, knowing that we will not be eating dog food, no matter how badly markets behave.
Yes, the separate portfolio model has some interesting psychological impacts. But, not all investors need as much insurance. Insuring that future minimal needs are met does not require the use of a separate portfolio. Using a separate portfolio is, economically, a luxury; yet, possibly a necessary economic luxury due to psychological needs. It's up to the investor to assess his needs and wants (economic and psychological).
ghariton wrote:In my own case, economic logic suggests that I should be 100% equities, with perhaps three months' worth of living expenses in liquid fixed income. That's the logical approach. But, having lived through three major downturns now, I know that I would worry too much when the fourth one comes, if I were 100% equities. Having "enough" RRBs allowed me to go through the 2008 episode with equanimity.
The nice thing about having enough money is that one gets more choices. You have the money to build a robust, separate liability-matched RRB ladder to meet your future minimal needs, and it helps you sleep better at night. Why would anyone criticize your choice? I think that you've made a rational choice.

I was not criticizing this. I was criticizing the fact the Bodie did not discuss alternative models (like you rightfully criticized that I did not emphasize the psychological aspect).

ghariton wrote:The mystery for me is not the role of RRBs in constructing my portfolio. Rather, it is what possible use long term nominal bonds might be. They certainly don't make me feel any safer, given their lack of inflation protection. And while they do protect me against the short term volatility in equity markets, that volatility doesn't particularly bother me (provided I have my safe RRBs). Their returns are definitely below the expected returns on equities, so I can't be holding them to help grow my portfolio. And while nominal bond returns are higher than those on RRBs, the difference isn't that big. If we ever do get high inflation, nominal bonds may prove more volatile than even equities -- which is exactly the time when I don't need highly volatile securities.
Yes, nominal bonds are puzzling. The reason I keep them in my portfolio is protection against ignorance. I do not trust myself to know enough about future possibilities to shun them. Anyway, even with them, my portfolio fits the criterion: to the question "Will my portfolio meet future minimal needs?" the answer is "Yes". For the psychological aspect: to the question "Will I stay the course with my portfolio in the worst part of a bad scenario?", the answer is also "Yes". :wink:
ghariton wrote:Finally, as everyone knows*, higher risks are rewarded by higher returns, and if an investment like RRBs have very low risk then the probably have low returns as well.
Everyone knows that nominal bonds are the worst investment ever, too... :wink: It's just impossible to know, at any point in time, whether assets are properly priced. In other words, it's impossible to predict which asset will have the highest returns. Personally, I don't even believe in applying the probabilistic models to my investments, because I have a single life. I won't be trying to live several thousands of lives and try to maximize my average outcome across the collection of lives. I find the traditional probabilistic guidance to investing and asset allocation quite misleading, in that view.
ghariton wrote:Others, who are less bothered by the risk of unanticipated inflation, will find the price of the insurance too high. Good. That means that they aren't driving up the insurance premium, leaving me with a (relative) bargain.


I'm sorry, I won't be helping you with the bargain, here. :oops: With my constant 25% allocation to ZRR, my RRB investments will eventually exceed what's strictly necessary to meet my future minimal needs.

longinvest

P.S. I edited my previous post to mention the psychological aspect. Thanks for the insight!
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by BRIAN5000 »

to sustain me in my need-to-have expenditures.
Why would you design a portfolio to only meet my need-to-have expenditures as a base. I think I would like to design my portfolio for my wanted retirement. If things go wrong I can still cover my need-to-have expenditures.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by Quebec »

@Brian: that's fine with a large portfolio. With a small risky portfolio, if things go wrong, there might not be enough money left to live on. So the book says, make sure you guarantee at least the minimum income needed. In a US context, that's social security plus a certain amount in TIPS.

Maybe the title of the thread should be ''Risk less and survive using RRBs''.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by 8Toretirement »

Quebec wrote:@Brian: that's fine with a large portfolio. With a small risky portfolio, if things go wrong, there might not be enough money left to live on. So the book says, make sure you guarantee at least the minimum income needed. In a US context, that's social security plus a certain amount in TIPS.
We still haven't solved the problem of volatility during the withdrawal phase on long duration RRB's. Delaying CPP and OAS would be a better strategy than RRB's for the long term assuming more than essential income requirements are saved by the retiree.

Everything is predicated on the retiree being able to save/invest more than the minimum yearly spending. If the retiree cannot save more than the minimum yearly spending required then it might be argued, that short of disability they may not be ready to retire, and doing so prematurely will bring an additional level of risk.

Assuming you have a surplus of funds, a structured portfolio mix of short term bonds, 5 yr GIC ladder, and stocks could cover the required spending to 70. If you let the stocks ride and draw down the GIC ladder, bonds, and spend dividends from stocks, the delay of CPP to 70 will increase payments 8.4% per year or a 42% increase in payments at 70. Delay of OAS will increase payments by 7.2% per year or a 36% increase in payments at 70. The increase in payments decrease the amount of savings required and increases the overall portfolio subject to cost of living increases.

