moneyFYI
Financial Freedom Is Merely Organized Common Sense
On Transparent Fees
If you earn income by arranging investment funds for clients, you must address the MER question. There is a quite a lot of discussion going on, so you clients probably already know part of the story. You don’t know which part yet.
If you are a financial adviser, you should be able to explain where the investment fees go and who gets them. Disclosure has questions though. The key to the distinction between should disclose and should not is a fairly easy one.
From the old days of consulting, I found this note. Should you post the salary list of all the people who work for you on the bulletin board in the lunch room?
Answer. Probably not; but you should not refuse because it would embarrass you.
If it would be embarrassing, the recommendation was always adjust salaries until, if you had to disclose, you would be comfortable with their amounts and could explain your reasoning.
Same thing with fees. If it would embarrass you to disclose then you have a problem and you have the option of dealing with it or risking discovery.
From the client’s side understanding of how much is paid and to whom is important and is part of the perception of fairness.
People see things this way. “What you cannot explain harms me in some unknown way.” Disclosing solves that or at least clarifies the conflicts so you can address them.
The bigger problem now is that, being human, people extend the idea to, “What you do not explain probably harms me in some unknown way.” You cannot deal with this until you disclose.
Truth is as much perception as it is fact, so if you care what others believe, you will need to address transparency. Tell the folks what they get for their money and tell them the costs they incur to avoid the fee.
If that explanation embarrasses you, then you must adjust what you do until it does not.
Transparency will not automatically lead to acceptance of the facts you present. Some will argue with you. That has value too:
- It will help you clarify your own thinking on what you do and do not do. Hopefully that leads to delivering what clients want. Perhaps a buffet of services they can choose from.
- It will identify clients who have issues that you cannot deal with and who you are better off without.
In either case, you win. You can be businesslike.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com
Follow on Twitter @DonShaughnessy
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How Much Should Gasoline Sell For?
Over the years there has been continual runs at the oil companies about how much gasoline should sell for. In some ways it is similar to the continual griping about mutual fund fees. There is one similarity in the cases. People don’t know, they don’t like it and they assume they are being taken advantage of. The oil industry is not clarifying the information. Like the Fund industry, they should set out where the money goes.
If you want to displace bad information you need to provide good information.
Here is a fairly straight-forward thought experiment about gas prices. It is only reasonably accurate in Ontario, but the ideas behind the method work everywhere.
The Toronto gas price is $1.299 per liter of regular gas on May 20. So where does that money go when you buy gasoline?
I have next to no specific knowledge but I can assume that in general, the retail price pays for the following:
- The crude oil used to make the gasoline
- Transportation from the oil field to the refinery
- Refining and storage
- Transportation to the service station
- Service station operator mark-up
- Federal Gas Tax
- Provincial Gas Tax
- In Ontario, 13% Harmonized Sales Tax (HST) on the whole thing
- Credit card charges
Let’s start with what we know for sure. Federal Gas Tax is $0.10 per liter, Provincial Gas Tax is $0.14 per liter and HST is 13%
I have made assumptions about the rest but, because there are so many assumptions, I am hoping that the errors offset each other. I learned that building models. Ten guesses are better than one.
I assume dealer margin at $0.05. If you buy 60 liters, the dealer makes $3.00 before overhead. If you buy 1,000,000 they make $50,000 and that won’t go far to pay overhead. You better buy some things in the variety store section. $0.05 then is not a terrible guess, I think. If anything it is low.
Transportation to the service station or maybe to a distribution center and then to a station. I would need to know how many liters on a truck and whether the dealer price is the same regardless of how far away from the station the refinery or distribution point might be. If I guess 40,000 liters traveling an average of 200 miles each way, then with the cost for the driver to dump the fuel in each station and do paperwork, I think 3 to 5 cents is reasonable. $0.03 in this formula. Again, probably more.
Refining is a hard one for me. I think that refineries are highly operationally leveraged. Huge fixed cost and almost zero variable costs. I also think they are very efficient. I think refining will therefore be a small number. Say $0.01 including temporary storage.
