As tax time looms, it’s prudent to get your plan in place

This time of year you should be talking with your financial advisor about where to put your hard earned money.  Will you contribute to an RRSP or pay down debt?  Or should you do both by contributing to an RRSP and using the tax savings to pare debt?

Contributing to an RRSP should be done with a view of keeping the funds committed for a longer period of time and pulling them out at retirement, hopefully when you’re in a lower income tax bracket. This option is suitable for individuals who have stable income.  If it’s debt reduction, you always have the flexibility of taking out equity in your home later on if capital is needed. On the other hand, if you need capital and your only access to savings are from your RRSP you will have to make one of the most common RRSP mistakes – deregistering RRSPs before retirement and paying tax. In addition, you will not have the RRSP contribution room replenished.

Since 2009, financial options were further complicated with the introduction of the Tax Free Savings Account (TFSA). The main benefit of an RRSP is the deferral of income within the account until the funds are pulled out. Another is the tax savings in the period in which the contribution is first applied. The TFSA has the same first benefit of an RRSP, deferral of all income including interest, dividends and capital gains. TFSA contributions do not provide you a tax deduction; however, withdrawals are not taxed at all. Withdrawals can be replenished in the next calendar year. .

Business owners have the ability to have active small business income taxed at a lower rate. Most owners are encouraged to pull out only the income they need to live on. The rest of the income is left in the corporation. Income paid out of the corporation is either through dividends wages, or both. Should business owners still contribute to an RRSP or TFSA when income is already taxed at low rates?  Wages paid helps future CPP benefits and also creates RRSP deduction room.  Dividends paid can be tax efficient, but do not create RRSP room and have no benefit for CPP purposes.  Some organizations provide RRSP programs that involve matching and length of service programs that are linked to the member’s RRSP.

Singles have a higher likelihood of paying a large tax bill upon death. With couples, the chances that one lives to at least an average life expectancy are far greater. Couples can also income split where the higher income spouse can contribute to a spousal RRSP.

If you have a good company Registered Pension Plan (RPP), you may not have a great a need to have an RRSP. If a person had debt and a good RPP then the decision to pay down debt is a little easier than someone that doesn’t have an RPP at all. Individuals who have no other pensions (not counting CPP and OAS) really need to consider the RRSP and how they will fund retirement.

Income levels below $37,606 in BC are already in the lowest income tax bracket. Contributing $5,000 to an RRSP while in the lowest bracket would result in tax savings of approximately $1,003 or 20.06 per cent.  Income over $150,000 is taxed at 45.8 per cent and this same contribution would save $2,290.   I would encourage the lower income individual to put the funds into a Tax Free Savings Account or pay down debt depending on other factors. If the lower-income individual’s income increased substantially, then the option to pull the funds out of the TFSA and contribute them to an RRSP always exists.

In order for your advisor to provide guidance about the right mix between TFSA, RRSP, or paying down debt, they require current information.  In some cases, your advisor should be speaking with your accountant to make sure everyone is on the same page.  Every situation is unique and your strategy may also change over time.  Preparing a draft income tax return in late January or early February helps your advisor guide you on making the right decisions.

The submitting of your completed tax return should be done only when you are reasonably comfortable you have all income tax slips and information. Some investment slips, such as T3s, may not be mailed until the end of March. We recommend most of our clients do not file their income tax return until the end of the first week of April.  By providing projected tax information to your advisor in January or early February you have time to determine if an RRSP should be part of the savings strategy. If it is not, the discussion can lead to whether you should pay down your mortgage or contribute to your Tax Free Savings Account.  

Most mortgages allow you the ability to pay down a set lump sum amount (such as 10 or 20 per cent) on an annual basis without penalty.  Every January you are given additional Tax Free Savings Account room. 

Liquidity in investments

Investments that can be bought and sold easily are considered to be liquid. Investments that are difficult to buy or sell are considered illiquid. Liquidity is one of many important objectives of investing. We can actually look at liquidity in several different ways, and for purposes of this article I’ve broken it down to four general discussion items, as follows: Basic Rules of Settlement, Liquid for a Cost, Exceptions to Liquidity, and Ratio of Liquid to Illiquid.

Basic Rules of Settlement

When buying and selling different investments, there are specific rules with respect to transaction dates and liquidity. Two dates are often used to describe transactions, trade date and settlement date. Trade date is fairly straight forward to understand. It is normally the day your purchase or sell is first executed. If you spoke to an advisor after cut off times (i.e. market hours) and your advisor entered the order for the next market day then trade date would be the next market day. Settlement is a little more difficult to understand and changes with different investments. The following is a chart with the most common investments and the respective settlement dates:

Common Investments

Settlement Date = Trade Date + (below)

Money Market Mutual Funds

1 business day

High Interest Savings Accounts

1 business day

Short Term Bonds (3 years or less)

2 business days

Long Term Bonds (3 years plus)

3 business days

Mutual Funds

3 business days

Canadian and US Equities

3 business days

European and Foreign Equities

Depends on market

To illustrate trade date and settlement date we will use a typical week with no public holidays. Michelle purchases a stock named ABC Company on Monday – this is the trade date. Settlement as per the above schedule for equities is the trade date plus three business days – settlement is on Thursday. What this means is that Michelle does not have to deposit money into her investment account until Thursday, even though the investment was purchased on Monday. If Michelle already had money in a high interest savings account then her advisor could sell a portion of this investment on Wednesday to cover the purchase. The opposite happens when an investment is sold. Let’s assume that a few months go by and Michelle needs some money and sells ABC Company on Monday – this is the trade date. Although we did the trade on Monday, the settlement date is Thursday. We would not be able to transfer funds to Michelle until the settlement on Thursday. We explain settlement to new clients to ensure they give us a few days notice if they require funds.

Liquid for a Cost

At any time you should have the right to make a change in your investments without it costing you a fortune. Having flexibility with investments ensures you never feel like you are backed into a corner with no options. We recommend asking the liquidity question prior to making any investment decisions – what will it cost me tomorrow if I need to sell. Everyone should know the total cost to liquidate an entire portfolio. When I have sat down with people wanting a second opinion the first thing I look at is the types of investments they have and what it would cost to make any necessary changes. I will use Wendy who came in for a second opinion as an example. Wendy was holding a basket of proprietary mutual funds that were originally sold to her more than two years ago on a deferred sales charge (DSC) basis. I explained that with proprietary mutual funds they can not be transferred in-kind (as is). Her only option was to sell the mutual funds, and transfer the net cash after redemption charges, if she wanted to make a change with her investments. In explaining DSC mutual funds to Wendy, she was shocked to know it would cost her four per cent (or $23,200) of her $580,000 investment account to make a change even though she has owned these investments for more than two years. Immediately Wendy felt she was backed into a corner. I explained to Wendy that if she had sold these mutual funds soon after she purchased them two years ago then the cost would have been $37,700. Although Wendy had liquidity, it was liquidity for a cost – she had no idea. In my opinion, every investor should avoid being backed into a corner with excessive liquidity costs.

Exceptions to Liquidity

Not every investment will be easily converted to cash. Your principal residence is one investment that is not easily converted to cash. Many assets that people buy either have restrictions on when they can be sold or take significantly longer than the settlement dates for common investments noted above. Examples of investments that are not easily liquidated include: infrastructure assets, private real estate investments, antiques, art work, private companies, hedge funds, flow-through investments, venture capital funds, etc.. Some investments have in the fine print that they reserve the right to suspend redemptions under certain circumstances. It can be very frustrating for people who have invested in illiquid investments and would like their money back. Prior to purchasing any investment you should determine if it is liquid, illiquid, or has the possibility of becoming illiquid. If it is illiquid you should be prepared to hold it until key dates are reached or a liquidity event occurs.

Ratio of Liquid to Illiquid

A good exercise for all individuals is to list all of your investments and categorize them in the liquid or illiquid category. In my opinion, everyone should have some liquid investments, including cash as an emergency reserve, or investments to either obtain income, growth, or a combination of both. There is no set rule on what ratio of liquid to illiquid investments people should have. As a general guideline, younger individuals may have more illiquid investments, especially if they have real estate with debt or the higher risk tolerance to invest in illiquid investments. Another general guideline is that as people age, or if they have a lower risk tolerance, the ratio may favour liquid investments.

Timing stock markets is always a challenge

At any point in time the stock market can either go up, stay at current levels, or decline. However, over time the stock market has an upward bias. During the last twenty years the TSX/S&P Composite Index has increased annually 8.19 per cent in spite of volatility during this period. When the stock market takes a sharp downward correction, the natural response from investors is to try to anticipate the decline and sell off before this happens. It sounds easy when you’re looking in the rear view mirror. Timing when you’re in or out of the markets is in essence basing your investment strategy on a speculative approach rather than a disciplined investing approach that incorporates a long term vision and goal. Short term emotional thinking can cloud long term investment decisions.

The best way to illustrate the challenges of trying to time the stock market is by looking at an investor who is currently fully invested. Mr. Wilson has $1,000,000 invested and is currently earning $40,000 in annual income from dividends and interest. In addition to this income, Mr. Wilson’s investments fluctuate in value based on the markets which create either capital gains or losses.

Mr. Wilson decided that he wanted to be a market timer. By market timer, I mean that he felt he could predict the direction of the stock market and would sell his investments if he anticipated a decline in the markets. If Mr. Wilson sells off his investments and converts his portfolio to 100 per cent cash, then his income will drop to $12,500 per year, assuming that savings accounts are earning 1.25 per cent. The downside to savings accounts is that interest income is fully taxable each year. Mr. Wilson currently has the majority of his investments earning tax efficient dividend income with some tax deferred growth. As a result of the difference in taxation between interest income and dividend income, the impact on income would be even greater than 2.75 per cent (4.00 – 1.25). For purposes of this article, we have assumed that both interest income and dividend income are equal.

Mr. Wilson should also factor in that if all of his investments are sold then he would have to report all the realized gains on his investments and lose the deferral benefits that exist with non-registered equity investments. If you have stock that has increased in value, you do not have to pay tax on the capital gain until it is sold. If Mr. Wilson has a stock that has declined in value and he realizes a loss then he has to use caution when timing transactions. He must wait at least 30 days before repurchasing a stock sold at a loss or risk violating the superficial loss rules and having the original loss declined.

From an income standpoint, Mr. Wilson will immediately see his income drop $27,500 a year ($40,000 – $12,500). The potential tax liability, superficial loss rules and loss of income are the easy components to quantify for Mr. Wilson. Has Mr. Wilson made the right choice to liquidate? If the markets increase then Mr. Wilson clearly made a mistake. If the markets remain flat then Mr. Wilson still made a mistake as his income will drop $27,500 a year.

If the stock market goes down it’s not necessarily a given that Mr. Wilson will benefit from having liquidated his account. If Mr. Wilson makes a correct prediction that the stock market declines then for him to benefit he has to also make another correct timing decision to buy back into the market at lower levels to potentially be better off. If the markets decline and Mr. Wilson does not have the insight to buy back in (before it rises back to the level that Mr Wilson originally sold at) then he would still be worse off. In essence Mr. Wilson has to make two correct timing decisions: (1) selling before the markets decline, and (2) buying back before they rise.

Mr. Wilson should also factor in the timing in which he feels his predictions for the market will unfold. To illustrate this component we will assume no transaction costs and no tax impact to the trades for simplification purposes. The difference between the current income Mr. Wilson is earning of 4.0 per cent and the new income of 1.25 per cent if he converts everything to cash is 2.75 per cent. Depending on how long Mr. Wilson is out of the market impacts how much the stock market would have to decline to make the strategy of going to cash successful. Let’s assume that Mr. Wilson waits six months, one year, two years, and three years before buying back into the stock market. If every year Mr. Wilson is losing 2.75 per cent in income then the longer he waits the greater the stock market has to decline. At the six month point the markets would have to decline 1.38 per cent (2.75 x .5) or greater, at the one year point the markets would have to decline 2.75 per cent (2.75 x 1) or greater, at the two year point the markets would have to decline 5.5 per cent (2.75 x 2) or greater, and at the three year point the markets would have to decline 8.25 per cent (2.75 x 3) or greater.

Making two right short term timing decisions against a stock market that has a long term upward bias is not as easy as it may seem.

Switch trade strategies

In the last column I talked about model portfolios and how many advisors establish a uniform basket of stocks for their clients. Most advisors have two sets of lists for their model portfolios: one that has the stocks they are considering buying and another that has the stocks they are considering selling. One trading tool that advisors use in developing and keeping their model portfolio basket of stocks up to date is switch trades. A switch trade occurs when a position is simultaneously sold from a model portfolio and another position is bought.

Mr. Jones is retiring and now requires income from his portfolio. Mr. Jones came to us for a second opinion. Currently he holds $500,000 in mutual funds that are not generating any income, while also paying the management expense ratio that costs $12,000 annually. We suggested he sell these mutual funds and switch into a basket of direct holdings containing dividend paying blue chip equities that would pay him a minimum of $20,000 in dividends annually. This would increase his income substantially. Moreover, he would save $7,000 annually since direct equity investments through a fee-based account would have lower investment costs than mutual funds. His investment costs for the blue chip equities would bring his cost of investing down to $5,000 annually.

When an individual is fully invested, such as Mr. Jones, switch trades are effectively the only way someone can purchase securities. Initially, Mr. Jones will be executing switch trades on a macro level as he is completely remodeling his portfolio from entirely mutual funds to all direct holdings. Once his portfolio contains direct holdings, switch trades will be executed on a micro level. Essentially, you sell the weakest name to purchase what you feel is a stronger name. These switch trades can be done for many different reasons, some of which will be explained below.

Changing Objectives

As your investment objectives change, certain securities may no longer be appropriate for your current situation. Switch trades can be used in these circumstances to better align the portfolio with your needs, investment objectives and risk tolerance. For instance, a switch order could be placed to liquidate a higher risk holding for a lower risk holding and vice versa.

Changing Yield

To increase the overall yield of the portfolio, you may wish to substitute one position for another with a higher yield. As stated above, if you are fully invested, you may not have funds available or the liquidity necessary to act on a trade quickly which could increase your portfolio’s yield. Therefore, by executing a switch trade, you will be able to purchase a new holding and increase the income. On the other hand, if you have a net capital loss carry forward, or if you want to defer growth, a strategy could be implemented to focus on growth stocks with little dividends. Investors can benefit from switch trading both by changing to a lower or higher yield, depending on their unique situation.

For example, Mr. Jones is trying to increase his yield to provide retirement income. He currently holds a growth stock with a yield of 1.2 per cent; however, he is looking for a higher yield and is interested in switch trading his growth stock for a value stock that pays 4.6 per cent. If Mr. Jones holds a position of $20,000 with the growth stock’s yield of 1.2 per cent, he will make $240 in dividend income. If Mr. Jones switched to the value stock with a yield of 4.6 per cent, his annual dividend income would increase to $920 (a $680 increase) on that one holding of $20,000.

Sector Rotation

Due to market variations, each of the different sectors may be either underperforming or outperforming others during any given period. Switch trades can be useful in these instances for re-balancing a portfolio to overweight or underweight a different sector. By using a switch trade, investors are able to rotate between sectors with relative ease, allowing them to overweight a sector that is expected to outperform and underweight a sector expected to underperform.

For example, the value of Mr. Jones’s stocks of company ABC have appreciated nicely; however, he believes their sector will soon decline and he is now looking to sell those stocks. With the proceeds, Mr. Jones is looking to invest in stocks of company DEF, which is in a sector that he believes will outperform in the future. A switch trade can be done to execute this order. Mr. Jones holds 200 shares of ABC, currently selling at $50 a share. As ABC is sold, the switch trade simultaneously buys DEF with the proceeds. Since DEF is currently selling at $25 a share, Mr. Jones is able to buy 400 shares. As a result of this switch trade, Mr. Jones is now overweight in a sector expected to outperform, and has minimized his holdings in a sector expected to underperform.

Asset Mix Rebalancing

Your asset mix is not static; rather, it is always fluctuating depending on the current state of the markets. With time, it’s not uncommon for an investor’s portfolio to stray from its prescribed ranges due to market movements. Switch trades can be used to rebalance your portfolio, keeping it consistent with your initial asset mix weightings and risk tolerance. For example, over time Mr. Jones’s portfolio has become unbalanced, and he is now overweight in equities and requires more fixed income. To solve this, a switch trade can be executed selling equities and buying fixed income. Alternatively, if Mr. Jones was underweight equities, he would sell fixed income and buy equities through a switch trade.

Tax Planning

For tax planning purposes, switch trades are ideal for ensuring you are minimizing the amount of tax you pay. As an illustration Mr. Jones has experienced a capital loss in a particular stock in the energy sector; however, he wishes to keep the same weighting of energy in his portfolio. An option for Mr. Jones in this situation is to place a switch order. By selling the energy stock he currently owns and simultaneously buying another similar energy stock, Mr. Jones is able to use the capital loss to reduce his tax payable for that year while still maintaining the same weighting in that sector. By keeping the same weighting in a sector, an investor will benefit from any sector recovery.

Reflect on investments during tax time

As a Chartered Accountant I’ve always felt that it is a good thing if a person owes taxes – it means that you had income. Investment income is generated from taxable capital gains, dividends, and interest income. When I worked directly in public practice as a Chartered Accountant we had the ability to see the investment returns of all tax clients. One thing for sure is that the returns would vary considerably based on how savings were invested and with who they were invested with.

From time to time, we would see an individual who had significant savings but was not generating sufficient income from those savings. To illustrate we use Betty Brown who received a $500,000 life insurance payment when her husband passed away two years ago. In our first meeting we reviewed Betty’s prior year tax return and current investments. We noticed a T5 (income tax slip for investment income) in the amount of $4,750 for interest income and some high cost mutual funds that were under performing. This translated to a return of less than one per cent before tax. The T5 that she did receive was fully taxable interest income from her GICs. In talking to Betty we discussed that our “income” goal for clients is four percent. In her case, that would be $20,000 versus the $4,750 she is currently receiving. We also notice that Betty was generating some rental income from an investment property. We scheduled a second meeting to show her our plan.

At the start of our second meeting we explained to Betty that not all income is created equally. Interest income is the worst type of investment income as it is fully taxable in the year it is earned. We explained how some equity investments generate tax efficient dividend income that qualifies for the dividend tax credit. We also outlined how she could take advantage of the deferral rule on equities. The deferral rule essentially means that Betty would not be taxed on any gains until she decides to sell the investments. Betty understood this quickly as we compared this to her rental income. Years ago she had bought an additional investment property to generate rental income. Annually she has to declare the rental income. The value of the property has increased over the years but she has not had to report this. When she sells the property she will have to pay tax on approximately one half of the profits from the property value increase. This is an example of both deferral and tax efficient taxable capital gains on the eventual sale. The rental income is not tax efficient – it is like interest income.

We also talked about how equities pay dividend income which is tax efficient. Dividend income is significantly better than both interest income and rental income. Betty was excited about both the increased income and the tax efficient approach of buying direct common and preferred shares. Betty mentioned that she was still nervous about investing in the stock market. I explained to Betty that she had approximately $250,000 already in the stock market through her higher cost and under performing mutual funds. Betty was also unaware that she was paying $6,750 which was embedded in her higher cost mutual funds ($6,750 was calculated by multiplying the $250,000 in mutual funds by the average management expense ratio of 2.7 per cent).

In the discussion with Betty we mapped out a plan to largely replace the GICs with ten preferred shares and to replace the mutual funds with thirty large dividend paying common shares. We recommended opening up a fee-based managed account that would enable us to set up the accounts with no transaction and commission costs. Betty’s cost of investing would drop immediately and she could also begin deducting the fees she pays as investment council fees on her tax return. The plan that we mapped out would lower Betty’s fees, convert the cost of investing so it is fully tax deductible, increase her income, improve the transparency, and ensure she has maximum flexibility and liquidity.

We outlined the specific investments Betty would receive and how the tax efficient income is generated. Betty really liked the expected income report and how we could automate transferring all of the dividend income directly from her investment account to her bank account on a monthly basis. Betty even thought that this would allow her to stop working part time.

Our biggest concern with new clients investing in direct equities for the first time is to ensure they understand that not every stock will go up. In outlining the above with Betty we explained how she will see more volatility in the 30 common shares versus the mutual fund approach. It is generally a success if 25 stocks go up in value and only five go down. The main focus should always be on the total account rising in value from net growth in the share prices plus generating approximately four per cent from income. The growth will be variable, and possibly negative in some years. Over a reasonable time, Betty should experience more positive years then negative while experiencing significantly higher after tax investment income.

This article is intended as a general source of information and should not be considered as personal investment, tax or pension advice. We are not tax advisors and we recommend that individuals consult with their professional tax advisor before taking any action based upon the information found in this publication.

 

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.