taxesandwealthmanagement_may2014 (condensed).pdf

8/12/2019 TaxesAndWealthManagement_may2014 (Condensed).pdf

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PRESERVING WEALTH FOR PEOPLE AND PRIVATE COMPANIES

TAXES & WEALTH

MANAGEMENT

IN THIS ISSUE

Editors: Martin Rochwerg, Miller Thomson LLP;

David W. Chodikoff, Miller Thomson LLP;

Hellen Kerr, Thomson Reuters

The Movement Toward Using HighTax Jurisdictions For International TaxPlanning: The Counter-Revolution HasBegun .................................................................. 1

Use Behavioral Finance To Manage Risk...........10

Are You A Serial Entrepreneur or aCloset Venture Capitalist? ..................................11

Retirements Volatility Bogeyman..................... 14

A Taxpayers Last Resort: The RemissionOrder ..................................................................17

Canadas Anti-Spam Legislation (Casl)Is Coming Into Force On July 1, 2014:Why You Should Pay Attention AndSome Suggestions For CompliancePreparation ....................................................... 19

Daimsis v. The Queen, 2014 TCC 118:Findings Based On Credibility: It Is NotAs Easy As You Might Think............................ 21

MAY 2014 | ISSUE 7-2

RETIREMENTS VOLATILITYBOGEYMANBy Adam Butler, Mike Philbrick and Rodrigo Gordillo, Portfolio

Managers with Butler|Philbrick|Gordillo & Associates atDundee Goodman Private Wealth

Investment marketing is like watching a talented magician plyhis trade. While the marketing geniuses keep everyone focusedon the hottest new funds and stocks in an effort to chase strongreturns, people forget about the single most important thingthat matters to your retirement portfolio: volatility.

So lets be crystal clear: retirement sustainability is extremelysensitive to portfolio volatility. Further, volatility is the onlyportfolio outcome that we can actively control. Therefore, volatilityis the critical variable in the retirement equation, not returns.

To repeat: Volatility is the critical variable in the retirementequation, not returns.

FORGET RETURNS: ITS ABOUT SWR AND RSQ

If you are within five years of retirement, or are already inretirement, it is time to learn some new vocabulary:
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TAXES & WEALTH MANAGEMENT MAY 2014

Safe Withdrawal Rate (SWR):The percent of your retirementportfolio that you can safely withdraw each year for income,assuming the income is adjusted upward each year to accountfor inflation.

Retirement Sustainability Quotient (RSQ): The probabilitythat your retirement portfolio will sustain you through deathgiven certain assumptions about lifespan, inflation, returns,volatility and income withdrawal rate. You should target anRSQ of 85%, which means you are 85% confident that yourplan will sustain you through retirement.

Forget about investment returns! From now on, the onlyquestion a retirement-focused investor should ask theirInvestment Advisor when discussing their options is: How doesthis affect my RSQ and SWR?

PORTFOLIO VOLATILITY DETERMINES RSQ AND SWR

The chart below shows how higher portfolio volatility results inlower SWRs, holding everything else constant:

All portfolios deliver 7% average returns.

Future inflation will be 2.5%.

Median remaining lifespan is 20 years (about right fora 65-year-old woman).

We want to target an 85% Retirement SustainabilityQuotient (RSQ).

Note how SWR declines as portfolio volatility rises.

The green bar marks the volatility of a 50/50 stock/U.S.Treasury balanced portfolio over the long term, while the redbar marks the long-term volatility of a diversified stock index.Note the SWR of the stock/bond portfolio is 6% versus 3.4% forthe stock portfolio, highlighting the steep tax volatility levies

on retirement income.

STEADY EDDY AND RISKY RICKY

This is actually quite intuitive when you think about it. Imaginea scenario where two retired persons, Steady Eddy and RiskyRicky by name, draw the same average annual income of$100,000 from their respective retirement portfolios. Bothdraw an income that is a percentage of the assets in theirretirement portfolio at the end of the prior year.

Steady Eddys portfolio is invested in a balanced strategy witha volatility of 9.5%, while Risky Ricky is entirely in stocks witha volatility of 16.5%. Both portfolios earn the same return (as

they have done for the past 15, 20 and 25 years, though we willaddress this in greater detail below).

Due to the lower volatility of Steady Eddys portfolio, his incomeis less volatile: 95% of the time his income is between $82,000and $117,000. In contrast, Risky Ricky s portfolio swings wildlyfrom year to year, and therefore so does his income: 95% of thetime his income is between $67,000 and $133,000. Of course,both of their incomes average out to the same $100,000 peryear over time.

All other things equal, which person would you expect tobe more conservative in the amount of income they spend

each year? Obviously, if your income were subject to a large
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amount of variability each year then you would tend to be moreconservative in your spending: perhaps you would squirrelaway some income each year in case next year s income comesin on the low end of the range.