Transportation from the field to the refinery is again unknown to me but as with the refinery, an efficient system. Blending the cost of pipeline sometimes, ships sometimes and even trains and trucks, I think $0.04 per liter.
At this point we have 24 cents for the governments and 13 cents for the refiner/distributor/dealer, 37 cents for all expenses other than crude oil and with HST and debit and credit card charges to add-on at the end.
Crude price is volatile and usually expressed in American dollars. Fortunately the $C is about the same so I am ignoring the currency difference. I need a formula to convert crude oil price in barrels to cents per liter of gasoline.
Most price complainers, including journalists, are feeling the answer, not thinking it. Here is a clarifying question for them. How many liters of gasoline come out of a barrel of crude oil?
There are 159 liters of crude oil in a barrel, but the gasoline equivalent is a harder question.
How much of the barrel turns into gasoline and how much turns into other things? Some of the other things are more valuable than gasoline (high test gas, jet fuel, chemicals, and plastics) and some less, (fuel oil, butane, propane, bunker C, tar, asphalt, and the like.) So we have a cost allocation problem. A difficult and probably seasonal one at that. I have decided to make a simplifying assumption to average out all the fractions and their values and get an equivalent liter of gasoline.
Take the current price ( US$94.00) of crude oil and take 80% of it (US$75.20) and then change the answer to Canadian cents. which becomes C$0.752.
To summarize:
- crude oil cost $0.752
- refining, transportation, and service station dealer margin, $0.13
- federal tax $0.10
- provincial tax $0.14
- total cost of $1.122,
- HST of 13%, $0.169
- for a total of $1.291
I assume credit card charges average maybe 1%. To get that right you need to know the price of and the mix among credit card, debit card and cash sales.
At 1% the retail price then needs to be $1.304.
QED. The price in Toronto today of $1.299, makes some sense.
What you get for your money:
- $0.41 of obvious tax. (.10 plus .14 plus .17 HST)
- $0.752 worth of crude oil (some of this is tax. Probably 25% or more. call it $0.20)
- $0.01 for the banks
- $0.13 for the folks who explored, drilled the well, took the oil out of the ground, moved it, refined it, moved it again, operated a clean and efficient station and took the abuse from the uninformed. And they all pay income taxes on their share of the 13 cents.
Governments everywhere get almost five times more than the oil companies, pipeline operators, truckers and the dealers combined. That leads to a question about whether some politicians are hypocrites.
How can we take an MP or MPP seriously when they are disingenuous enough to complain about the price of gasoline? Even to the point of wanting a royal commission to investigate. They are taking the big share of the money.
I would be happy for someone to show me where I am substantively wrong in this thought experiment. Especially someone who knows what they are talking about.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com
Follow on Twitter @DonShaughnessy
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If I Triple Your Money In Two Years, Can I Be A Bad Guy?
You would like to say “NO!” but you know better.
Daniel Kahneman is a psychologist who won the 2002 Nobel Prize in economics. An interesting combination. How could that happen? Perhaps the stock market is psychotic. It is more likely that the people who invest there are not completely rational. We can and should learn from that. Kahneman has some interesting things to say in his 2011 book, “Thinking, Fast and Slow”
Investment statistical material and techniques assume a fully rational, fully informed trader and are therefore almost certainly imperfect. Something else must matter, too. I suggest that learning to manage yourself may be as important or even more important than learning to manage your money.
If you expect 7% and get 8% you are happy. You won. If you expect 9% and get 8% somebody has some ‘splainin’ to do. At an emotional level, people do not compare results to what is rational and objective, they initially compare results to their expectations. Only later and only sometimes will they put the the rate of return in context of what they were trying to accomplish.
Rule 1: When the outcome is not as expected, it is not the event that causes the problem it is the comparison to expectation.
If clients use only a comparison to expectation to decide if the results are good or bad, they are not being rational. The yield is what it should have been, it is the expectation that was wrong. Kahneman has pointed out that, emotionally, losses are twice as disappointing as gains are pleasing. Clients would need to beat expectation twice as often as they lose to expectation just to break even emotionally. That is not going to happen.
