The Snows of Kilimanjaro inspired my cousin Charles many years ago. He has long dreamed of climbing the mountain. The possible demise of K's snowfields finally inspired him to action: Charles, my sister Penny and I will be climbing Kilimanjaro in January 2010. I'm already in training (compliments about my new slim figure are always welcome). We have scheduled our Spring Training for this April. Our K Adventure will get the green light if Charles can handle the altitude in the Colorado mountains.

Wasootch Ridge, Kananaskis Country

Preparing for Retirement

• Your time horizon is at least 30 years. Inflation will more than double over 30 years.
• Since you don't know how long you'll need the income, I recommend a maximum 6% withdrawal rate (0.5%/mo) from an RRSP/RIF/LIF as being a rate that is both sustainable and gives you the possibility of inflation protection. Once the RIF minimum withdrawal exceeds 6%, the excess should go into a TFSA (see below for an explanation). I do not recommend a deliberate drawdown of your retirement savings for normal living expenses. This policy gives you available cash for unplanned pleasures (a Mediterranean cruise, perhaps?), unexpected emergencies (new roof on the house; new car) or to give your grandchildren a little extra when they start college.

If you don't have a pension plan, a life annuity can serve as a substitute. Annuities are offered by life insurance companies. In exchange for a lump sum, the life insurance company contracts to provide you and your spouse a fixed, continuing, monthly income for the rest of your lives. The payments are ultimately guaranteed by the insurance equivalent of CDIC.

At current interest rates, $100,000 placed into an annuity will give a 60-year-old male a lifetime income of around $625/mo. The more practical option may be a joint last-to-die annuity, with payments rising over time with inflation. $100,000 placed into a joint annuity indexed at 2% will give a couple both aged around 60 an initial income around $400/mo (rising by 2% each year).

These quotations illustrate the incredible value that a government pension offers to a civil servant. Angela recently retired from teaching. She qualifies for an indexed $4,000/mo pension. Her sister, Adele, worked as an interior designer, and has no pension. Adele needs to have a $1 million RRSP to get an annuity income that is equivalent to Angela's pension.

Balanced Portfolio 1
A balanced portfolio is suitable for someone who can accept that their pension account value is likely to fluctuate because the money is exposed to the vagaries of the financial market. They also want to leave an estate for their children or for charity.

Balanced portfolios are a mixture of stocks and bonds, with stocks usually representing between 30 and 70% of the portfolio. Other assets, such as rental real estate, may also form part of the mix.

In today's low interest rate environment, portfolios with a high GIC or fixed income weighting will generally not be able to meet the income needs of the pensioner. Let's take Canada's oldest balanced mutual fund as an example. This fund started in 1950, so has a 58 year track record. This particular fund is not on my recommended list, but we'll use it anyway because of that long track record.

Chart 1 shows the effect of targeting a withdrawal rate of 6% of the portfolio value each year. After a good year, we can increase the dollar amount of the withdrawals; after a bad year we keep the same withdrawal level.

Chart 1

From an initial portfolio value of $100,000 the account has grown to over $200,000 (at the end of September), despite taking cumulative withdrawals of $737,000. The retirement income withdrawn from the portfolio has grown from $500/mo in 1950, to $1,400/mo in 2008.

Despite taking 6% or more out of the portfolio each year, the monthly withdrawals and estate value have grown at an average rate of 1.8% per year.

I've done some stress-testing on this and other balanced portfolios. There has never been a starting point from which the balanced fund "blows up" and is unable to support a 6% withdrawal rate. In 1973-74 this balanced fund had consecutive annual returns of -4.7% and -19.0%. Even someone who had the unfortunate luck of beginning retirement on 1 January 1973 would not have had to take a pay cut!

I conclude that a well-managed balanced portfolio can support a 6% withdrawal rate. With luck, retirement income may be able to rise in line with inflation.

Balanced Portfolio 2: T-SWPs
There's a special class of mutual funds offered by most fund companies that deserves a mention on its own: T-series mutual funds. These are funds designed to deliver tax-efficient monthly income from non-registered portfolios.

They are tax efficient because the distributions are considered to be Return of Capital (RoC), rather than interest, dividends, or capital gains. A RoC distribution is not taxed in the year received; rather RoC reduces the adjusted cost base of the investment, and will result in a potential capital gain when the investment is eventually sold.

Most mutual fund companies have their balanced funds and more conservative equity funds available as T-series.

Income ranges from 5% (T5) to 8% (T8) of the asset value at the start of each year. Income can fluctuate each year, depending upon the performance of the fund in the previous year.

