Part VI – Real Estate: Skipping to Other Generations When Planning Your Estate

With the value in real estate and other holdings, many Canadians have accumulated a significant estate that involves planning.  Talking about estate planning need not be uncomfortable.  For many, this naturally leads to who you would like to receive your estate – either family, friends, and/or charitable groups.  The process involves mapping out a plan that minimizes tax, while at the same time ensuring your distribution goals are met.

The second stage of the estate-planning process is when we ask for clients to bring a copy of the documents they currently have in place. We also obtain a copy of their family tree and information about current executor(s), representative, or other individuals currently named in the will.

To illustrate the process, we will use a typical couple, Mr. and Mrs. Gray, both aged 73. They last updated their wills 24 years ago.  They have what is commonly referred to as “mirror wills” where each leave their estate to their spouse in a similar fashion.  The will also has a common disaster clause that if they were to both pass away within 30 days that the estate would be divided equally amongst their three children.  We will refer this to as the “traditional method”.

Since they last updated their Will, all three of their children (currently aged 56, 54, and 52) have started families of their own. In fact, the Gray’s now have seven grandchildren between the ages of 11 and 32, and two great grandchildren (aged seven and three).  None of which were born when they last updated their Will.

In reviewing their will, we noted that this traditional method of estate distribution left everything to their now financially well-off adult children, to the exclusion of their grandchildren. We highlighted that the current will does not mention the grandchildren or great grandchildren. In exploring this outcome, they expressed they wanted to map out an estate plan that also assisted those that needed help the most.

The last time the Gray’s updated their will they had a relatively modest net worth, but in the last 24 years they were able to accumulate a significant net worth. We had a discussion with Mr. and Mrs. Gray that focused around the timing of distributing their estate.

The traditional method effectively distributed nothing today and everything after both of them passed away.

We discussed the pros and cons of distributing funds early. During our discussion, the plan that was created was combination of components, parts involved a distribution to the grandchildren based on certain milestones.  They also wanted to make sure their grandchildren obtained a good education.  The estate plan details that we outlined in the short term were relatively easy to put in place and were as follows:

  1. For the youngest members of the family they wanted to set up and fund Registered Education Savings Plans (RESP) for all eligible grandchildren and great grandchildren. The RESP contribution shifted capital from a taxable account to a tax deferred structure. This effectively results in income splitting for the extended family. Another added benefit is that RESP accounts would receive the 20 per cent Canada Education Savings Grant based on the amounts contributed.
  2. For the family members already in university, the plan was to assist with the cost of tuition and other university costs up to $10,000 per year per grandchild.
  3. For the grandchildren who were at the stage of wanting to purchase a principal residence, they wanted to set aside a one-time lump sum payment of $50,000 specifically to assist each grandchild with the down payment on a home.

One of the more challenging areas of the Gray’s estate plan dealt with their real estate. In addition to their principal residence, they also owned a recreational property in the Gulf Islands. The recreational property had some significant unrealized capital gains. It was important for the Gray’s to ensure both properties were kept within the family, if possible. We called a family meeting together where we outlined different options to achieve this goal. The key with this part of the estate plan was communication with Mr. and Mrs. Gray and their three children. We were able to obtain a clear plan that was satisfactory to all family members.

The finishing touch to a well-executed estate plan is ensuring the details are clearly documented in an up-to-date will.

 

Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the TC. Call 250.389.2138. greenardgroup.com

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in  this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a 
division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

Part V – Real Estate: Use Caution When Purchasing First Home

As of September 30, 2016, the price for a single family house has risen 22 percent, from September 30, 2015.  This could be discouraging for anyone not in the real estate market or for younger people looking to save for a down payment to buy a house.  With prices at historic highs, the temptation may be to rush into real estate before it goes higher.  Similar to the stock market, when you buy is extremely important.  Buying your principal residence is different which we will explain below.

The housing market is typically one area where using leverage (borrowed money) to purchase an asset has been good. Let’s walk through an example of leverage to purchase a single family home in Victoria.  According the Victoria Real Estate Board (VREB) the benchmark median value (September 2016) for a single family home in Victoria is $745,700.  Unfortunately, the exemption rules with respect to first time home buyers and property transfer tax are archaic and unrealistic in larger centres – property transfer tax of $12,914 would apply.   We think it would be beneficial if the province would adjust the qualifying value for exemption or at least allow some form of proration for affordable housing.  In Ontario, the Finance Minister  has announced that they will refund up to $4,000 from the land-transfer tax for first-time home buyers.