Advisers can help mitigate the problem. Keep reporting focused on the goal, not the yield.
Setting expectations and reporting results so that the emotional response to shortfalls is in context, is an important part of the adviser function. It is one of only a few things that can make or break the client relationship.
Expectation is everywhere. Friends, family, bosses and associates have expectations and they are unhappy when you don’t meet them.
If we go golfing and each arrives back home at 8:00 different things happen. If I told my wife I would be home at 9:00 and you told your wife that you would be home at 6:00, we will see asymmetric results from a single event. You would think that a single, objectively verifiable event, being home at 8:00, would always generate the same outcome. You would be wrong!
Rule 2: Comparison to expectation matters, so be cautious about what you cause people to expect.
If you build a financial plan with an interest assumption of 6%, that will become the carved in stone expectation. You better hope the first year or two are higher. Average returns will only save you later.
Especially, be cautious about implicit expectations. While we may say past performance does not imply similar future performance, that is not how people understand the world. All of us use the past to help estimate the future. Recent events easily translate into expectations for the future. When current results are good, it is especially important for you to emphasize that the past does not predict the future. Congratulating yourself will merely reset the expectation higher. A guaranteed to fail tactic.
Rule 3: Comparison to expectation overwhelms facts.
Suppose I meet you at a New Year’s Eve party. You decide to let me invest $25,000 for a year, just to see what happens. You have no firm expectations, just hopes.
A year later I am happy to tell you that your $25,000 investment is worth $1,000,000. Clearly unexpected but very nice. You let me continue for another year and at the end of that second year, your investment is worth $75,000.
I don’t know what will happen for year 3, but I know you are unlikely to introduce me to your friends as the person who tripled your money in two years.
Write down Rule 4: At an emotional level, there is such a thing as a paper profit, but all losses are real.
You cannot be a successful investor or a successful adviser if you cannot manage expectations and the emotions that arise from the events that follow.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com
Follow on Twitter @DonShaughnessy
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Misrepresenting Government Spending
Everything governments tell you may be true but it is intended to mislead. When I hear that the government has instituted some plan to reduce spending by $800 billion over 10 years, the government hopes my first impression will be, “Wow! $800 billion is a lot.” When I trusted them, it likely would have been my first impression. Now sadly, skeptic me treats all of this fluff in context.
Notice that it is 10 years. Why 10? I don’t know. 100 years of saving would have been truly astounding. Perhaps they are not completely shameless. 10 years saving in context of a one year budget. Misleading.
Their second hope is that even the skeptics will say, “800 over 10 years, that’s 80 a year. That’s good.” Again wrong. It is more likely about 10 this year and 150 in year 10. It is so much easier to overestimate savings that are well over the predictable horizon. Even the 10 this year is likely covered in qualifications and double speak.
Last and most important, the 10 is inconsequential in the big scheme. During Fiscal year 2012, the US federal government spent $3,540 billion. (Does $3.54 trillion sound less?) A $10 billion saving is 1/354th of their spending.
Suppose you are a family with income of $45,000 per year after taxes, with debt of $140,000 and you overspend this year’s income by $16,000. I will bet that the bank will not be happy because you have cut your spending by $14,238 over 10 years and $178 (maybe) this year. That immediate $15 per month spending reduction will not save you, even if you expect a raise next year.
It is time to pay attention. Just grow up Government. Most of the people would prefer governments were smarter rather than more generous with money that is not their own.
There is a solution. Term limits. As it is, people are personally incentivized to do wrong things that will help them be elected again.
Stop the madness.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com
Follow on Twitter @DonShaughnessy
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How To Catch A Monkey
Catching a monkey is not difficult, but you need a trap of some kind. A trap is pretty easy to understand at a fundamental level. A trap involves the promise of something for nothing. The bait.
Here is an example of a kind of trap that will catch a monkey. Perhaps other primates, too.
- Begin with a large bottle with a narrow neck. Perhaps a water bottle.
- Fill the bottle two thirds full of sand. The bottle will weigh about 30 pounds and that is more than an adult Capuchin monkey weighs.
- Put a shiny object in the bottle. Maybe a chrome watch.