The wonderful thing about the cash received from a T-series fund is that you don't have to report RoC income on your tax form. T-SWP income does not affect means-tested government benefits such as the OAS or Alberta healthcare premium subsidies. Low-income seniors with a small income from GICs or bank interest should definitely switch their investments to T-SWPs. So should higher-income seniors who are impacted by the OAS clawback.

I use T-series funds as the core product in my clients' investment lending portfolios. The income covers the monthly interest costs, with a little left over to apply against the loan principal. The loan interest is deductible for tax purposes, but we don't have to report the income!

Guaranteed Retirement Income products (GRI) are complex. There's a very great danger that clients don't really understand what they are buying. The GRI has 2 phases: an Accumulation phase, and a Withdrawal phase. Let's look at these separately.

In the Accumulation phase, you can invest your funds in any of a wide choice of fixed income or balanced funds. Because of the guarantee, it makes sense to invest as aggressively as allowed.

The insurance company guarantees that if you leave your funds untouched for 10 or more years, you will obtain the higher of the market value or a 5% simple return on your investment. The plan allows resets every 3-5 years if the market value exceeds the Guaranteed Minimum amount.

Suppose you put $100,000 into a GRI product, and left it for 10 years. At worst, the account value will be $150,000 ($100,000 initial capital + 10 x $5,000 per year) at the start of the withdrawal phase.

In the Withdrawal phase, the insurance company guarantees that you can take out 5% of the account balance at the start of the withdrawal period for the rest of your life.

Using the worst-case example shown above, if you have $150,000 at the start of retirement, the insurance company will guarantee an income of $7,500/yr for the rest of your life. Never, ever, withdraw more than the guaranteed minimum in any year! Doing so will destroy the guarantees that you bought the GRI for in the first place.

It makes sense to invest a GRI fairly aggressively even in the withdrawal phase. If the market returns prove to be greater than the withdrawals, the GRI resets every 3-5 years, and your guaranteed minimum withdrawal will rise. With luck, you should be able to get a 5% withdrawal rate on your retirement capital, rising more or less in line with inflation.

GRIs are an interesting and valuable tool. In effect, they are a perpetual fixed income investment yielding 5%, with potential for increased returns depending upon the performance of the underlying investment. Because of the guarantees, they may encourage someone to invest a little more aggressively than they would if they were investing in a non-guaranteed balanced fund.

A GRI is a perpetual fixed income investment yielding 5%, with potential for increased returns depending upon the performance of the underlying investment.

You may have noticed that my research showed that a 6% withdrawal rate is sustainable for a balanced portfolio, while the GRI only guarantees a 5% withdrawal rate. The difference is the fee. The life insurance company tacks a fee of approximately 0.8%* onto the management fee of the underlying investments. Call it the cost of peace-of-mind.

*This fee is fixed for current contracts. However, I expect that sometime in the near future the guarantee is going to become much more expensive as a result of the current market turbulence. If a GRI sounds interesting to you, you'll need to make a commitment in the very near future!

Life Cycle Funds

In the early years, the portfolio will maximize the equity weighting in order to take advantage of the growth opportunities that stocks provide. Over time, the bond weighting will increase. This makes the portfolio less susceptible to the vagaries of the stock market as the time when the funds will be needed approaches.

Life Cycle funds were originally developed for the 50+ Baby Boomer crowd who want some assurance that their investment portfolio will be there for them when they retire. The last 5 years before retirement and the first 5 years after retirement are the most critical for those who are responsible for their own retirement savings. We've recently seen how devastating a market pullback can be for retirement savings! They are also useful for RESPs, which also have a definite date at which the funds will be needed.

A couple of investment companies have Life Cycle products with "rear view mirror" guarantees. The guarantee says that the fund will mature on a known future date at the highest value ever reached by the fund, even if that price was reached before the investor purchased the fund. For example, with the recent market pullback one 2020 Life Cycle fund is available at $10.37 while the guaranteed value at maturity in 2020 is $12.95 - a 19.9% discount!

A long-dated guaranteed Life Cycle fund, purchased now at a discount, could be an interesting purchase option in these uncertain times.

Tax Free Savings Accounts

• Individuals can deposit $5,000/yr into their TFSA, with no spousal attribution rules. The eligible maximum is supposed to increase each year;
• Unused contribution room accumulates;
• Unlike an RRSP there is no tax deduction for a TFSA contribution;
• Interest, dividends and capital gains accumulate within the TFSA on a tax-free basis;
• Withdrawals from a TFSA do not attract any tax;
• TFSA withdrawals do not affect the annual contribution limit. Furthermore, the withdrawal can later be redeposited, also without affecting the contribution limit.