In addition to the purchase price, I estimate the following additional costs at a minimum: legal fees $750, house inspection $500, and house insurance $800. At a minimum, the immediate cash out-lay to purchase the home is $760,664.  To avoid CMHC insurance, a purchaser must put a down payment of 20 per cent, or in this case $152,132.80.  The remaining $608,531.20 must be financed or in other words, “leveraged”.

As noted at the very beginning, prices for Real Estate jumped 22 per cent in one year. It is, therefore, not unreasonable to stress test what would happen if real estate declined 10 per cent in one year.  If a 10 percent correction in real estate prices occurred, then this single family home example would decline $74,570.  Based on the down payment of $152,132.80, this would represent a loss on capital saved of 49 per cent.  Illustrating leverage to a younger person is essential in order to understand the associated risks.

In our first column we talked about the tax benefits of owning a principal residence – essentially no tax on capital gains. Canada Revenue Agency has a term called “personal-use property” which applies to a principal residence.  Any loss on the disposition/sell of a property which is used as a primary residence is deemed to be nil by virtue of sub-paragraph 40(2)(g)(iii) of the Income Tax Act.

If an investor entered the stock market with a non-registered account at a market high point before it pulled back, then, at least with the stock market, people are able to claim a capital loss and use it indefinitely.

Assuming a 25 year amortization and monthly payments, let’s do another form of stress test to see how a change in interest rates would impact payments on the $608,531.20 mortgage.   Assuming a mortgage at 3.2 per cent, the monthly payments would be $2,949.43.  If rates rise slightly to 3.7 per cent, the monthly payments would rise to $3,112.12.  In the near term it looks like rates will stay low, but a realistic view of the 25 year amortization should reflect rates rising off historic lows.  The best scenario would have the first time home buyer paying down as much of the principal before rates potentially rise to reduce the impact.

When interest rates go up, home prices tend to go down simultaneously. This would only compound the effect of the loss on capital saved in the short-term.

Taking a long-term vision and being sure that you can weather the stress tests above in the short-term are key factors prior to rushing in to buy a home. Similar to the stock market, we feel confident in the long-term that valuations will be higher than today.

Kevin Greenard, CPA CA FMA CFP CIM, is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the TC.  Call 250.389.2138. greenardgroup.com 

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

Part IV – Real Estate: Creating Cash Flow from the Proceeds from Selling Your House

Prior to selling your home, we encourage you to have a clear plan of what the next stage would look like.

If that next stage is renting, then meeting with your advisor ahead of time is recommended.   Once you sell, the good news is that you no longer have to worry about costs relating to home ownership, including property taxes, home insurance, repairs and maintenance.

Budgeting, when your only main expense is monthly rent, makes the process straight forward.  The key component is ensuring the proceeds from selling your house will be invested in a way that protects the capital and generates income to pay the rent.

The first step is determining the type of account in which to deposit the funds. The first account to fully fund is the Tax Free Savings Account (if not already fully funded). Then open a non-registered investment account for the proceeds.  Couples will typically open up a Joint With Right of Survivorship account.  Widows or singles will typically open up an Individual Account.

The second step is to begin mapping out how the funds will be invested within the two accounts above. A few types of investments that are great for generating income are REIT’s (Real Estate Investment Trust), blue chip common shares, and preferred shares.  Not only do these types of investments offer great income, they also offer tax efficient income, especially when compared to fully taxable interest income.

When you purchase a REIT, you are not only getting the benefit of a high yield, but you are generally getting part of this income as return of capital. The return of capital portion of the income is not considered taxable income for the current tax year.

As a result of receiving a portion of your capital back, your original purchase price is therefore decreased by the same amount. The result is that you are not taxed on this part of the income until you sell the investment at which point if there is a capital gain you will be taxed on only 50% of the gain at your marginal tax rate. You have now effectively lowered and deferred the tax on this income until you decide to sell the investment.

Buying a blue-chip common share or a preferred share gives you income in the form of a dividend. The tax rate on eligible dividends is considerably more favourable than interest income.

Another tax advantage with buying these types of investments is that any gain in value is only taxed when you decide to sell the investment and even then, you are only taxed on one half of the capital gain, referred to as a taxable capital gain. For example, if you decide to sell a stock that you purchased for $10,000 and the value of that stock increased to $20,000, you are only taxed on 50% of the capital gain. A $10,000 capital gain would translate to a $5,000 taxable capital gain.

We have outlined the approximate tax rates with a couple of assumptions.  Walking through the numbers helps clients understand the after-tax impact.

To illustrate, Mr. Jones has $60,000 in taxable income before investment income, and we will assume he makes $10,000 in investment income in 2016.  His marginal tax rate on interest income is 28.2%, on capital gains 14.1%, and only 7.56% on eligible dividends.