- Wait
Eventually a monkey will decide to have the shiny object in the bottle. He will reach in, grab the shiny bauble and try to leave. But while holding the bauble, his hand is too large to withdraw from the bottle and the bottle is too heavy to drag away.
What to do?
It is what the mathematics folks call a binary decision set.
- Release the bauble and go away, or
- Do not release the bauble and stay.
How like our world.
How attached to things are we? Are we willing to give up too much to keep things? Do we expect the laws of nature to work in our favor rather than to operate objectively? Can we understand what harms us and cease to be trapped by that?
Not always. Probably we are not fully rational when we want something, or maybe it is momentum. We become set in our ways.
Can we have the wit to let go of things that don’t work or even harm us? Too much or wrong food, too little exercise, smoking, drugs, alcohol, government spending, election promises, overspending with credit cards, and a thousand more.
Here is a way that will work for the monkey. Let go of the bauble. Not having to have so many things is a winning strategy.
Could work for us too.
You might find this useful. Addition by Subtraction
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com
Follow on Twitter @DonShaughnessy
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I Am, Once Again, Disappointed With The Financial Post
Canadian mutual fund fees have again appeared in a misleading Financial Post story. This time – Canada’s mutual fund fees still highest of 24 countries by David Pett 16 May 2013 Financial Post Page 6
While the article clearly parrots the Morningstar “Global Fund Investor Experience
2013 Report” it seems to have missed an important comment included therein on page 14 of 172.
“One of the difficulties in comparing annual expense ratios across countries has been the development of unbundled fee arrangements, whereby an advisor is not paid a sales commission by the fund company in the traditional model but rather is paid a separate fee by the fund investor. When taken, this action has the effect of lowering official fund expense ratios since funds no longer need to collect money from shareholders to make advisor payments. It also has the effect of complicating expense-ratio comparisons, since the fact that the investor in a lower-cost fund may pay an additional fee to an advisor is not considered in Morningstar’s calculations.”
Emphasis added. More here: Morningstar report
Canada uses the traditional model and the US does not. That seems an important point to leave out and it is not the first time Financial Post has missed it.
See these too. Barbara Shecter 25 April 2013 and Fred Vettese 29 April 2013
The uninformed fee discussion is flourishing. A search for, {Canada “mutual fund fees”} generates thousands of hits, many recent. I seem to be picking on the Post but the other papers are at least as guilty of comparing pineapples and grapes.
As it is an important variable, and not described, I assumed that it would be difficult to find what the external fee paid to an adviser in the US might be, but I was wrong. Investment Executive and an IFIC submission to the OSC both have the fact needed. It is typically between 1% and 1.5% of assets.
Not surprisingly, the difference between Canadian MER (includes adviser fees) and American TEP (does not include adviser fees) is about 1.25%
The stories purport to show a valid comparison but do not provide or even include all of the necessary information to make such a comparison. The “incomplete comparison” logic fallacy is sometimes found in advertising. A responsible journalist should avoid logic fallacies that are used to persuade rather than inform.
If you compare price only and pay no attention to what value you get back for your price, you will make mistakes. Factory second parachutes are not cheap regardless of how little the price may be.
To make this an adult discussion, these three points at least should be addressed.
- If you get more, you should expect to pay more. For the clients who acquire substantially the same service in both jurisdictions, the cost of ownership is about the same. If you don’t pay for an adviser, your price is lower. Not too unreasonable, so why is it a point of contention?
- The Industry has some culpability. It is irresponsible and not businesslike of advisers to fail to disclose their fees. If I don’t know what you are doing for me, your price is too high. Tell me what you do and why that is important to me. If you don’t tell me what you do, I will always assume it is less. I cannot value what I cannot see. Tell me often. Remind me after that.
Most people do not mind paying for value. If you have some that mind paying, they will be trouble. Send them away. Notice that you will not be able to tell where the potential trouble lies until you start to communicate your value and your price. The fault lies with you, the adviser. - Does paying nothing create value? It is easier for Americans to drop out of advised services and pay no fees. For some that will have value, for others a cost. A valid comparison should address the value or cost to do so. Paying nothing is not value. I can pay less for a car with no brakes, but it would be unwise to say that I receive value for the omission.