• Saving for a major purchase - interest on funds in a TFSA savings account won't get taxed;
• Retiree - required withdrawals from a RRIF that are in excess of the funds needed for living can be placed in the TFSA and not attract further taxation;
• Estate Planning - funds in a TFSA will not be part of the "final tax return" and can be passed to heirs tax-free.
• Income splitting - TFSA is a way to get $5,000/yr into a low-income spouse's hands.
• High-income Individuals - while there is no tax deduction, the investments in the TFSA won't get hit by tax on the investment returns.
• Low-income students - deposit any extra funds (or funds from parents) into a TFSA, then withdraw the money in higher-earning years for deposit into an RRSP.

Where We Are

We're now into the season when stock market returns have traditionally been the strongest. We shall see whether this year holds up to tradition.

Table 1 indicates how we were doing up to the end of September. The bottom of the market was October 10. Believe it or not, the Canadian stock market was up 8.7% over the last 3 weeks of October, while New York was up 6.1%. The devastation has been everywhere. The Globe & Mail balanced fund average, which serves as a good benchmark for most client portfolios, was down -8.5% to the end of September.

Bonds are holding up. The fall in the looney has really helped the returns from foreign bonds. Canadian short term rates have fallen but long term rates rose substantially, thereby giving muted results to the overall bond index. The fall in commodity prices has relieved any possible inflation worries, and interest rates are on their way down all around the world.

2008 Returns to 30 September

MSCI: Morgan Stanley - Capital International
EAFE: Europe, Australia & Far East
SCM: now DEX Bond Indexes
Globe: Globe & Mail

Raising taxes and tightening credit are surefire ways of creating a Depression from a Recession. Dr. Bernanke received the nickname "Helicopter Ben" when he facetiously suggested that the best way to avoid a depression would be to shovel $100 bills out from a helicopter!

You'll note that central banks all around the world have been doing precisely that. The only difference is that so far all the money has fallen into the vaults of the chartered banks!

The earnings from Canadian corporations reached an all-time high this week (red line on Chart 2)! How can that be? The TV and newspapers are full of devastating news of plant closures and layoffs and people tightening their belts from the hard times. Perhaps we need to be reminded once again that bad news sells newspapers.

Things aren't nearly as bad as they seem, particularly in Canada. Employment was another piece of data that was positive last week. Canada now has an unemployment rate below that of the US.

Chart 2

The record earnings reflect the recent high energy prices that stuffed the wallets of the oil companies. We'll likely see a drop going forward. The energy trusts are already cutting their distributions in anticipation. This shows up as a drop in the gold line on Chart 2.

Chart 2 shows that the US corporate earnings and dividends are continuing to fall. Many other indicators are also weak in the US, but it must be emphasized that the drops are nothing like what was experienced in the early days of the Great Depression.

The Toronto Stock Exchange was formed in 1919. Chart 3 shows the entire history of the TSX Index.

Chart 3

The slide from September 1929 to June 1932 was a terrible event. However, you'll also notice that it was preceded by the greatest stock market bubble that has ever taken place! In the 5 years from 1924 to 1929, the TSX tripled, for an average annual return of 25%. The Roaring Twenties were certainly roaring! In fact, the lows reached in the middle of the Dirty Thirties just returned the index to the level it was at 10 years prior. I would argue that the stock market collapse from 1929 to 1932 was, at least in part, a consequence of the "irrational exuberance" of the previous 5 years.

We have never had a bubble even remotely similar to 1924-29 since. (NB: while Canada hasn't had another triple over 5 years, the US has: from 1994-99. The 2000-2002 Bear removed half of that bubble; we may be in the process of wringing out the rest of the excess right now).

Many of the laws and regulatory bodies that govern banking and finance were developed in the 1930s. The result has been a substantial difference in stock market behaviour and performance before and after the Depression. I've drawn a trend line onto the market data in Chart 3.

Since the end of 1931, the TSX has grown at an average annualized rate of 6.6%. The stock market growth rate has a basis in economics. The stock market cannot grow faster than the economy as a whole, and a developed economy such as Canada has real growth of roughly 3%/year. Add in inflation at 3% and productivity improvements at 1-2% per year. The result is the long term 6.6% growth rate shown by the TSX in Chart 3. Once dividends are added, the return from Canadian equities has averaged very close to 10%. Every developed economy in the world has a long term stock market return (including dividends) of roughly 10%.