This relates directly to the impact of volatility on SWRs inthe chart above. Volatility introduces uncertainty, which isamplified by the fact that money is being extracted from theportfolio each and every year regardless of portfolio growth orlosses.

HOW MUCH GAIN WILL NEUTRALIZE THE PAIN?

Of course, this effect can be moderated by increasing averageportfolio returns, which would then increase average availableincome. The question becomes, how much extra return isrequired to justify higher levels of portfolio volatility?

The chart below defines this relationship quantitatively by

illustrating the average return that a portfolio must deliver toneutralize an increase in portfolio volatility. In this case we holdthe following assumptions constant:

Withdrawal rate is 5% of portfolio value, adjustedeach year for inflation.

Inflation is 2.5%.

Retirement Sustainability Quotient target is 85%.

Median remaining lifespan is 20 years.

Again, the green bar represents the balanced stock/Treasurybond portfolio discussed above, and the red bar representsan all-stock portfolio. From the chart, you can see that thebalanced portfolio needs to deliver 6.8% returns to achieve an85% RSQ with a 5% withdrawal rate. The higher volatility stock

portfolio, on the other hand, requires 9.2% returns to achievethe same outcomes.

In theory, higher returns in your retirement portfolio shouldequate to higher sustainable retirement income. In reality,higher returns at the expense of higher volatility actuallyreduces your retirement sustainability.

FOCUS ON WHAT YOU CAN CONTROL

There are many ways of improving the ratio of returnsto volatility in a portfolio, mainly through thoughtfuldiversification across asset classes (our particular specialty).However, many investors are (perhaps rationally) concerned

about diversifying into bonds now that the long-term yieldis 3% or less, so lets see what can be done with a pure stockportfolio to take advantage of the growth potential of stockswhile keeping volatility at an appropriate level to maximizeRSQ and SWR.

What if, instead of letting the volatility of the stock portfolio runwild, we set a target volatility for our portfolio and adjust ourexposure to stocks up and down to keep the portfolio volatilitywithin our comfort zone.

For example, lets set a target of 10% annualized volatility, so ifstock volatility is 20%, our allocation to stocks =

target vol/observed vol = 10% / 20% = 50%,


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with the balance in cash. If stock volatility drops to 15%, ourallocation would be 10% / 15% = 66.6% invested, with thebalance in cash.

For the purposes of this example, we will assume that cash

earns no interest, because it currently does not, and we want tofocus on the effect of managing volatility alone.

More specifically, lets assume we measure the trailing 20-dayvolatility of the SPY ETF (which tracks the performance of theU.S. S&P500 stock market index) at the end of each month, andadjust our portfolio at the end of any month where observedvolatility is 10% above or below the volatility we measured atthe end of the prior month.

For example, if we measured volatility last month at 15%annualized, and the volatility this month was greater than16.5% or less than 13.5% (10% either way from the prior month),then we adjust our exposure to the SPY ETF according to the

most recently observed volatility using the technique describedin the last paragraph. If this months volatility does not exceedthe threshold to rebalance, then we do not trade this month.

By using this simple technique to control volatility since theSPY ETF started trading in 1993, we achieve 6.65% annualizedreturns with a realized average portfolio volatility of 10.73%.This compares with returns on the buy and hold SPY ETF of7.99% with a volatility of 20%. Note that our average exposureto the market over that period was just 69%, with the balanceearning no returns. All returns include dividends.

The chart below shows the Sustainable Withdrawal Rate for

the two portfolios: the volatility target SPY and the buy andhold SPY.

Source: Butler|Philbrick|Gordillo& Associates, 2012, Algorithmsby QWeMA Group.

You can see that by specifically targeting portfolio volatility oursustainable withdrawal rate rises to 4.7% per year, adjusted forinflation (at 2.5%) versus the Buy and Hold portfolio, which willsupport a withdrawal rate of 3.65% per year. This despite thefact that the Buy and Hold portfolio outperforms the volatility-targeted portfolio by 1.35% per year.

We can't control the returns that markets will deliver inthe future, but we can easily control portfolio volatility byobserving and adapting. Withdrawal rates from retirementportfolios are highly sensitive to this volatility, and we havedemonstrated that by controlling volatility we can increase oursafe withdrawal rates, and therefore boost retirement income,by almost 30% before tax.

Just imagine what is possible with a diversified portfolio

of asset classes when you volatility-size them (see www.darwinstrategies.ca).

Adam Butler, Mike Philbrick and Rodrigo Gordillo are PortfolioManagers with Butler|Philbrick|Gordillo & Associates atDundee Goodman Private Wealth in Toronto, Canada.

Adam, Mike and Rodrigo can be found at www.bpgassociates.com

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