If Mr. Jones earned $10,000 in interest income, he would pay $2,820 in tax and net $7,180 in his pocket.  If Mr. Jones earned $10,000 of capital gains, he would pay $1,410 in tax and net $8,590 in his pocket.  If Mr. Jones earned $10,000 of eligible dividends, he would pay $756 in taxes and net $9,244 in his pocket.

The one negative to dividend income for those collecting Old Age Security (OAS) is that the actual income is first grossed up and increases line 242 on your income tax return. Below line 242 the dividend tax credit is applied.  The gross up of the dividend can cause some high income investors close to the OAS repayment threshold to have some, or all, of the OAS clawed back which should be factored into the after tax analysis.  The lower threshold for OAS claw-back is currently at $72,809.  If taxable income is below $72,809 then the claw-back is not applicable.  If income reported on line 242 is above $72,809 then OAS begins getting clawed back.  Once income reaches $118,055 then OAS is completely clawed back.

The schedule for dividend payments from blue chip equities and preferred shares is typically quarterly.  For REIT’s, it tends to be monthly. Once you decide on the amount you want to invest, then it is quite easy to give an estimated projection for after tax cash flow to be generated by the investments.

Preparing a budget of your monthly expenses makes it easy to automate the specific cash flow amount coming from your investment account directly into your chequing account.

Kevin Greenard, CPA CA FMA CFP CIM, is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria.  His column appears every week in the TC.  Call 250.389.2138. greenardgroup.com 

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

Part III – Real Esate: Benefits of Selling Real Estate Early in Retirement

In our last column we talked about CRA cracking down more on individuals who are non-compliant with respect to the principal residence deduction. Certainly individuals who have frequently bought and sold homes under the principal residence deduction will have to think twice and be prepared to be audited.

This article is really about the individuals who are contemplating a change in their life. Health and life events are often the two trigger points that have people thinking about whether to sell or not.   It can certainly be an emotional decision when it comes to that time.  Selling your home when you have control on timing when it is sold is always better than the alternative.

For our entire lives we have been focused on making prudent financial decisions and doing things that increase our net worth. There comes a point where you shouldn’t always do something that is the best financially.  If we only made decisions based on financial reasons you would never retire, you would work seven days a week, work longer days, and never take a vacation.  Throughout our working lives most people try to create a reasonable work-life balance.  In retirement I try to get clients to focus on the life part and fulfilling the things that are important to them.

Selling a principal residence could translate to a foolish move for someone looking at it only through net worth spectacles. I encourage clients to take off those spectacles and focus on what they truly want out of retirement and life.  At the peak of Maslow’s hierarchy of needs is self-actualization where people come to find a meaning to life that is important to them.   I think at this peak of self-actualization, many find that financial items and having to own a house, are not as important as they once were.

About ten years ago I remember having meetings with two different couples. Let us talk about the first couple, Mr. and Mrs. Brown who had just retired.  One of the first things they did after retiring was focus on uncluttering their lives.  They got rid of the stuff they didn’t need, and then they listed their house and sold it.  They then proceeded to sell both cars.  Shortly thereafter they came into my office and gave me a cheque for their total life savings.  Mrs. Brown had prepared a budget and we mapped out a plan to transfer a monthly amount from their investment account to their bank account.  They walk everywhere and are extremely healthy.  They like to travel and enjoy keeping their life as stress free as possible.  If any appliances break in their apartment it is not their problem, they just call the landlord.  Our meetings are focused on their hobbies and where they are going on their next trip.

I met another couple ten years ago, Mr. and Mrs. Wilson. They had also just retired.  They had accumulated a significant net worth through a combination of financial investments and they owned eight rental properties (including some buildings with four and six units).    At that time I thought they would have had the best of retirements based on their net worth.   The rental properties seem to always have things that need to get repaired or tenants moving out.  When I hear all the stories it almost sounds like they are stressed and not really retired.  Every year their net worth goes up.  Every year they get older, Mr. Wilson is now 75 years old and Mrs. Wilson is 72.  In the past I have talked to them about starting to sell the properties, to simplify their life and get the most out of retirement.   They are still wearing net worth spectacles and have not slowed their life down enough to get to the self-actualization stage.

My recommendation to clients has normally been to stay in their home as long as they can, even if this involves modifying their house and hiring help. This is assuming they have their health and the financial resources to fund this while still achieving their other goals.   Even in cases when financial resources do not force an individual to sell a house, the most likely outcome is that the house will be sold at a later stage in life and the proceeds used to fund assisted living arrangements.