Stock markets fluctuate. However, they seem to fluctuate within boundaries. I've marked lines on Chart 3 that are 20% and 40% below the trend line. Most bear markets, including the 2000-02 and 1991-92 bears, reversed course at the -20% level. That's about where we are right now. However, the really bad Bears of 1941-42, 1973-74 and 1981-82 touched the -40% mark.

We cannot predict the stock market. We may have seen the worst already; we may see new lows. No one - absolutely no one - has any clue about what 2009 will bring. Chart 3 does bring home strong evidence that the stock market will recover, and that the best time to invest is when the market is trading substantially below trend - as it is right now.

Some may argue that economies cannot continue growing at 3%, so therefore the stock market will never return to the trend line shown in Chart 3. To argue this is to deny technological progress that continues at an ever-increasing rate, and that China, India, Brazil, Russia, and all the other newly-industrializing countries won't continue to develop. Globalization will bring challenges and change; it does not have to bring stagnation.

The US economy represents more than 1/3 of the global economy. (Europe is another third, and Japan dominates the remaining piece. China has less than 10% of world GDP.) The health of the US economy is critical to the health of the world economy. Unfortunately, the US is not very healthy right now.

The US consumer represents 2/3 of the US economy, and the spending of US consumers has been fueled by debt. In particular, US policy has encouraged homeowners to have as large a mortgage as possible on their residence. In a land where mortgage interest is deductible and it was easy to refinance, it made sense for homeowners to either take out a home equity line of credit or renegotiate their mortgage.

Chart 4 shows that in 2005 and 2006, US homeowners were pulling equity out of their homes at a rate of $2 billion per day. The chart also shows that those happy days are now over.

Chart 4

At a time when 20% of all mortgages are now under water (the mortgage is higher than the value of the home), mortgage equity withdrawals (MEW) are virtually non-existent.

The impact of MEWs on the US economy was substantial. Chart 5 indicates that at its peak MEW represented an additional 3% top-up to normal US GDP growth. John Mauldin, who supplied this data, commented that George Bush would not have been re-elected in 2004 if the economy had been struggling along without that huge MEW boost!

Chart 5

The US economy isn't going to grow strongly until the US consumer can get back to spending freely once again. That won't happen until house prices have returned to levels where the home can serve once again as an ATM. And that won't happen until the surplus of unoccupied new and foreclosed homes in the US has been absorbed through new family formation and immigration. And that won't be for another year at minimum!

This week Jeff Rubin, chief economist at CIBC, put another wrinkle on this story. In his view, much of the economic difficulty that the whole world is going through can be blamed on high oil prices. High energy prices effectively served as a huge tax hike that pulled money from the wallets of consumers. Now that energy prices have fallen by 50%, consumers will see a marked jump in their available cash, and rush out to spend it! It's an interesting theory, but I don't buy the argument.

You may think that in a slow-growth or no-growth environment it would not be prudent to hold stocks. Not so. The stock market is a leading indicator, and when investors collectively decide that the market offers good value the next great bull run will start, irrespective of the prevailing mood. Edwin Lefevre, writing in 1923, put it this way:
Not even a World War can keep the stock market from being a bull market when conditions are bullish, or a bear market when conditions are bearish.

Where We're Heading

Chart 6

Chart 6 needs an explanation. The blue line shows the Commodities Research Bureau Index in US dollars. The yellow shaded zones indicate the times when commodities are strong, as indicated by a rising CRB Index. The red line shows the relative performance of the Canadian stock market (in US$) versus the US stock market. The red line is rising when Canada is out-performing; the red line is falling when the US is the stronger market.

First let's look at the unshaded portions of Chart 6. These mark times when commodity prices are weak. Note that in every case the red line falls - the US market outperforms Canada when commodity prices are weak. Now let's look at the shaded areas on Chart 6. Here we see the opposite. The red line rises in the parts of the chart shaded in yellow: the Canadian stock market out-performs the US when commodity prices are strong. There is only 1 exception to this rule. Mr. Chrétien just about lost the whole country in the 1995 Quebec referendum. I think that this might have had a bearing on Canadian stock prices at the time.

The CRB Index is falling. We're in an "unshaded" portion of Chart 6. True to form, the red line is also falling. This indicates that non-Canadian, or more specifically US, stocks are outperforming Canadian stocks, primarily because of the fall in the Canadian dollar.

Until commodity prices strengthen, the US stock market will outperform Canada.