Additionally, early withdrawals from RRSP's will minimize the overall tax owed by delaying CPP and OAS. All assuming the retiree has sufficient funds.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by longinvest »

8Toretirement wrote:We still haven't solved the problem of volatility during the withdrawal phase on long duration RRB's.
8Toretirement,

An RRB is a bond; it is a contract to pay specific amounts of money in inflation-adjusted dollars on specific future dates. These amounts are written and won't change, for an existing RRB, regardless of what happens with interest rates in the market. The only thing that changes is the market value of the RRB, if one wishes to sell it before maturity.

One can easily match RRB maturities (with a 5-year window) to one's need. (Within the 5-year window, one could assume a small inflation risk by investing into GICs or other short-term nominal fixed income). As each RRB gets nearer to maturity, its value converges towards par (in inflation-adjusted dollars) and its duration converges towards 0, significantly reducing its market value volatility.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by Quebec »

Longinvest,

You may have mentioned this already, but why did you opt for a fixed percentage of RRBs in your portfolio, rather than a target dollar amount?

Also, why choose an ETF as opposed to a customized liability-matched ladder of RRBs?

In other words, why treat RRBs as ''just another asset class'' when it can serve almost as a home-made inflation-indexed annuity to cover basic needs in retirement, or a bit more than that, if you can afford it?

With a fixed percentage of RRBs in your portfolio, and regular rebalancing, you are in part letting your future equity returns decide how much RRBs you will have (in dollars) on your retirement date.

I'm not saying that's wrong, I just want to understand your reasoning.

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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by 8Toretirement »

longinvest wrote:
8Toretirement wrote:We still haven't solved the problem of volatility during the withdrawal phase on long duration RRB's.
8Toretirement,

An RRB is a bond; it is a contract to pay specific amounts of money in inflation-adjusted dollars on specific future dates. These amounts are written and won't change, for an existing RRB, regardless of what happens with interest rates in the market. The only thing that changes is the market value of the RRB, if one wishes to sell it before maturity.

One can easily match RRB maturities (with a 5-year window) to one's need. (Within the 5-year window, one could assume a small inflation risk by investing into GICs or other short-term nominal fixed income). As each RRB gets nearer to maturity, its value converges towards par (in inflation-adjusted dollars) and its duration converges towards 0, significantly reducing its market value volatility.
With RRB's there is no set par value as with nominal bonds. The holder could receive lesser amounts due to deflation. The problem you get, especially with the secondary market when trying to match short term obligations within a portfolio, is RRB's are very volatile compared to short term bonds and the face value at maturity could be less than you paid. RRB's are not understood very well, as there is some risk in a deflationary environment.

From WIKI Financial, which explains the problem:

"Determining the value when RRB matures: When an RRB matures, you'll get the face (par) value times the then current index ratio. In other words, you'll get the face value indexed for inflation. This will probably be more than the original face value, but if there's been a period of deflation, it could be less."

http://www.finiki.org/wiki/Real_Return_ ... ular_bonds

An entirely separate issue: If you are forced to withdraw during a 13% loss in value, as has been achieved by RRB's in recent history you lose purchase power from an asset that is supposed to provide safety. I believe I read the worst year for nominal short bonds was 4%. Big difference.

If the investor has not received OAS and CPP they might be better served by delaying these pensions that are inflation protected while also receiving higher payouts and associated additional inflation protection on the additional payout.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

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If the investor has not received OAS and CPP they might be better served by delaying these pensions that are inflation protected while also receiving higher payouts and associated additional inflation protection on the additional payout.
@Brian: that's fine with a large portfolio.
I think we must be talking about large portfolios. I'm not sure how many Canadians 5-10%? could retire between 50-65 and not HAVE to draw their CPP and or OAS as soon as possible just to make ends meet?

Maybe someone could lay out an example, age, accumulation, deaccumulation, spending targets, savings rates? There is a lot of variables it seems.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by 8Toretirement »

BRIAN5000 wrote:
If the investor has not received OAS and CPP they might be better served by delaying these pensions that are inflation protected while also receiving higher payouts and associated additional inflation protection on the additional payout.
@Brian: that's fine with a large portfolio.
I think we must be talking about large portfolios. I'm not sure how many Canadians 5-10%? could retire between 50-65 and not HAVE to draw their CPP and or OAS as soon as possible just to make ends meet?

Maybe someone could lay out an example, age, accumulation, deaccumulation, spending targets, savings rates? There is a lot of variables it seems.
My example was based on delaying OAS and CPP from 65-70. Delaying from 60 to at least 65 provides a similar benefit. The determination on when to retire would be based on personal circumstances and retirement funds available. Still think that for individuals worried about inflation, that delaying pensions would simplify the issue of volatility during the withdrawal phase.

The model breaks down with early retirement, however, withdrawing RRSP funds early to maximize after tax income is an advantage to be explored based on personal circumstances. The model is not likely to work for people retiring at 55 as the delay would eat available personal funds for the majority of individuals.
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Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by Shakespeare »

The model is not likely to work for people retiring at 55 as the delay would eat available personal funds for the majority of individuals.
The dropout limits force most early retirees (I retired at 50) to take CPP as soon as possible after the dropout is exhausted.
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