Many people are house rich and cash poor. From my experience clients have two choices.  Option one is they can have a relatively stressful retirement trying to stretch a few dollars of savings over many years.  With this option you will likely leave a large estate.   Option two is selling the house and using the lifelong accumulation of wealth to make the most out of your retirement.    Although this option results in a smaller estate, you’re more likely to reach the self-actualization stage.

Kevin Greenard, CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the TC.  Call 250.389.2138. greenardgroup.com 

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

 

Part II – Real Estate: Mandatory to Report Sale of Principal Residence

In our last column we talked about the tax benefits for Canadians owning a principal residence. One of the positve parts about selling a principal residence in the past was that you didn’t even have to let Canada Revenue Agency know you sold it.

 

That is about to change.

 

On October 3, 2016, the Government announced that the Canada Revenue Agency now has a new reporting requirement for the sale of a principal residence. Starting with the 2016 tax year, individuals will be required to report basic information about the sale.   This new rule will require individuals who sell a home at any time during 2016 to report the disposition in their 2016 tax return.

 

The reporting of the sale will be done on Schedule 3 of your tax return. CRA will modify this form for the 2016 tax year.  It is anticipated that you will be required to report the date of acquisition, proceeds of disposition, and description of the property.

 

If the disposition is not reported to CRA, it will not be bound by the normal three-year limitation period for reassessing the disposition. The reassessment period for unreported dispositions will be extended indefinitely, regardless of whether the taxpayer’s failure to report the disposition was innocent or not. Prior to this change, the CRA could only reassess beyond the normal three year limitation period where the CRA could prove carelessness, negligence, willful default or fraud in failing to report the disposition.

 

Listed on the Canada Revenue Agency website, a property qualifies as your principal residence for any year it meets all of the following four conditions:

  • It is a housing unit, a leasehold interest in a housing unit, or a share of the capital stock of a co-operative housing corporation you acquire only to get the right to inhabit a housing unit owned by that corporation.
  • You own the property alone or jointly with another person.
  • You, your current or former spouse or common-law partner, or any of your children lived in it at some time during the year.
  • You designate the property as your principal residence.

 

The actual rules with respect to the disposition of your principal residence have not changed other than the disclosure component. CRA has been increasingly focused on those non-compliant with the rules.

 

In British Columbia, the CRA doubled their efforts on auditing the real estate sector in 2015 and they have started a review of 500 high dollar value real estate transactions in this province.

 

The end goal for CRA is likely to uncover any unreported tax issues.   With computers, real estate information obtained from third parties can more easily be used in their risk-assessment tools, and analytical work.

 

It always amazed me over the years that CRA focused on the reporting of investment income on dividends, interest, and other income as it was mandatory that those amounts were recorded on a tax slip such as a T3 or T5.

 

For most of the years that I have been a Wealth Advisor, CRA did not have a mechanism to monitor the actual disposition of stocks in taxable accounts.

 

As Wealth Advisors we would send a realized gain (loss) report to clients which they would report in part 3 of Schedule 3. If clients failed to report this, CRA had no mechanism linked to a third party to monitor for non-compliance.  It is not until recent years that CRA has required financial firms to report the capital disposition of securities in taxable accounts to CRA. CRA now has a mechanism to monitor for non-compliance for sale of publicly trades shares, mutual fund units and the like.

 

Of course, the process of non-compliance is not black and white. A simple example is CRA targeting the short holding periods (the home may not qualify as capital property, a condition of being a principal residence), a house that was not ordinarily inhabited in each year of ownership by the vendor (another condition to qualifying as principal residence), or builders who build, then occupy, a house before selling (these would be considered inventory and not a capital property).

 

No doubt this change will result in many more audits and reassessments to deny the principal residence exemption.   Careful attention should be paid by trustees and executors to obtain a clearance certificates prior to distributing estates where there has been a recent home sale where the principal residence exemption could be questioned.

Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the TC.  Call 250.389.2138. greenardgroup.com 

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

Ten Tips on Working With A Portfolio Manager

HEALTHY LIVING MAGAZINE

Over the years, I have had many discussions with people about what is important to them.  Health is nearly always at the top of the list.  Connected to this is having time to enjoy an active and social lifestyle.

Life has become busy, and it is tough to squeeze in everything that you have to do, let alone have time left over for all the things you want to do. Sometimes it is simply a matter of making a choice. One of my favourite concepts I learned years ago in economics is ‘opportunity cost’. It can relate to time, money or experiences. We can’t get it back, borrow or save it. Time is sacred – especially family time and doing your own investing can take time and attention away from your family. So ask yourself – is doing your own investing worth the time you are spending on it?

One way to focus on the things you want to do is to delegate the day-to-day management of your finances to a portfolio manager who can help you manage your investments by creating what is called a ‘managed’ or ‘discretionary’ account. They are able to execute trades on your behalf without obtaining verbal permission, so when the market changes, they are able to act quickly and prudently.

Here are some tips for working with portfolio manager to improve your financial health:

Have a Plan

You are more likely to achieve the things you want if you set goals to paper. With fitness goals it would be things like running your first 10k race or lowering your blood pressure. Financial plans are the same – sit down with your portfolio manager and outline what you want to achieve with your estate, your investments and your retirement. Once a plan is in place, a periodic check-up takes a fraction of the time to ensure everything is on track.

Stay in Control

If you are worried about being out of touch with your investments, there are measures in place to keep you in the driver’s seat. One of the required documents for managed accounts is an Investment Policy Statement (IPS). This sets the parameters with your portfolio manager and provides some constraints/limits around their discretion. For example, you could outline in the IPS that you wish to always maintain a minimum of 40 per cent in fixed income. This lets you delegate on your terms, and ensures a disciplined approach to managing your portfolio. Technology has made it easier and faster for you and your portfolio manager to track your progress, review changes or update the program. Developing a written agenda that gets shared in advance of a meeting, whether in person or virtual, can create efficiencies and ensures nothing is missed. Whether it is email, Skype, or even text messaging – there are many ways for you to stay connected to your finances.

Think About Taxes and Legal Issues

Your finances often involve other professionals such as lawyers or accountants, so it is beneficial to get everyone connected early on. Work with your portfolio manager to complete a professional checklist that includes important names and a list of key documents. If your team can communicate directly with one another, it’s easier to map out planning recommendations and tax-efficient investment strategies. Your portfolio manager can also act as your authorized representative with the Canada Revenue Agency and can even make CRA installment payments on your behalf. Every summer, I am reviewing assessment notices, carry-forwards, contribution limits (i.e. TFSA and RRSP) and income levels to allow my clients to enjoy the outdoors and improve their quality of life

Put Family First

Having a complete picture helps a portfolio manager map out strategies to preserve your capital and to protect your family. If a life event occurs or your circumstances change – from new babies, to inheritances, to critical illness –  your portfolio manager can provide options and solutions. When the family member who manages the finances passes away suddenly, it can be very stressful for the surviving spouse or children during a time that is already emotionally draining. To help in this situation, many families create well thought-out plans that can involve working with their portfolio manager to make discretionary financial decisions in a time of transition. A Portfolio Manager can take care of your finances regardless of the curves that life throws them.

As a portfolio manager, I feel it is critical to be accessible and to keep clients well-informed with effective communication. What I am finding is that conversations are shifting to areas outside of investments, including the financial implications of health issues and changes within the family.

If you are looking for a way to simplify, reduce stress in your life, and proactively manage your finances, a portfolio manager might be a good way to improve your financial health.

 

Let’s make things perfectly clear

CAPITAL MAGAZINE

When hiring an accountant or lawyer, you’re billed after services are rendered. In the investment world, it’s not so transparent. With embedded costs, market-value changes, withdrawals and deposits, it hasn’t always been clear exactly what you’ve been charged.

The introduction of fee-based accounts and recent regulatory changes are making significant strides in providing better transparency to investors.

In the past, most types of accounts were transactional, wherein commissions are charged for each transaction. With fee-based accounts, however, advisers don’t receive commissions. Instead, they agree to a set fee schedule, usually charged on a quarterly basis. This fee is normally based on a portfolio’s market value and composition. Buy and sell recommendations are based on the client’s needs and goals. If an investor’s account increases in value, so do the fees paid; conversely, if an account declines in value, fees go down.

The recent increase in fee-based accounts correlates to the implementation of the second phase of the “Client Relationship Model” (CRM), a regulatory initiative passed by the Canadian Securities Administrators in March 2012. The CRM affects both the Mutual Fund Dealers Association and the Investment Industry Regulatory Organization of Canada.

While the key objective of CRM1 was relationship disclosure and enhanced suitability, CRM2 is designed to increase transparency and disclosure on fees paid, services received, potential conflicts of interest and account performance. All of these mandatory disclosures are being phased in from 2014 to 2016.

Last July, CRM2 mandated pre-trade disclosure of all fees prior to an investor agreeing to buy or sell an investment. With transactional accounts, an adviser must disclose all of the fees a client is required to pay, such as commissions when buying or selling positions. Many investors have complained about hidden fees, especially in mutual funds. With CRM2, all of these fees now have to be disclosed prior to the transaction.

Certain types of transactions had no disclosure requirements in the past. For example, an adviser used to be able to purchase a bond and embed their commission in the cost of the bond on the trade confirmation slip. Now, fixed-income trades also require full disclosure. In other cases, even if there was disclosure in the legal sense of the word, understanding this disclosure required clients to read the fine print in lengthy prospectus documents.