With money, it does not matter how much you pay for advice. Your account value matters. Focus on what is important, not on a single incident factor. Single point thinking is a logic error. Specifically, “causal reductionism.” It is the fallacy that results when the purveyor of the opinion assumes that there is one simple fact the explains the behavior. In this case “funds in Canada overcharge you” is implied. When comparing properly, there will be several reasons and the joint operation of all the reasons is necessary to establish truth.
The truth to be found is the answer to this question. Do persons that pay for advice end up with more money or less? How they get there is not very important.
While the Post stories are clearly not objective, even wrong, they may serve a purpose that has value. Advisers, pay attention. The defense to bad information is good information. Get busy. Develop your value proposition and then communicate both that and your price. To do so, you might find this useful. What do you get for the fund fees you pay?
Note: I have no practical reason to care about this subject but it is annoying to see rhetoric dispensed as fact. Sorry, but that is my personal preference. Others may prefer something else. Stephen Colbert’s “Truthy” comes to mind.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com
Follow on Twitter @DonShaughnessy
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No One Party Can Govern All Of The Time
As a politician, once you know that fact you can attempt the next best thing. Govern most of the time. That goal is an easy one because you do not have to be competent to implement it. There is a trick of course. You need to choose the times when you do not govern.
I should point out that this argument does not make sense in countries where the primary objective is to govern effectively. I believe there may be one of these still existing. The rest have gone to the dark side and governance has been replaced by politics. A poor trade.
Suppose there are two parties. With more parties, what follows is still true but the discussion is confusing.
In our confined discussion model, Party A is incompetent and Party B is not. By reason of their incompetence, Party A will govern most of the time.
I hear the cries of “WHY?”
It is simple really, incompetent parties do things and spend money politically rather than economically or socially. They do not recognize limits to how they can and should be involved. Evil may have a limit, but goodness has none.
Competent governments are more disciplined.
Incompetence gets votes because voters seem to get things for nothing. While I am not opposed to getting things, I recognize that it is impossible for everyone to have everything they want. Well-meaning cannot work forever. Recall that in the real world, a decision to have one thing automatically is a decision to not have something else instead. You, personally, can only use resources once because your resources are limited. Governments have more ways to get the money so can give both things for a lot longer than you or I. But, not forever.
As the result of their profligacy, the government of Party A must eventually raise revenue (taxes) to balance the budget. That is unpleasant for the voters, so in the short to intermediate run they borrow instead. The deficit is merely the amount they overspent this year. Deficits become ordinary and people seem not to notice. A never discussed and unpleasant reality is that a dollar the government borrows today is a dollar they must collect in tax some day in the future. Plus interest of course.
Eventually Party A cannot continue to spend and then to tax and/or borrow. Time to leave office. A smart Party A will leave just before they must reign in spending.
Their adversary, Party B, will win the election, partly because the people understand the limits, at least a little, and partly because Party A does not want to win. After all, who wants to be in the building as the roof falls in.
Party B will be in power when the consequences of Party A’s waste becomes obvious and they will be blamed for the problems because they are the government today. People seem to not notice that the effect of government policy takes years to become apparent.
Being competent, Party B will cut unneeded spending, and attempt to rationalize the budget. They will diminish the people’s expectation of government largesse, promote growth and hope for higher tax revenues. Eventually things turn around, the budget balances, and prospects for the future are exciting.
Time for Party A to reappear.
They can promise things again because there is a likely supply of money. Party B will be seen to have been the source of the pain and to be uncaring ogres and fiscal fascists for fixing it. Not a particularly desirable platform. Reason never sells. Party A wins and will get credit for the resurgence. They will govern until the roof again begins to creak.
And the cycle repeats.
What I have outlined above, as incredible as it sounds, is the good case. What we have now is worse. There are zero competent parties.
In no longer matters much who wins. People want more than they can have and the government will do little about changing that. No reason they should. A large share of the people do not recognize the problem or are too wedded to the handouts. Their votes won’t change anything. They get apparently free things.
It is disturbing. Consider this; more than one in five thinks the government has their own money. They have missed the fact that the government’s money is the people’s money.
As long as the people are not competent voters and as long as the parties value politics over governance, the result is both inevitable and unpleasant.
In homage to Herb Stein’s Law. “A thing that cannot go on forever, will stop.”
Corollary to the law – Usually catastrophically.
Be prepared.
You might find this interesting. Incentive Traps
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com
Follow on Twitter @DonShaughnessy
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On Personal Budgeting
A personal budget is a financial plan that covers a short period of time. Typically a year, but there is nothing sacred about the time period. It is quantitative and it relies on limits. Two limits. How much will you spend, and how much is to come in.
The budget is the link between your long term plan and today. No long plan is complete until you know what you need to do today to make it happen.
There are rules.
- You cannot spend more than you bring in, at least not indefinitely.
- If you overspend now, you must underspend in the future, because you must pay back what you borrowed. You must underspend by the interest. This is a hard one. Many do it painlessly for a long time. Hyperbolic discounting makes it seem okay. Why do you suppose furniture stores have a huge space between purchase and the first payment?
- Not all months look the same. You need a fund to handle lumpy expenditures. Because there is money left over this month says nothing about whether it is extra. It could be next month’s car insurance bill.
- Build the budget the way you pack the trunk of the car. Bigger, more rigid things must be placed first, because there are fewer options for them. Some spending is certain (rigid) and other spending is not (flexible.) In a budget, build in the essentials before the optionals. Food and shelter before new and pretty shoes. (Even if they are on sale) Similarly, the kid’s clothes before the golf balls or the beer.
- Know what you spend money on now. You cannot budget effectively until you know. People who do not know, can create theoretically perfect budgets and they usually stop paying attention to them in the first 2 months.
- Know plan B. If your income falls or stops, or a necessary expense increases, how soon and in what areas does the budget change?
Preparing the budget is not the important part. The comparison of the plan to actual is important but the most important part is what do you do about deviations from the plan. This like a test in high school. Not fun but you learn from your mistakes. No one gets there first budget right. Not the second very often either. Persistence pays.
People who do budgets regularly and govern themselves by the plan usually end up okay. Many of the others do not. Many of the others fail for a simple reason.
You cannot spend the same dollar twice.
When you think about it, that is the essence of budgeting. Budgeting is about unique preplanned choices. That is the problem for most people who fail. They don’t like the limits that budgets impose. They have failed to recognize a fundamental fact. When you spend on A it automatically means you have decided to not spend that money on B or C or any other attractive choice. Some people do not recognize the “decided not to” part of the decision. Some think it is still open for discussion. It is not. You cannot spend the rent money at the track and still pay the rent.
Some people don’t get the concept. You cannot have it all unless you are very wealthy indeed. I have been told that the thinnest book in the world is, “Things I Cannot Afford To Buy, by Bill Gates” The rest of us have rather thicker versions on this subject.
Is it possible to get more with what you have for resources? Of course, but you need to work at it. I don’t know whether extreme couponing works if you consider all the inputs; but shopping for lower prices probably makes sense and most of us can do it.
Consider replacements. There are good quality, white label, substitutes for many routine things. For many years Michelin designed and built Sears tires for about half the price. May still, I have not checked.
Avoiding interest works but it requires discipline. Just because you can borrow the money doesn’t mean you should. Things like education and houses will tend to create debt and are exceptions. Other than those, you probably don’t need whatever it is that you are borrowing for – right now. Borrowing for a vacation for example. Take a cheap one this year and put aside during the next year what would have been the credit card payments had you taken the expensive trip. Then pay cash for your next trip. Continue to put money aside for the one following. Given credit card interest rates you would likely get a free trip about once every 10 years.
Creating the budget is not fun and adhering to it is even less fun, but the payback will make it worth the trouble.
You might find these useful:
Compare and Contrast Distant Elephants
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com
Follow on Twitter @DonShaughnessy
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Value Is In The Using
Is a possession you do not use of any value?
- Knowledge is of no value unless you put it into practice. Anton Chekov
- A man who does not read has no appreciable advantage over the man who cannot read. Attributed to Mark Twain and several others.
- Everyone should put several $100,000,000 aside for a rainy day. Henry Ford, 1928
- You can live as well with $4 billion as you can with $12 billion. Craig McCaw
I think Henry Ford and Craig McCaw may live in different financial realms than I. Nonetheless I can understand their point. If you are wealthy enough, you only need some of the money you have to live as you wish.
What is the rest of the money for? Beware! A great deal of money is wasted because it does nothing. It is like potential energy, waiting for a purpose. No more useful than a battery in a drawer.
Maybe it is waiting for an opportunity, perhaps it is accumulating for a future acquisition, either business or personal, or maybe for a future expense like education or merely for security. For some, it is just there.
Financial security is nice but at what level? The more you have to look after, the more time and brain space is consumed in doing so. Perhaps the hermits and mystics have it right. Need less, have less, and use your resources to achieve only what you value. I am not sure I can do that, but I think there are a great many people who have, and have lived complete lives in the doing.
An analogy. If gardening becomes burdensome or takes time away from important things, reduce the size of the garden. Pretty obvious.
But what about security? How could you have too much? Better how much do you need and what could be done with the excess?
No one really knows how much. It is a little like tidying up your office. What should you throw away? The things you don’t need, right? But which are they?
With security, the first step is to define what the word means for you. For most people the intuitive idea of security is that the future is predictable and controlled within some margin of error.
There are several security issues to address:
- An event might happen and would be adverse financially if it happened. Something I don’t want to do or have. Medical emergency is first on the list. Automobile accident with a claim over the limit, child needs help, parents need help and more.
- Something that produces or will produce income for me that stops or reduces. An employer pension or a government benefit. Government benefits are not promises they intend to keep at any cost. These are things they will do if it remains expedient. If not, they will amend the rules. Some employers are not going to be able to pay what has been promised.
- One partner dies and the remaining pension income to the survivor is less.
- Income from investments may be different than expected. For those that retired in 1990 expecting to get 10% on government bonds life has been interesting.
- Capital can be irretrievably lost. Bernie Madoff comes to mind but weak investment decisions, especially ones made to overcome the lower interest rate environment are there too.
- Inflation and the tax system could be such that the after tax yield on investments is negative. You erode real capital each year even if the nominal capital looks to remain intact.
- Your spending on lifestyle may be more than you thought.All of these presuppose you know what your preferred cost of living looks like and you know how it will change. Not many actual know this. Guessing is common. Pay attention to the fact that as you age you lifestyle choices change too. Experience shows that beyond about age 80 lifestyle spending falls and inflation may be a non-issue.
- Yield fluctuates widely and you are drawing money. Early adverse swings may not affect the average yield over 30 years but they will affect you because your draws reduced your capital.
Knowledge is a part of the defense to margin for error. If you know enough about the dimensions of the possibilities, and have insured some of them, (shrinking the garden) then you can get a clearer idea of needs. You may need to do some research.
Facts trump assumptions.
You can model the capital that underlies the cash flow required to fund your life style for decades into the future and you should do it. You should probably do it under several contingencies.
- Everything turns out like I hope
- The after tax spread between yield and inflation is adverse
- Seriously adverse
- Spending is higher and I cannot reduce it
- A significant capital consuming event or loss occurs early on. It won’t have as much effect later.
What you will find is the capital needed to make your cash flow work. First the minimum; everything turns out as expected or better. After many trials, the worst, with the others between.
At the beginning you will need to see the capital that supports the worst case safely in your possession. If you revisit it every 5 years or so, the amount will shrink even with the same adverse assumptions, because your time of using it grows shorter.
Whatever you have in excess of this “minimum margin of error” fund is dead money. You will almost certainly never use it. If you spend any time or effort looking after it, it is practically, for you at least, a liability.
Like the Twain quote above, slightly amended.
A man who does not use his money has no appreciable advantage over the man who has none.