Currency
The looney is a petro-currency. After a couple of months in which it seemed in which the oil and currency markets weren't talking to one another, the looney, at 84¢, and the oil price, at $61/bbl, have resumed their former relationship. See Chart 7 below:

Chart 7

Interest Rates
Bond yields have stabilized at just over 4% (red line on Chart 8), while short term rates such as T-Bills (green line) continue to decline. The Canadian Prime Rate is now 4%, versus 6.25% just a year ago. That trend may continue in the coming weeks as central bankers around the world try to cope with the US financial mess. This week the European Central Bank dropped its prime by ½%, while the Bank of England dropped its rate by an astounding 1¼%, to just 3%.

Chart 8

I think that it is safe to say that the central bankers are no longer worried about inflation. There is little or no chance of rates going up in the next while. On the contrary, bankers will be worrying about keeping the global economic system functioning, and are likely to continue to drop administered rates, perhaps substantially.

Stock Market
There's no sense sugar-coating the huge drop that stock markets have undergone over the past while. It is both the speed of the drop - most taking place in September and early October - and the huge volatility both up and down that is so unnerving. It is impossible to do any rational financial planning when we can have swings of more than 5% in a day. If you're a glutton for punishment, Table 2 indicates the extent of the carnage. If it is any consolation, Canada is performing best in terms of both magnitude and duration.

Table 2

Drops of this magnitude are rare. History has shown us is that while times like this are tremendously destructive of our wealth on paper, they also represent once-in-a-lifetime buying opportunities for those willing to invest.

Chart 8 reinforces this positive view. You may recall that Chart 3 indicated that Canadian corporate earnings are at an all-time high. Record earnings plus a 36% fall in market price has resulted in an astounding earnings yield (blue line) of greater than 9%, versus just 4% for bonds. Dividends (brown line) have fallen back from record levels, but are still approaching 4%. This is much higher than treasury bills, and is approaching the level of bond yields.

The Canadian stock market is paying us to wait for stock prices to rebound. Up until 1958, it was considered normal for dividend yields to be higher than bond yields. After all, dividends were uncertain and risky. We may well be going back to the future!

Opportunities Amid the Rubble

Guaranteed Retirement Income Portfolios
You may want to reread my earlier section on this topic. The GRI permits a wide variety of possible investments, and the insurance company guarantees a minimum 5% simple interest return during the accumulation phase. We should do much better than that when markets recover. The GRI is too good a deal for the customer, and fees are likely to go up. Buy now!

Flow-Through Shares
No sector has been devastated to the extent of junior mining shares. The sector is so desperate for exploration and development cash that junior companies are offering flow-through shares at zero premium to their common shares. If you're a believer in Buy Low, Sell High, this is for you, particularly when Steve in Ottawa picks up half the tab! The flow-throughs that I have on offer will be sold out by the end of November.
Buy now!

Dividend-Paying Stocks
A Royal Bank 5-year GIC pays 2.6%. Royal Bank stock pays a 4.2% dividend. Which is the better deal?

My favoured GIC supplier pays 4.6% for a 5-year compound-interest GIC. The Financial Post lists the TSX Top 100 companies; 27 out of the 100 pay a dividend higher than 4.6%.

I mentioned earlier that we can expect US stocks to perform better than Canadian stocks when commodity prices are weak. According to the CNBC stock screener, there are 543 companies listed on the New York Stock Exchange that have a dividend yield higher than 4.6%!

The shares of the most blue-chip companies have been beaten down to seemingly ridiculous levels. I favour mutual funds that specialize in US and global senior dividend-paying companies.

Corporate Bonds
The financial crisis has caused a flight from corporate bonds to government bonds. The massive selling has pushed down bond prices, thus pushing up corporate bond yields.

Chart 9 shows the spread between BAA-rated corporate bonds (the lowest investment-grade classification) and 10-year US Treasury bonds. The bonds of very strong corporations - many are household names - are now trading to give a yield of better than 9%. Non-investment grade corporate bonds - those with ratings of BB and B - are now trading at spreads of 15% above Treasuries, giving a yield of virtually 20%. This is extraordinary. That kind of yield spread suggests that most Canadian and US companies will be going bankrupt over the next while - a scale of devastation not matched even during the Depression.

Chart 9

Chart 9 indicates that spreads normally widen during recessions as the fear of default increases. The spread compresses once the recession is over and default fears subside.

This can provide extraordinary gains for bondholders. In fact, as shown in Table 3, corporate bonds with ratings from BBB to B give the highest risk-adjusted returns of any investment asset class!

Table 3

I do not recommend buying individual bonds. Bond ratings are not perfect. It is better to pay a bond manager his fee to conduct his own credit analysis and manage the default risk.

A Pretty Spot in the Foothills

Fall Colours in Calgary