I Will Invest Your Money like a Pension

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1 I Will Invest Your Money like a Pension Beware of this loosely used marketing term By: Susan Mallin, Certified Financial Planner Contact susan.mallin@steinbergwealth.com or Susan Mallin is a Certified Financial Planner and Chartered Investment Manager with over 17 years of experience. She is also knowledgeable in cross border issues for US citizens living in Canada, as well as Estate Planning for Canadians.

2 I Will Invest Your Money like a Pension Beware of this loosely used marketing term. A few years ago, I met a couple (I ll call them Bill and Sally) at a wedding. When they found out what I did for a living, they began telling me the struggles they had in the past with their investments and how they decided to fix their problem. Determined not to make similar mistakes again, Bill and Sally spent countless hours looking for a new financial advisor. They wrote a detailed financial summary of their situation along with a list of questions, and ed it to approximately 15 different advisors. They short listed their favorites based on the responses they received and set up personal meetings. I congratulated them on their efforts and asked them how they eventually made their choice. Sally indicated that because they wanted to retire in the coming year, they chose the advisor who told them the following: I will invest your money like a pension. Not wanting to spoil the mood, I just smiled and said good for you. But what I wanted to say was you have just been sold on the classic equivalent of a financial advisor pick-up line. I will invest your money like a pension or pension style investing is a safe way to manage your retirement assets are common marketing terms used by many financial advisors. These lines sound good and they make people feel comfortable and safe, as they sound like low-risk propositions to achieve an unending and reliable flow of income regardless of what the market does or how long they live. The reality is that your personal savings and investments do not have the same mechanisms or characteristics as a pension fund. The biggest difference being, the constant in-flow of cash coming from the current working contributors to help offset current pension payments. In fact, when looking at the Canada Pension Plan (CPP), 75%-80% of contributions are expected to finance benefits, and investment growth finances the balance. Now that Bill and Sally are retired, there will not be any further contributions to their savings and, unfortunately, rules prohibit a pool of random strangers to continuously contribute to their retirement plan. Another reason why it is difficult to mimic pensions surrounds the type of investments, and the extralong-term nature these investments are projected to be held. Often, it is up to 25 years before any income is expected from any single investment. This does not fit well into the reality that we humans have a limited retirement life span (25-30 years) and income is usually required on a regular basis immediately upon retirement. Many pensions make multi-million dollar transactions and invest in large scale private equity, which is out of reach to regular investors - making it difficult to copy the investments within investment portfolios. In most cases, a typical financial advisor does not even have access to the same institutional markets as pension funds. Considering that we cannot copy the same incoming cash flows, the private equity and debt (to the same extent), is there anything we can do that would be similar to the way large pensions invest? The answer is YES, but I will not call it pension style investing as that would be misleading. In fact, it should just be called a diversified, well-constructed, risk-managed, monitored portfolio, with a large dash of financial planning, which is what all investors and financial advisors should strive for.

3 Using the Canada Pension Plan (CPP) as my main example, here is how we can achieve some of the same attributes that make it a diversified, well-constructed, risk-managed, monitored portfolio, with a large dash of financial planning : 1) Diversification Starts with asset allocation. Back in the year 2000, the CPP asset allocation was 95% fixed income and 5% equities. Today, the pension looks vastly different: 49% equities, 34% fixed income, and 17% real assets.. FIND YOUR OPTIMAL ASSET ALLOCATION Further Diversification This is achieved within the asset classes. The CPP could be considered a global fund now, with 31% Canadian assets and 69% foreign. In fact, they plan to add more foreign investments going forward. DIVERSIFY YOUR PORTFOLIO GLOBALLY Even Further Diversification They achieve more diversification with alternate asset classes, such as private equity (for equities) and private debt (for fixed income). Today, 41% of the entire portfolio is invested in private investments, such as part ownership of Neiman Marcus (luxury retail stores), or Royal Bank Plaza in Toronto (a real estate example).

4 2) Well-Constructed Portfolio Portfolio construction has a lot to do with how the investments are combined as a function to reduce single asset risk. Once the initial asset allocation and diversification strategies have been determined, the dollar amount per individual investment selection is analysed (also known as portfolio weightings). The individual investment weightings in the CPP are on the small side, which significantly reduces risk. For instance, the $219 billion dollar CPP fund has 17.7% assets allocated towards real estate. Within this, the fund owns 140 various real estate holdings located in 33 countries around the world (42 office towers, 73 retail malls, 17 industrial assets, and 8 multi- family buildings). If everything was equally divided, it would amount to 1.2% weighting per investment. By having smaller weightings, it reduces single investment risk if one investment goes to zero, the fund will not be severely damaged. WATCH YOUR WEIGHTINGS. HIGH CONCENTRATION AND HIGH CONVICTION PORTFOLIO ARE GENERALLY MORE RISKY Expected Returns are part of forming a wellconstructed portfolio. In the above example, I assumed that the 140 real estate investments were equally weighted in the portfolio but in reality, that is doubtful. The decision on how much to buy of an investment is based on the expected risk/return. In the real estate example, I might start with a smaller weighting if the expected return is very good, but the risk is high - such as a new shopping centre in an emerging economy. Conversely, I might have a higher weighting on an investment that has a lower, more predictable and less risky return. The decision on weightings for each asset class is also similar. In fact, the problem with traditional asset allocation strategies is that they do not often consider the expected rate of return given the inherent risks going forward. The asset allocation models some advisors/firms use to construct a portfolio are derived from simple software programs using historical returns per asset class, which might not repeat going forward. 3) Risk Management - Total Portfolio management approach is part of the risk management Continuing with the CPP as our example, for every investment considered, the managers attach a degree of risk to it and assesses the impact to the portfolio. For instance, if a new private investment is being considered with a 30% degree of risk attached to it, they would sell $1.30 of a similar public equity for every $1.00 purchased of the new private investment and keep the extra $0.30 in cash to hedge against the specific investment risk. OWN A HOME OR RENTAL PROPERTY. IF YOU OWN YOUR OWN BUSINESS THAT S YOUR PRIVATE EQUITY. THERE ARE SOME PRIVATE EQUITY FUNDS FOR ACREDITED INVESTORS (NEED HIGH RISK TOLERANCE AND A LONG TIME HORIZON)