You might find this interesting. Stewardship
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com
Follow on Twitter @DonShaughnessy
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Taxes Due After Death
Lynne Butler is the purveyor of useful estate planning information. Her Blog “Estate Law Canada” provides good answers to questions that come up regularly and for some others that are rare. There is an extensive and searchable archive. You will benefit from her collection.
A recent one caught my attention. It deals with taxation and covers the ground for the majority of people. Taxes due when the second parent passes away.
It would be useful as a client handout and might help reduce the inevitable surprise that taxes payable by an estate engender in the previously uninformed heirs. A younger client might want to forward a copy to Mom and Dad.
In the client situation, facts, problems and opportunities are interesting. People will need to have an idea how to fix it as well as how to know about it. Offering implementable solutions is always welcomed.
A planner should help create the “irreducible minimum” for all of the demands in the estate. This means take the steps that are cost and/or cash reducing that are consistent with your preferred lifestyle, your tolerance for complexity and other life goals. Spending a two dollars to save one is not smart, even if it eliminates a tax dollar due.
Once the irreducible minimum cost is known, you can find ways to deal with it.
An adviser should address the matter of funding the liabilities that arises. In addition to taxes there are fees to myriad people. Lawyers, accountants, business and property evaluators, the courts and executors are some. These can often be 10% of an estate and should not be overlooked. There are some minimizing techniques available.
With income taxes, things like an RRSP or mutual fund can self fund the liability, but for other assets like cottages, rental properties and businesses, the liquidity must be created. Watch for promises, preferences, pledges and guarantees while estimating the needed cash.
Do not make the mistake of treating the irreducible debt, fees or taxes as problems. These are not problems, they are merely facts. The problem in an estate is finding cash to deposit so that the executors can write the necessary checks.
All estate plans need to address liquidity and the distribution plan of any estate needs to be based on what is likely to remain after costs and taxes and the liquidation of other obligations.
Be prepared. The net amount is, not infrequently, much less than people expect.
Your will gives you the necessary clue to how things will work out. Follow the logic. The form of your will shows that the executors are to find the assets, pay the liabilities, costs, and legacies like charitable donations, and then distribute the rest to the heirs. Despite the clarity, many people intuitively plan around the idea that they can distribute what they own intact. Seldom true and that rarity can, does, and will in the future, create problems.
Every estate distribution plan is multipart. 1) Discover the assets owned, 2) go through the hoops imposed by the courts, 3) liquidate the liabilities, fees and specific bequests that arise, and finally 4) distribute to heirs.
Miscalculations or inability to meet step 3 will delay and probably reduce step 4. No executor has ever complained about having more cash than they need, but many have problems with a shortfall.
Understand how liquidity will come to be. There are only four ways the executor will have that cash to meet the obligations. (Exactly four.)
Two are controlled by the deceased and two are controlled by the executor.
Controlled By The Executor
- Sell Something . Typically, time is of the essence and they will need to sell the best and keep the rest. Does “Estate Sale” imply a bargain? Then there are the costs and the time it takes to sell complex assets for full value. Estate shrink and added costs.
- Borrow tends to tie up the estate for much longer than the heirs might prefer. You will need to pledge almost the whole estate to get 25% of it as a loan. The interest will be non-deductible for taxes. Delay and some shrink.
Controlled by the Deceased
- Own liquid assets before death. This method has high tax costs and low yields while living. There is a material opportunity cost with this one. Owning liquidity is typically the most expensive way to solve the problem.
- Own life insurance, possibly second to die life insurance. When you arrange life insurance, it is merely a post-dated check with an unknown date of payment. In the estate need situation, the date is, coincidentally, the same day the executor needs the money. In almost every case, it is less costly than any of the other three alternatives. Provably so. You might want to check it out.
You can try to anticipate what is likely to occur and find good ways to deal with the deficiencies. If your estate is more than minimally complicated, then you might usefully work with your accountant or other advisers and “Test your will.” Preferably pre-mortem. It is a bit technical but in the end little more than a big arithmetic question.
Get busy. You have the information at hand and know your wishes. Your executor and your heirs will know less. Guaranteed.
Well prepared usually leads to well done.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com
Follow on Twitter @DonShaughnessy
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