With fee-based accounts, the client has a discussion about fees with their adviser up front, and an agreement with full disclosure is signed by investor and adviser.

Another reason for the popularity of the fee-based platform is that many advisers can offer both investment and planning-related services. Many advisers can offer detailed financial plans and access to experts in related areas, such as insurance, and will and estate planning.

In a traditional transactional account, where commissions are charged for every buy or sell, it has always been challenging for advisers to be compensated for additional services such as financial planning. Consequently, many transactional-based advisers would not offer these services to their clients.

Fee-based accounts also offer families one more opportunity for income splitting by setting up account-designated billing for their fees. The higher-income spouse can pay the fees for the lower-income spouse.

Another benefit of a fee-based structure for non-registered accounts is the ability to deduct investment counsel fees as carrying charges and interest expense. Anyone who has non-registered accounts would be well advised to read Canada Revenue Agency’s interpretation bulletin 238R2. Investment counsel fees cannot be deducted for registered accounts, but there is the benefit of paying the fees for registered accounts from a non-registered account.

Adviser-managed accounts have been the fastest-growing segment of the broad fee-based group. In this type of account, the adviser is licensed as a portfolio manager and able to use discretion to execute trades. In setting up the adviser-managed account, one of the criteria is that the account must be fee-based. Regulators have made it clear a portfolio manager is not permitted to use discretion when it comes to commissions or transaction charges. One of the starting points to setting up a managed account is to get a defined investment policy statement that sets out the relevant guidelines that will govern the management of the account.

Regulatory Change Helps Drive Popularity of Fee-Based Investment Accounts

CPABC IN FOCUS MAGAZINE

The investment services industry is changing at a dramatic pace, with investors demanding more choice, more transparency, and more personalized advice. One of the fastest growing trends within the financial services sector is the use of fee-based accounts. While there are many reasons for the increasing popularity of these accounts among advisers and clients alike, recent regulatory changes have been a major catalyst.

Traditional vs fee-based account structures

In the past, the most common type of account structure has been a transactional one, wherein commissions are charged for each buy or sell transaction. With fee-based accounts, however, advisers do not receive commissions—instead, they agree to a set fee schedule, usually charged on a quarterly basis. This fee is normally based on the portfolio’s market value and composition. Buy and sell recommendations are based solely on the client’s strategic needs and goals. If an investor’s account increases in value, so do the fees paid to the adviser; conversely, if an investor’s account declines in value, so do the fees paid. With a fee-based structure, the adviser has a direct (and overt) incentive to ensure that the investor’s account increases in value.

Client relationship model initiative enters second phase

The recent increase in the use of fee-based accounts correlates to a large extent to the implementation of the second phase of the “Client Relationship Model” (CRM), a regulatory initiative passed by the Canadian Securities Administrators in March 2012 The CRM affects both the Mutual Fund Dealers Association and the Investment Industry Regulatory Organization of Canada.

While the key objective of CRM1 was relationship disclosure and enhanced suitability, the key objective of CRM2 is to increase transparency/disclosure for investors with regard to fees paid, services received, potential conflicts of interest, and account performance. All of these mandatory disclosures are being phased in from 2014 to 2016.

In July 2014, CRM2 mandated pre-trade disclosure of all fees prior to an investor agreeing to buy or sell an investment. With a traditional transactional account, an adviser must disclose all of the fees a client is required to pay, such as any commissions for transactional accounts when buying or selling positions. However, many investors have complained about “hidden” and unexpected fees, especially with respect to mutual funds. With CRM2, all of these fees now have to be fully disclosed prior to the transaction.

This move to greater transparency is a major shift from certain types of transactions that had no disclosure requirements in the past. For example, an adviser used to be able to purchase a bond and embed their commission in the cost of the bond on the trade confirmation slip. Now, fixed income trades also require full disclosure. In other cases, even if there was disclosure in the legal sense of the word, understanding this disclosure required clients to read the fine print in lengthy prospectus documents. Similar CRM2-type regulations for full disclosure were implemented in Australia and the UK in 2013, requiring transparency regarding all fees. Not surprisingly, this resulted in a significant reduction in the number of financial advisers working in the industry in both countries. It’s possible that we could also see a reduction in the number of advisers here, once the new rules are fully implemented in Canada.

Fee-based accounts are already onside of the new rules, as transparency is embedded in their structure: The client has a discussion about fees with their adviser up front, and a fee-account agreement with full disclosure is then signed by both the investor and the adviser. 

Comprehensiveness

Another reason for the growth in popularity of the fee-based platform is the fact that many advisers now offer a comprehensive wealth offering, which includes both investment and planning-related services. This differs from the role of the stock broker of the past.

Clients have a variety of financial planning needs, primarily with regard to retirement and estate planning. Many advisers can offer detailed financial plans and provide access to experts in related areas, such as insurance, and will and estate planning. An adviser will often communicate with the client’s accountant and lawyer to ensure everyone is on the same page.

In a traditional transactional account where commissions are charged for every buy or sell, it has always been challenging for advisers to be compensated for additional services such as financial planning. Consequently, many transactional-based advisers simply would not offer these services to their clients.

Some unique benefits

Certain benefits are unique to fee-based accounts.

Rebalancing without additional cost

For example, this structure enables wealth advisers to rebalance portfolios as needed to reduce risk at no additional cost. Multiple types of rebalancing are important when managing risk. At the macro level, let’s assume a client’s optimal asset mix is 60% in equities and 40% in bonds. After a period of strong equity markets, the client’s equity percentage rises to 68%. Reducing equities by 8% and allocating this to fixed income is rebalancing at the macro level. At the micro level, there is an optimal position size for one holding. In this example, let’s assume the optimal position size is $24,000 for each company held in the portfolio. If one stock rises significantly above or below the optimal position size, then consideration for a rebalancing trade should occur.

Several trades could be required on an annual basis to rebalance a portfolio. With transactional accounts, the commissions for doing multiple small adjustments would likely be prohibitive. However, not doing the trades because of the commission payable in a transactional account means that you’re not managing risk as effectively.

The adviser’s ability to make tactical shifts in an account is another benefit of fee-based accounts. For example, there are times when investors benefit from moving in or out of USD-denominated holdings. Being able to make these changes when the currency is right should be done without concern for the trade’s commission cost. Being able to move between sectors based on current outlook can also be strategic, especially when transaction charges are not a factor (if a transaction charge is 2% to sell and 2% to buy, then the cost of any switch trade has to increase by 4% to break even).

Income splitting and “householding”

Fee-based accounts also offer couples and families one more opportunity for income splitting by setting up account-designated billing for their fees. For example, the higher income spouse can pay the fees for the lower income spouse. Let’s assume the lower income spouse has an RRSP and a TFSA. The higher income spouse can put funds into the lower income spouse’s account as a contribution of fees without attribution. In another example, a client with multiple fee-based investment accounts (i.e. one non-registered and five registered) can arrange to have all of the fees paid out of the non-registered account.

“Householding” is a term used in fee-based accounts to link accounts together for fee-billing purposes. As the total of the householded assets increases, the percentage fee for the adviser’s services decreases. Let’s say we have a middle-aged couple with $400,000 in investments. The couple has parents with $680,000 in investments, over which the couple has power of attorney. The couple also has a corporate account totalling $120,000 in investments. By householding, or combining all accounts under one agreement, the household value becomes $1,200,000, which results in lower overall fees for everyone.

Deducting investment council fees

Another benefit of a fee-based structure for non-registered accounts is the ability to deduct investment council fees as “carrying charges and interest expense.” Many investors are still not aware of these tax benefits. Anyone who has non-registered accounts would be well advised to read the Canada Revenue Agency’s (CRA) interpretation bulletin on this topic (IT-238R2). The investment council fees cannot be deducted for registered accounts, but there is the benefit of paying the fees for registered accounts from a non-registered account, especially for younger clients where registered accounts are deferred for many years.

Adviser-managed accounts

Over the last several years, adviser-managed accounts have been the fastest growing segment of the broad fee-based group. In this type of account, the adviser is licensed as a portfolio manager and able to use his or her discretion to execute trades.

In setting up the adviser-managed account, one of the criteria is that the account must be fee-based. The regulators have made it clear that a portfolio manager is not permitted to use discretion when it comes to commissions or transaction charges. One of the starting points to setting up a managed account is to get a clearly defined investment policy statement that sets out the relevant guidelines that will govern the management of the account. At this same time, a fee-based agreement is signed that clearly outlines the negotiated fee structure.

Shifting to a new model

As the financial services industry continues to change and evolve, so do the solutions being offered. There is now more flexibility and choice in how a wealth adviser and an investor can work together.

High-net-worth clients are looking for advisers who have the credentials and licensing to offer discretionary portfolio management. Within that context, there is also an expectation that financial planning and other related services will be part of the overall fee-based structure. The traditional model of solely doing stock trades for trading commissions is becoming an increasingly difficult business model to sustain.

Kevin Greenard is a portfolio manager and associate director of wealth management with ScotiaMcLeod, a division of Scotia Capital Inc. and ScotiaMcLeod Financial Services Inc.

Exploring the world of fixed income investments

The term fixed income can be confusing, especially when the financial industry has so many names for the same thing. For someone new to investing I typically draw a line down the middle of a page. On the left side of the page I label this “debt”, and on the right hand side I put “equity”. Debt is another term often associated with “fixed income”. In explaining what debt is I begin by using a simple example, a two year annual pay Guaranteed Investment Certificate (GIC). With a two year GIC you are giving your money to a company and in exchange you receive interest for the use of the capital. You receive your original capital back at the end of two years. You have no direct ownership in the company with debt.

The equity side of the page would have common shares, this is what most people would directly link to the stock exchange. Although some fixed income investments trade on a stock exchange, the majority of listed securities are equities. When the news is flashing details of the TSX/S&P Composite Index, the Dow, or the S&P 500 – these would all be equity indices reflected on the equity side.

Most people would agree that on the equity side of the page it would not be a good idea to put all your eggs in one basket. A prudent approach would be to diversify your equities by holdings various different stocks (i.e. between 20 and 30 different companies) in different sectors and geographies.

All too often I come across investment portfolios that have zero diversification on the fixed income side. As an example, it may be a person that has $500,000 or a million dollars all in GICs. In my opinion the best approach to fixed income is to have diversification – different types and different durations.

If we move back to the left hand side of the piece of paper, underneath debt we have already listed GICs. Let’s list a few other types of fixed income investments including: corporate bonds, government bonds, real return bonds, bond exchange traded funds, notes, coupons, preferred shares, debentures, bond mutual funds, etc.. Over the last decade there has been a huge growth in non-domestic bonds for retail investors. Perhaps one area that is often underutilized by many Canadians is the use of international bonds. Bonds are available in different developed countries. Advisors are able to purchase direct foreign bonds in developed countries and emerging markets. The emerging market bond space has opened up many different opportunities. With certain structured bond investments, these can be hedged to the Canadian dollar or not hedged (you are exposed to the currency risk).

Within each of the above main categories there are sub-categories. As an example, with bond ETFs one could purchase numerous different types, including: floating rate, short duration (example: one to five years), long duration, all corporate, all government, high yield, US bonds, etc.

Another example of subcategories can be explained using preferred shares as an example. Preferred Shares are generally classified as “fixed income” even though they pay dividend income (similar to common shares that are on the equity side of the page). For clients who have non-registered funds, a portion of your fixed income in preferred shares can be more tax efficient than interest paying investments. The main types of preferred shares are retractable, fixed-reset, floating rate, perpetual, and split. All have unique features that an advisor can explain to you.

When equity markets perform well it is natural that they become overweight in a portfolio. We encourage clients to periodically rebalance to their preferred asset mix. In good equity markets this involves selling some of the growth in equities and purchasing fixed income investments. When equity markets are declining, the process of rebalancing could result in selling fixed income and purchasing equities at lower levels.

The idea of adding “fixed income” is not that exciting in this low interest rate environment, especially when many “equity” investments have yields that exceed investment grade short duration bonds. Opportunities still exist in fixed income for reasonable yields, especially when you explore different types of fixed income. One always has to assess the risks they are comfortable with. As an example, I ask clients what they feel is the greater risk, stock market risk or interest rate risk. By stock market risk, I define this as the risk that the equity markets will have a correction or pull back (say, 10% or greater). By interest rate risk, I mean that interest rates will jump up materially and do so quickly (in a short period of time).

Every model portfolio I manage has fixed income. This is the capital preservation and income side to a portfolio. The percentage in fixed income really comes down to a clients risk tolerance and investment objectives. Time horizon and the ability to save additional capital is also a key component in determining the allocation to fixed income. It is important to first determine the right amount to allocate to fixed income, and second, to diversify it to enhance liquidity and overall returns.

Kevin Greenard CA FMA CFP CIM is a Portfolio Manager with The Greenard Group at ScotiaMcLeod in Victoria. His column appears every second week in the TC. Call 250-389-2138.

 

Behind the scenes with trade execution

If we define every transaction in an account as a trade then we can start a conversation about the basics of trade execution.

Some people may believe that trading is executed through a primary stock market. If we keep this article specific about Canada, the primary exchanges are Toronto Stock Exchange and the TSX Venture Exchange (for small and medium sized companies). Both of these exchanges have trading hours between 9:30 am and 4:00 pm eastern time, Monday to Friday, with the exception of certain holidays. In British Columbia, this means the primary exchanges close at 1:00 pm.

Over the last decade new marketplaces have emerged in Canada, these have been referred to as Alternative Trading Systems (or ATS). These systems at first grew in popularity because brokers were able to avoid paying the exchange trading fee. