Planning for 30 years in retirement

Imagine that you have just retired and have booked a meeting with your financial advisor to share this exciting life event. After sharing the news you spend time talking about your first big travel plans and all the things you want to do – things that cost money. The conversation naturally shifts to your investments and whether or not you should change strategy.

When it comes to investing in retirement, the period can be thirty years or longer. This is a long period in your life and for many people, they require some growth during this period as well. When interest rates were higher it was definitely advised to shift to a more conservative asset mix with a higher percentage in fixed income investments, such as corporate bonds, provincial bonds, federal bonds, coupons, GICs, term deposits, debentures, notes, and preferred shares. Many of these interest bearing investments today do not exceed the rate of inflation, and certainly the estimated return would be on the low end of any financial plan prepared in the past.

It may be a daunting task to plan the next thirty years of your life in retirement. By planning we are really looking at how you see everything in retirement unfolding and then looking at the associated costs of the things you need and want. Breaking this thirty year period into three decades is perhaps more manageable. Let’s refer to the first ten years as the Early Retirement Years (ERY). The second ten year period will be referred to as the Middle Retirement Years (MRY). The last ten years of retirement will be referred to as the Final Retirement Years (FRY).

Before you enter the ERY, it is useful for you and your spouse (if applicable) to have a clear understanding of the costs of the things you need. These should be the amounts that are clearly outlined in your financial plan. Ideally before the ERY starts you should also look at the things that you want. Putting plans down on paper really helps map out options and the associated costs of each decision. One couple may want to purchase a sailboat of their dreams. Another couple may want to purchase a motorhome and explore North America. Possibly flying to a warmer climate every winter or travelling the world is the agenda. Planning the first ten years of your retirement before it begins will better ensure that you focus your resources in the best areas and that you make the most of your time. Once options are discussed then it is easier to communicate this to your advisor and determine the cash required for the things you want to do. Again, this is different from the things you need. Before, and during, retirement it is important to let your advisor know what cash you require for both the things you need and the things you want.

A recommended approach is to create a cash reserve, also known as a cash wedge, equal to the amount of cash required for the upcoming year. With increased volatility it may be prudent to increase your wedge to two years to cover your cash flow needs.

Using Mr. Wilson as an example, he is 60 years old and has $1,000,000 to invest. He would like $5,000 a month transferred from his investment account to cover his needs. Annually this is equal to $60,000. In the next year Mr. Wilson feels he will need a new car, which he estimates after the trade-in to be a difference of $25,000. Mr. Wilson’s cash wedge should be in the range of $85,000 – $145,000. The lower end of the range is calculated by his needs $60,000 x 1 year plus his wants $25,000. The upper end of the range is calculated by his needs $60,000 x 2 plus his wants $25,000. This wedge will ensure that cash is available when required.

As a general rule of thumb, you will spend more money on an annual basis in the ERY then the MRY. The reason for this is that you may have capital purchases and more expensive plans during this period. This is the period in which most people have good health and the desire to do things. This period has lots of changes, including beginning to receive CPP, OAS, and other pension income. You may find that you want to volunteer or work part time, or spend time with new grandchildren. Certainly you will likely have to adjust to spending more time with your spouse. Developing new interests, hobbies, and friendships are important, especially if you’re planning to spend your retirement close to home.

The MRY is generally the decade with more stable cash flows when compared to both the ERY and FRY. By this time you have a clearer understanding of your cash in-flows and out-flows. During this period you will be required to convert your RRSP to a RRIF. We also advise during the MRY that you should ensure that all your legal documents are in place (powers of attorney, representation agreement, and updated will). This is important to be done when you have your health and have the capacity to make decisions. It is during the MRY where you may sell your personal residence or begin thinking about selling it. The decision about whether to sell your personal residence during the later part of this stage is often linked to your health.

Depending on your life expectancy, the FRY may be shorter or longer. Generally during this stage, the costs are mostly associated with the things you need. The FRY are the toughest to plan before retirement begins. It is more in the late MRY where you will begin thinking in greater detail about where you want to live as you age. Some people may have a home that is easily accessible and suitable for growing old in. Others may look at other options including: modifying/renovating home, buying another home with lower maintenance, renting, or moving into an assisted living arrangement. Provided you have a home that is fully paid for, the equity that you have built up in your home should cover the costs associated with the Final Retirement Years. I’ve seen many creative ideas, such as building a suite in a home to have a caregiver, or family member, living in the home for assistance. Planning for thirty years in retirement will help you prepare for all three stages and the associated financial costs of each.

Don’t rely solely on pensions for retirement

Retirees have become reliant on their employer sponsored pension plan(s), Old Age Security (OAS), and Canada Pension Plan (CPP) for a comfortable retirement. When these pensions are threatened in any way it can have a significant impact on your retirement. These plans are changing – and not necessarily for the better.

Financial analysts have come out with reports showing how many companies in Canada have real problems with their defined benefit plans and funding benefits. With interest rates at extremely low levels, and uncertain equity markets, it has put many employers in a material pension shortfall position. To address these problems, companies are looking at how the pension is structured and making decisions that do not favour the employees. Employers are also looking to reduce benefits such as health care and dental as a way for companies to save costs.

The biggest change that a company can do with a pension is to change it from a defined benefit plan to a defined contribution plan. Below is a brief description of each type of plan:

Defined Benefit Plan

With a defined benefit plan, the employer is committed to providing a specified retirement benefit. The “benefit” is established by a formula, which normally takes into account the employee’s years of service, average salary and some percentage amount (usually between one to two per cent). The key point to take away is that the employer bears the risk of pension fund performance. Another key point is that the employee is able to calculate their benefit with more certainty than a defined contribution plan.

Defined Contribution Plan

The “contributions” made into this type of pension plan are established by a formula or contract. Many defined contribution plans require the employer and/or employee to contribute a percentage of an employee’s salary each month into the pension fund. The employer does not make a promise with respect to the amount of retirement benefits. This leaves the employee to bear the risk of pension fund performance in a defined contribution plan.

Between the two types above, the defined benefit plan is normally viewed as the better type of plan for employees. As noted above the employer bears the risk with defined benefit plans. Employees have more certainty with a defined benefit plan. Unfortunately, most companies are choosing the defined contribution plan to avoid having unfunded liabilities and shortfalls as a result of low interest rates and market conditions. With the defined contribution plan, employees are generally given a choice amongst different types of investments (i.e. conservative, balanced, and aggressive). It is up to the employee to select their own investments (from the group plan offering), even if they have no knowledge in this area.

In planning for the most likely outcome it appears that pension plans will offer less for retirees in the future. As pensions deteriorate it is even more important to look at other ways to supplement your income at retirement.

Registered Retirement Savings Plans

(RRSPs) should be used by all individuals without an employer sponsored pension plan. Even if you are a member of a pension plan, an RRSP may be an effective way to build additional savings and gain investment knowledge. With defined contribution plans, many employees are required to transfer the funds to a locked-in RRSP upon retirement. If you have both a defined contribution pension plan and an RRSP, we recommend that you periodically look at these accounts on a combined basis to review your total asset mix (the percentage in Cash, Fixed Income, and Equities). This is a wise exercise because it helps in the investment selection for both the pension plan and your RRSP. As an example, you may choose to have the defined benefit pension plan invested 100 per cent in fixed income, and rely on your other accounts to provide the emergency cash reserve and equity exposure.

Tax Free Savings Accounts

(TFSA) are a great type of account to build savings on a tax free basis. How you invest within the TFSA is really dependent on your goal. It is important to note that the funds in your TFSA do not have to stay in a bank account as the name somewhat suggests. What is your current goal for the TFSA account? How does it fit into your overall retirement plan? Is the purpose of this account to act as an emergency cash reserve currently? At some point, these accounts are going to be significantly larger, exceeding most recommended emergency cash amounts. The investment approach in this account should be consistent with your objectives and risk tolerance. If the funds are not required immediately then we encourage clients to have a combination of growth and income. Purchasing a blue chip equity with a good dividend (four per cent or higher) can provide both growth and income over time. If income is not needed today then it can be reinvested until you need it at retirement.

Non-Registered Accounts

are as important as RRSP accounts at retirement. When we talk about non-registered accounts, we are referring to both investment and bank accounts. Both hold after tax dollars that can be accessed with no tax consequence. When I prepare a financial/retirement plan, one of the important areas I look at is the ratio of non-registered to registered funds. Having funds in a non-registered account at retirement does provide more flexibility. If all funds are within an RRSP or RRIF, it becomes more challenging to come up with funds for emergencies (i.e. medical, new roof, etc.)

Retirees that have built up savings within RRSPs, TFSAs, and non-registered accounts will be better prepared to deal with further changes to pensions. Regular contributions and savings into these three types of accounts over time will put more certainty on being prepared for retirement. Relying solely on your pensions and the government for a comfortable retirement could set you up for disappointment.

Just how liquid are your assets?

Liquidity is a term associated with the ease in which your assets may be converted into cash.  High interest savings accounts and money market investments are extremely liquid and can be sold and converted to cash within a day.  Holding a portion of your assets in cash is important for ongoing cash flow purposes and emergency reserves.

Fixed income investments, such as guaranteed investment certificates, are typically purchased for a period of time, but may be sold in a pinch with cash raised usually within three days.  Bonds can also be sold through a financial firm’s fixed income-trading desk.

Convertible debentures, also known as convertible bonds, are fixed income investments that trade on a stock exchange and have a three-day settlement timeline.

Equities that trade on a recognized stock exchange are typically classified as fairly liquid.  Cash can generally be raised within three days after the investment is sold.  Typically one could look at the number of shares trading each day to determine the volume.

We caution any investor buying too large of a position in a company, especially a small company with low trading volumes.  It may be easy to purchase the shares but selling is often a bigger challenge.

Equities that do not trade on a recognized exchange may or may not be liquid.  Most mutual funds is whether you purchased these on a deferred sales charge basis.  If a fee or penalty exists for selling an investment, then we would classify this as “liquid for a cost.”  Structured products such as principal protected notes, hedge funds, venture capital investments, may have restrictions with respect to liquidity.  If liquidity exists then you should understand the associated costs to sell the investment.

Non-registered investment accounts should be considered more liquid than RRSP investment accounts.  Withdrawals from an RRSP account are considered taxable.  We prefer planned RRSP withdrawals rather then required withdrawals due to emergency cash requirements.  Some registered investment accounts are considered “locked-in” and have restrictions with respect to withdrawals.

There are several categories of illiquid assets, which cannot be converted into cash quickly.  In most cases, it is a result of not having a market in which it regularly trades.  An asset is usually illiquid when the valuation is uncertain.   Two common types of illiquid assets are shares of a private company and real estate.

Retirement plans are more complicated when illiquid assets are meant to fund retirement cash flows.  In some cases, these assets generate net cash flow, such as rental income.

But what happens if a roof needs to be replaced, or you have tenant vacancies?  If the real estate is financed, how will a rise in interest rates impact you?

If the majority of assets are considered illiquid, this will cause cash flow pressures at retirement.  Planning should look at the different options, including selling assets.  By planning in advance, you should be able to factor in the most tax efficient option.  It may take longer to sell an illiquid asset.  We recommend that our clients plan ahead to ensure they do not find themselves stuck, having to sell an asset at the wrong time.

To illustrate our point we will use Norman and Pauline Baker.  Norman is 66 years old and Pauline is 70.  The Bakers have a personal residence valued at $750,000 and an 18 acre parcel of land valued at over $1 million.  They have registered investments valued at $250,000.  Annually they have been living off of CPP, OAS and small registered account withdrawals.

Pauline would like to sell the 18 acre parcel of land and enjoy retirement while they can.  She knows that if they sold the property that they would never have cash flow problems again.  Norman is a retired realtor, and feels that they should hold onto the land for a couple more years so that they will get a greater value. 

The above situation highlights that the Bakers failed to factor in liquidity as part of their retirement plan.  Waiting too long to sell an illiquid asset could result in unfavourable timing, such as a depressed real estate market.  Although the Bakers have a good net worth, this has not translated to cash flow at retirement for them. 

In order for the Bakers to begin enjoying their net worth to the fullest extent they will need to sell their 18 acre parcel of land.  With the proceeds we will assist them in developing a liquid portfolio that generates the cash flow they require.

Protecting your money against inflation

We are often asked our opinion on inflation and inflation protection products.  And as with most economic related questions, timing is really the key.   Is now a good or bad time to look at adding inflation protection products to your portfolio? Before we answer, let’s  look at what inflation is, and a few different investment options.

Inflation in Canada is based on the Consumer Price Index which has eight categories:

  • Food
  • Shelter
  • Household operations, furnishings and equipment
  • Clothing and footwear
  • Transportation
  • Health and personal care
  • Recreation, education and reading
  • Alcoholic beverages, and tobacco products.

Each of the above categories has a different weighting within the CPI.  As a simple illustration, food has a greater weighting over clothing and footwear, because most people spend more on food.

Let’s say in 2006 that Jack goes shopping for the day.  He picks up groceries, fills his truck up with gas, gets a haircut, and buys a new pair of shoes.  The entire shopping experience cost him $374.

In 2009 he went out and bought the identical groceries, put the same amount of litres in his gas tank, got another haircut, and another pair of shoes.  This time the total bill came to $412.

The change in the price of these goods can be boiled down to inflation.

In 2006 Jack was earning $63,200 annually, and in 2009 his income is expected to be $69,621.  In Jack’s case, his income kept pace with inflation.

Another case:

Charlie retired at age 65 in 2006 with a government pension and all of his savings in a simple savings account at the bank.  Overall inflation has been relatively low since he retired.  Recently he has been hearing a lot about inflation and is getting worried.  We explained to Charlie that CPI is used to index his company pension, CPP and OAS.  These parts of his income flow are protected.  The portion of his financial situation, exposed to inflation, is the $400,000 he has in the bank earning little to no interest.

If costs rise significantly in the future, the amount he has in the bank will purchase less than what it could purchase now.  One option Charlie has is to look at purchasing some investments that may better protect him, if he is willing to assume a little risk.

Charlie has specifically asked us about Real Return Bonds.  After all, he has read that bonds are less risky and RRBs protect against inflation.  In our opinion we do not feel RRB will be the best option for Charlie over the short term.  With the absence of inflation, RRBs function similarly and are influenced by the market very similar to long-term bonds.  In our last article, we discussed what happens to long-term bonds when yields rise – they decline in value.

If yields do rise as forecasted over the next year, we feel it will not be solely because of inflation.  We feel that if real yields rise, part of this will simply be based on the fact that we are at 50-year lows and the economy is recovering.  RRBs will likely trade similar to extremely long duration bonds and will be quite volatile.  Many investors are being told to buy RRBs because inflation will rise.  Sure, it will rise eventually, but we feel the potential for large losses exist based on the long duration associated with most of these investments.

Another possible outcome is that yields rise as a component of both inflation and real yields.  In this particular outcome, RRBs will likely outperform the nominal long bond of comparable term.  But it is also likely in that scenario that short-term bonds would outperform both!

To illustrate our point, one only has to look at some of the Real Return Bond products available.  In December 2008, many of these products hit a low and have posted nice returns since that date.  The returns have been positive although inflation has been negative.

What has caused the positive returns?  Interest rates have declined since last December causing a profit in most RRB products plus the demand for inflation protection products.

It would be extremely hard for the average retail investor to diversify by purchasing individual real return bonds.  These bonds are generally picked up in the institutional market.  A more practical way to obtain exposure to Real Return Bonds is to look at an investment such as iShares CDN Real Return Bond Index Fund (XRB).  This fund holds a basket of real return bonds and has a low management expense ratio (0.35%).

XRB has a current yield of 2.7 per cent.  To illustrate our point with long-term bonds, 98 per cent of the holdings within XRB have a maturity of ten years or greater.  The weighted average term is 21.23 years with a weighted average coupon of 3.62%.  We are at fifty-year lows when it comes to interest rates – they can only move up from current levels. If you have a short-term time horizon and an active strategy, we do not feel now is a good time for RRBs.

If an investor has a long-term time horizon and wishes to use a passive strategy (buy and hold) then RRBs generally make sense for a portion of a portfolio.  Typically, this type of portfolio would hold a flat percentage of their holdings within RRBs, such as five per cent.  In Jack’s case, with a $400,000 portfolio he would hold approximately $20,000.  We would not encourage overweighting RRBs.  As with other bonds, they are generally best held in a registered account, such as an RRSP or RRIF.   RRBs may help protect the purchasing power of a portion of your portfolio.  The key component that will impact performance is the change in interest rates.

For protection within non-registered accounts, we prefer holding a small portion in gold, agriculture, and energy common shares.  Several types of preferred shares also provide some inflation protection along with tax efficient dividend income suitable for taxable accounts.

 

Safe, secure GICs have downsides

Guaranteed Investment Certificates, or GICs as they are commonly known, are extremely popular savings vehicles.  They are the classic safe investment vehicle that provide a low-risk and low-return combination. Furthermore, many investors prefer GICs as they are a simple guaranteed investment that returns capital plus income.

The Canadian Deposit Insurance Corporation raised this guarantee from $60,000 to $100,000 in the 2005 federal budget.  CDIC provides valuable protection for investors primarily concerned with capital preservation.  When investors place money in eligible deposits they are automatically insured to a maximum basic coverage limit of $100,000, including principal and interest.  For information, visit www.cdic.ca

For all the simplicity and safety of GICs, investors sometimes pay little attention to the risk that their low interest earning investments may not preserve purchasing power over time. Interest rates on GICs are currently at low levels and when one considers the impact of taxes and inflation on their investments, the real rates of returns (return after accounting for inflation) can be negligible or potentially negative.

Let’s look at an example:  William has $300,000 in a non-registered annual pay GIC yielding 4 per cent, and has a marginal tax rate of approximately 43 per cent.  We will assume inflation is at 2.3 per cent.

GIC Income $300,000 x 4 Per Cent = $12,000

Taxes at 43 Per Cent                        =  ($5,160)

Net Return                                       =  $ 6,840

A net return of $6,840 is approximately 2.3 per cent.  With inflation at 2.3 per cent or higher the “real return” will be negative.  Investors with long-term objectives need to understand that the safety of GICs can actually erode the real purchasing power of their investments. In many cases, investors requiring income to provide for their day-to-day expenditures will be forced to encroach on capital as the real returns will be insufficient to meet their needs.

Clients dependent on GICs as their sole investment vehicles need to consider diversifying a component of their investments into alternative types of securities to provide inflation protection, generate tax-effective income, and to build long-term wealth.

Some tips for GIC investors:

Tip 1

We encourage investors to place no more than $100,000 per individual issuer.  Solution:  deal with a firm that is able to issue multiple issuers of GIC’s (as CDIC covers up to $100,000 held per issuing company).

Tip 2

GICs generate interest income which is fully taxed if held in a non-registered account.  Solution:  we encourage investors to look at the structure of their investments and consider putting GICs in their RRSP, as is the normal recommendation for most income generating products.

Tip 3

Occasionally we see GICs purchased near the end of the year in non-registered accounts.  Rather than purchasing a GIC at the end of the year it may make sense to put these funds into a high interest savings account until early January.  This would allow you to defer the annual interest one year.  A $100,000 one year GIC at 4.5 per cent purchased on December 6, 2006 would have $4,500 in taxable income for 2007.  Solution:  waiting until after December 31, 2007 to purchase a GIC would defer this taxable income one full year.

Tip 4

Many financial institutions will ask you if you would like to set up an automatic renewal of your GIC investments.  It only takes a few minutes to discuss rates and reinvestment options with your advisor when investments mature.  During these discussions you may want to consider different options and terms.  Most importantly you should make sure you are receiving a competitive rate.  Solution:  cancel all automatic renewals and ask your advisor to give you a call when your GICs mature.

Tip 5

Many structured products are attaching the “GIC” name in their advertisements.  One of the benefits of a GIC is its simplicity, transparency, and security.   Why does a GIC need to have some type of complicating feature to it?  Do those extra features benefit you or do they provide the issuer with more benefits?  Solution:  speak with your financial advisor for more information and avoid structured products that you do not understand.

Tip 6

Before purchasing a GIC you should determine if it can be transferred or sold.  Some GICs can be transferred to other institutions and some cannot.  In addition, most GICs cannot be sold prior to maturity.  Solution:  speak with your financial advisor for more information and attempt to purchase GICs that are transferable.

 

Fixed-income investments simplified

To diversify your investments you should have a fixed-income component in your portfolio, such as guaranteed investment certificates or bonds.

But you should have an understanding of the different ways of holding fixed income investments and the underlying risk of each option.

Term deposits and guaranteed investment certificates are a common way to hold fixed income.  The return is known and all fees are built into the initial sell price.  If you purchase a one-year $100,000 GIC at 4.5 per cent then you can count on receiving $4,500 and your original capital back in one year.  This certainty comforts a lot of people and the investment is easy to understand.  It is also easy to plan your cash flows.

Holding federal and provincial government bonds are generally considered low risk.  In recent years, GIC returns have often exceeded the returns offered by low risk government bonds.  Investment grade corporate bonds can be another way to purchase fixed income.  The return potential on corporate bonds generally exceeds government bonds and GICs but the risk element increases.

Another common form of fixed income investment is a bond mutual fund or a balanced mutual fund.  A bond mutual fund invests in a basket of fixed income investments.  Depending on the fund prospectus, the mandate can result in significantly different structures between funds.  Not all bond funds are created equal.  Some bond funds are very conservative while others may take on considerable risk.

Conservative bond funds may hold government bonds and investment grade (BBB rating or better) corporate bonds.  Treasury bills, banker’s acceptances, and term deposits are all considered low risk and are common in conservative bond funds.  One of the benefits of holding bond funds is the ability to diversify your fixed income.  Diversification of fixed income can be done through holding different types (issuers), qualities (credit ratings), and maturities (mixture of short, medium, and long term).

The added “diversification” benefit of bond funds comes at a cost often referred to as a management expense ratio (MER).  Regardless of where interest rates are at, it is important to ensure you are not paying an excessive amount to manage your money.

As an example, let’s use a typical bond fund with an MER of 1.5 per cent.  Let’s also assume that GIC rates are currently 4.5 per cent.  Individuals choosing the bond fund option should feel comfortable that the manager can put at least 4.5 per cent in your pocket.  With an MER of 1.5 per cent, the manager of this bond fund will have to take on some risk to earn 6.0 per cent or more. Your return is not guaranteed with bond funds and can be negative.

Riskier bond funds do exist and have very different mandates than the typical conservative bond fund.  Bond funds that hold non-investment grade bonds, also known as high-yield or junk bonds, may certainly have the potential to earn 6.0 per cent or more.  They also have a much higher degree of risk and generally have a higher MER.  Other funds may hold foreign bonds or concentrate in certain countries such as the United States.

We caution investors to understand currency risk before investing in foreign bonds.  For investors with a large portfolio, foreign bonds may provide some additional diversification.  Some bond funds have a small equity component, generally with dividend paying investments such as common shares.  If a fund holds a significant equity component then it is often referred to as a balanced mutual fund (holding a balance of equities and fixed income).

We encourage most investors to keep things simple.  Establish an asset mix and determine the percentage of fixed income that is suitable for your individual risk tolerance. Once the fixed income component is established we recommend most investors stick to lower risk and investment grade options.

Size of the bond market surprises new investors

New investors are often surprised to learn the sheer size of the bond market.  The Canadian secondary debt market is approximately 30 times greater than the total Canadian equity trading market.

If a bond is purchased at its new issue price the value is normally $100 per $100 par value (also known as face value).  However, most new issue bonds are not floated to the general public, but are bought by the large investment dealers such as the Canadian banks.  The general public has access to buy bonds in the secondary market from these dealers where bond prices will be trading at their perceived value based on many different factors such as world or county specific economic news, interest rates, credit rating, etc.

Due to the numerous variables, bonds are rarely trading at exactly $100 in the secondary market.  Bonds that trade at a higher price than their par value ($100), say $102, are said to be trading at a “premium.”  Bonds that trade at a lower price, say $97, are trading at a “discount.”

We will use XYZ bond to illustrate bonds trading at a premium or discount.

The original XYZ bond was issued at 100 with a four per cent coupon and a five-year term to maturity.  Most bonds in Canada pay their coupon on a semi annual basis (twice per year).  Therefore in this case, the client would receive a fixed amount of two per cent per six months on the total face value of the bonds purchased.  After the initial issue date, the price is not fixed and will fluctuate prior to maturity based on several factors as mentioned above.

Bond prices move inversely to interest rates.  Therefore, if interest rates have increased after a year from when XYZ bonds were initially issued, the price of the bond will decrease.

Many clients find this relationship difficult to understand so let’s use an example to illustrate why this occurs.  Let’s say that interest rates rise to the extent that a new five-year ABC bond, which is similar in term and credit quality as XYZ bond, when initially issued at par is paying a coupon of five per cent.  All else being equal, investors would find the ABC bonds more attractive than the four per cent coupon XYZ bonds issued a year earlier.  Therefore the market in general would sell the XYZ bond, causing the price to drop, in order to buy the more attractive ABC bond.

The opposite may happen to bond pricing if interest rates decline.  If new bond issues are currently paying three per cent coupon, the market would be more inclined to buy higher coupon paying bonds such as the XYZ bond paying four per cent.    The market would buy the XYZ bond, pushing its price above those that are issued at three per cent causing the XYZ bond to trade at a premium.  If XYZ is trading at $102, the premium above $100 can be seen as payment for a higher coupon.

Here are some key tips in acquiring bonds;

  • Never buy a bond solely on the coupon alone.  Yield to maturity for bonds is often the more important number to review as it allows bonds of different coupons and maturities to be compared to each other.  Yield to maturity is the total return, made up of interest and repayment of principal that you will receive if you hold the bond to maturity.
  • For taxable accounts, you should ensure that you are reporting all capital gains from bonds purchased at a discount and all capital losses from bonds purchased at a premium.
  • The coupon component on bonds is considered interest income.  We encourage investors to hold investments that generate interest income within a registered account, such as an RRSP or RRIF, if they have the option.
  • If you are an investor in a high tax bracket and have bonds in a non-registered account, consider those trading at a discount.  Bonds trading at a discount will result in both interest income and capital gains.  The taxable capital gains is more tax efficient than the interest income component.  Naturally, the higher your tax bracket, the greater the benefit of investing in bonds trading at a discount.
  • If you have capital loss carry forwards and are avoiding equity markets then you should ask your advisor to look for bonds trading at a deep discount.  This will convert part of your total return to capitals gains.  The capital gain component generated on a bond held to maturity may be offset by your capital loss carry-forward room.
  • We recommend sticking to “vanilla” type bonds versus those that have features that you may not understand or that do not appear to benefit you.  Before purchasing, you should obtain a complete understanding of all features (i.e. extendable, callable, changes in coupon rates) on bonds and determine how this may impact you as the holder.

Fixed Income 101: Carefully plan debt investments

Fixed income is an asset class that includes short term money market instruments, term deposits, GICs, government bonds, corporate bonds, debentures, and bond funds.  All of these investments are considered “debt” investments rather than “equity” investments.

When buying debt investments an investor is essentially lending money to the issuer of the bond.  For example, a company that needs to raise money generally has two ways to do so – issue stock in the open market or borrow.  By issuing a bond, the company is promising to repay money at maturity, along with, interest.

When purchasing fixed-income investments there are several things you should consider:  credit quality, liquidity, yield-to-maturity, term-to-maturity, and expected income stream of the investments.  The following five questions provide a framework to assist you in evaluating the relative merits of a particular investment.

1. What will my return be?

In order to determine how much you will earn on your fixed income investment, you generally need to consider two things: the coupon of the bond, and the overall yield.     The coupon is the percentage of the bond’s face value that you will receive as income on a periodic basis.  Most bonds pay coupons twice a year.  Yield (called yield to maturity for bonds) is often the more important number to review as it allows bonds of different coupons and maturities to be compared to each other.  Yield to maturity is the total return, made up of interest and repayment of principal that you will receive if you hold the bond to maturity.

2. When will I get my money back?

Most fixed-income investments are issued for a specific period, such as five years, and have a set maturity date.  This is the date on which the face value or principal amount of your investment will be repaid by the issuer, or borrower.

3. How safe is my investment?

You should always check what type of security or guarantee is behind your investment.  Most bonds are not backed by specific assets, but are backed by the full faith of the issuing company.  An investment is considered to be extremely safe and have high credit quality when there is little likelihood that the issuing government or corporation will default on interest payments or not repay your principal.  Bond rating agencies provide investors with information to assist them in gauging the credit quality of their investments.  Lower quality companies will have a higher likelihood of not paying out and therefore be rated lower.  Lower quality bonds will offer a higher yield to attract investors.  Remember higher risk, usually means higher return.  Higher quality bonds, with little chance of default such as Government of Canada, have a lower yield.  You should choose a balance of risk and return that meets your tolerance level.

4. Why is the price changing on my bonds?

Before investing in bonds, you should be aware of any potential volatility that could affect the value.  GICs are an example of a type of fixed income investment that do not fluctuate in value.  However, regular bond prices are affected by moves in interest rates, and therefore prevailing yield in the marketplace.  Bonds prices move inversely to the prevailing interest rates.  As rates go up, bond prices come down and vice versa.  Generally, if a bond has a coupon that is larger than the prevailing yield in the market, the bond will trade above 100.00, considered a premium.  Conversely if the coupon the bond is lower than the prevailing yield in the market, the bond will trade below 100.00, considered a discount.

Bond prices are more likely to remain stable when they are high quality, more liquid and have a shorter term-to-maturity.  Changes in the price of bonds can present different opportunities for active investors.  However, if you plan to hold a bond investment until its maturity, you will receive its face value, therefore, market volatility will not be a factor (provided no default).

5. Can I sell my fixed income easily?

Although you may intend to hold a fixed income investment until maturity, you should still obtain an understanding of its liquidity.  Circumstances may change and you may require cash.  Some fixed income investments are extremely liquid which means that you can sell them easily before they mature.

If you sell a bond between periods of receiving coupon interest you will receive from the purchaser the accrued interest you have earned up to that date.  Less liquid bonds may be harder to sell in the secondary market.  GICs are different than bonds when it comes to selling.  Cashable GICs should not be redeemed within 30 days.

Early redemptions generally result in a loss of interest.   Cashable GICs are usually classified as cash equivalents rather than “fixed income” because of their liquidity and short duration (one year or less).  As for non cashable GICs, investors may be able to find a market to sell.  It is not advisable to buy GICs if you know you may need the money

Balanced investments show success

One of the first discussions we have with new clients relates to risk, which is often associated with equity investing.

Fixed income investments such as term deposits, guaranteed investment certificates and bonds are usually considered lower risk.

Most investors over the age of 40 should have a portion of their investments in fixed income as their time horizon is shorter.  However, the downside to having too much fixed income is the limited return potential in today’s market environment.  Cash and fixed income ensure capital preservation while the equity component provides increased growth potential.

The key to having “peace of mind” as an investor, is to have the appropriate balance that reflects your risk tolerance.  This balance is also known as your asset allocation.

Asset allocation classes include cash equivalents, fixed income, Canadian equities, US equities, International equities and real estate.  Let’s look at Jack Jones and the steps taken prior to choosing individuals investments.

Step 1 involves determining an asset allocation that best matches Jack’s risk and return expectations.  Here’s an example of his optimal asset allocation:

Cash Equivalents 5%

Fixed Income 30%

Equities – CDN 35%

Equities – US  10%

Equities – International 15%

Real Estate 5%

A person who is more conservative than Jack may want to increase the cash equivalents and fixed income component while decreasing equities.  What we find is that many do-it-yourself investors take an all or none approach to a specific asset class.  This means they may end up with either a 100 per cent equity portfolio or all of their money in GICs.   Portfolios that are 100 per cent invested in equities generally are more volatile, and hold greater risk of decline.  However, those who invest entirely in GICs may find it frustrating as yields are generally much lower.  In addition, for non-registered accounts interest income is fully taxable.  After tax is paid, it may be difficult for GIC investors to gain wealth after inflation is factored in.

Simply put, most investors should have a balanced portfolio that can weather different market cycles.

After the optimal percentages are determined above, Step 2 is to establish acceptable ranges as follows:

Cash Equivalents 0-10%

Fixed Income  25-35%

Equities – CDN 30-40%

Equities – US 5-15%

Equities – International 10-20%

Real Estate 0-10%

In a bull market cycle investors may find that the equity component of their investments may increase above the optimal amount noted above.  If the value of the equity class exceeds the acceptable range then a disciplined investment approach should involve rebalancing to the optimal percentages in Step 1.

This rebalancing is Step 3.  Selling equities and adding to fixed income and cash equivalents essentially shifts a portion of your profits to a lower risk asset class.

We encourage investors to stick to their long-term plan.  As fixed income securities mature, we should replace those investments with other fixed income options.

What happens in a bear market cycle?  Investors may find that the fixed income component as a percentage of their total investments increases as equity markets decline.  As noted above a disciplined approach to investing involves rebalancing.  It is possible that this process may involve allocating some of the proceeds from matured fixed income to purchasing equities.  This would only occur if equity markets have declined significantly.

Periodic rebalancing creates the discipline to sell a portion of your equity investments when times are good.  The cash equivalents and fixed income components should also be viewed as a potential source to purchase equity investments when the opportunity arises.

Borrowing to boost your RRSP

Some points to consider when using loans to augment savings

The maximum RRSP deduction limit has increased to $20,000 in 2008.  Those with an income of $111,111 or greater may qualify for this upper limit.  Members of a defined benefit pension plan will have to factor in any current and past pension adjustments.   Most people have salaries below this amount and often it is not easy to maximize annual contributions to an RRSP.

As the deadline for RRSP season approaches many investors may be asking if they should borrow to invest in their RRSP.  The answer really depends on your financial situation.  If you are contemplating borrowing to make an RRSP contribution we recommend you consider these following points:

Taxable Income

The greater an individual’s taxable income the more it makes senses to maximize RRSP contributions.  Reducing your tax liability is often a motivating factor for many individuals when making an RRSP contribution.  Those in the higher marginal income tax bracket should speak with their advisor.  Even if you do not have the cash on hand to make an RRSP contribution it may make sense to borrow the funds to make a contribution by February 29th.

Future Income

Individuals who are considered “employees” may receive a relatively stable monthly income that is predictable from year to year.  Business owners and entrepreneurs generally have fluctuating income resulting in a higher tax bracket one year and a lower tax bracket in another.  RRSP contributions may provide a unique way to smooth your taxable income.  Individuals may have one time spikes in income from selling a real estate investment or other type of investment that generates a significant capital gain.  Planning to utilize a portion of your RRSP contribution room to offset this future liability may make sense.

Term of the Loan

Interest rates are currently relatively low making borrowing for an RRSP fairly attractive.  Most financial institutions provide RRSP loans; however, the rates can vary considerably.  The better the terms of the loan the more attractive borrowing becomes.  Some individuals may choose to utilize their lines of credit, which may have favourable rates and the greater flexibility for repayment.  Business owners may want to utilize an RRSP loan rather than their lines of credit, which have been set up for emergencies.

Length of Loan

The general rule-of-thumb is that the quicker you pay back the RRSP loan the more advantageous it is.  Short-term loans of less than a year may have minimal interest costs and may assist those with fluctuating income.  The more difficult question is when do larger, longer-term loans make sense?  Long-term loans are often used to catch up on a significant amount of unused contribution room.  With longer-term loans it is even more important to weigh the other factors in this article.

Carry Forward Room

Prior to 1991, individuals lost their RRSP deduction room if they did not fully utilize it in a given year.  The good news is that unused RRSP contribution room may now be carried forward indefinitely and includes any unused RRSP deduction room accumulated after 1990.  The bad news is that if you wait too long then you’re missing the biggest benefit of an RRSP – the compounding growth that may occur on a tax deferred basis.  Regardless of the timing, we encourage most individuals to utilize their carry forward room prior to retirement.

Interest Costs

Interest on a loan for your RRSP is not tax deductible. However, money borrowed to earn non-registered investment income may be deductible. This is why it may make sense to use extra cash to contribute to your RRSP and borrowed funds for non-registered investments.  If you have non-registered investments and are considering an RRSP loan you should meet with your accountant first.  There may be a way you can arrange your finances to ensure that more interest costs are deductible.

Return on Investment

This is perhaps the most difficult component for people to analyze.  If you knew with certainty the investment returns you would obtain then the decision may be easier.  Let’s step back and disregard how your investments may perform in the near term.  An RRSP is normally established with a long-term time horizon.  The focus should be on picking the highest quality investments that will prevail in the long run, regardless of market volatility.  We understand that many people scramble to make a last minute contribution to their RRSP.  This is okay provided care is taken when making the investment decision.  If the energy is focused on picking the best investments and the best advisor, then an RRSP loan may make sense.

Simple Strategy

Last year we highlighted a simple strategy that investors could adopt to ease the cash flow burden of trying to come up with their RRSP contribution limit every tax season.  Let’s consider an investor with a $20,000 RRSP contribution limit for the upcoming year.  For this investor we recommend multiplying their RRSP deduction limit by 75 per cent and dividing by 12 to obtain the monthly pre-authorized contribution amount of $1,250.  In either January or February of the following year, the investor could utilize their line of credit or obtain a short term RRSP loan to contribute another $5,000 to top up to the maximum.  After filing the tax return, the combined RRSP contributions of $20,000 may provide enough of a tax refund to pay off the short-term loan or line of credit.  This of course assumes that sufficient tax was withheld on other sources of income throughout the year.

The above strategy is a combination of “automatic” savings by paying yourself monthly and a “forced” short-term loan strategy that creates the discipline to pay off the loan as soon as possible.  This combination has worked well for many successful investors.