5 Sometimes an investment displays characteristics of both equity and debt, such as real estate or infrastructure assets. In this case, they would sell a proportionate amount of public equities as well as fixed income to fund the new purchase. BE AWARE OF SECURITY RISKS ASSOCIATED WITH EACH INVESTMENT Currency Hedging as part of risk management When investing globally, one of the various risks is currency risk. Valuations and volatility of various currencies can impact the returns of a portfolio either negatively or positively. As Canadian residents, we will most likely spend our money in Canadian currency once retired. Many people use that reason as their decision to hedge currency exposure. But, looking at it differently, we know most other countries that invest in Canada prefer to hedge away their Canadian dollar exposure, as they perceive our currency too volatile and strongly pegged to the price of oil. The CPP managers feel the same way, as they prefer to have a wide variety of currencies and believe it is prudent to diversify away from the Canadian currency when possible. They agree that the Canadian dollar is highly linked to oil which attaches a dominant and uncertain influence. However, the CPP managers hedge the currencies on the global fixed income portion of the portfolio. This provides for known and stable cash flows and also serves as a reasonable substitute for Canadian bonds. In fact, we do the same thing at our firm. Our High Yield Bond portfolio is currency hedged, whereas our Global Equity portfolios are not. 4) Monitoring the Portfolio Once investments are made, there is continuing accountability and a framework to ensure the investments are performing as expected. The CPP employs several hundred people, both internal and external, with different investment expertise to monitor the investments. BUILD YOURSELF A TEAM OF EXPERTS YOU CAN GO TO FOR INFORMATION

6 5) A Large Dash of Financial Planning Financial planning is the ongoing process of evaluating the effectiveness of various assets and the investments that will provide for a desired financial outcome in the future. It is an exercise in math and forecasting. Variables such as performance, inflation, and longevity (among others) are used to forecast different possible outcomes. The variables have a very large impact on the financial outcome, and because they are subject to change, it is important to recalculate the mathematics of the plan when certain assumptions become known facts such as performance for the latest year. The CPP uses an Actuary (a mathematician who specializes in probable outcomes of financial risk and uncertainty) to evaluate and re-crunch the numbers on a regular basis sort of like a financial planner on steroids. Based on the latest analysis, the Chief Actuary for the CPP has stated that the fund is sustainable at the current levels of contributions and investment growth for the next 75 years. The actuary uses a 4.01% annualized rate of return for the investments (net of fees and inflation). The 10 year annualized rate of return for the CPP is 7.1% and when adjusted for inflation it is 5.01% leaving a 1% cushion above the 4.01% variable used by the Actuary. HAVE YOUR FINANCIAL Conclusion: PLAN CHECKED Pension style investing can be a loosely used marketing and sales ANNUALLY phrase that makes people feel financially secure. The general mechanics of a pension fund are impossible to replicate in personal retirement accounts. However, there are some important characteristics of major pension funds that we can strive to copy - diversified, well-constructed, risk-managed, monitored portfolio, with a large dash of financial planning. This can be achieved by ensuring your portfolio is well diversified in properly researched investments to understand the degree of risk/reward. Also, global investing offers more diverse opportunities and is a good way to reduce portfolio risk. Investing in stocks (or other investments) is generally known to be a long-term strategy, yet frequent monitoring of investments is still an essential part of the process. Of course, financial planning is an important part of the puzzle that either confirms being financially on track, or provides advance notice of financial risks to the desired outcome and to provide timely solutions Our firm covers all five of the important characteristics mentioned in this article. For information on how this can be applied for you, please call or Susan Mallin. Susan.mallin@steinbergwealth.com Best Regards, Susan

7 Source for various charts and statistics: CPP Investment Board and fiscal 2014 CPP annual report. For more information about Steinberg Wealth Management and Financial Planning please contact me by or phone. or To view my financial planning video or an interview with our firm, please click the links below. Susan Mallin is a Certified Financial Planner and Chartered Investment Manager with over 17 years of experience. She is also knowledgeable in cross border issues for US citizens living in Canada, as well as Estate Planning for Canadians This document is prepared for general circulation to clients of Lorne Steinberg Wealth Management (LSWM) and is provided for information purposes only. It is not intended to convey investment, legal, tax or individually tailored investment advice. All data, facts and opinions presented in this document are based on sources believed to be reliable but is not guaranteed to be accurate, nor is it a complete statement or summary of the securities, markets or developments referred to in the report. This is not a solicitation for business. Past performance is not a guide to future performance. Future returns are not guaranteed. No use of the LSWM name or any information contained in this report may be copied or redistributed without the prior written approval of LSWM.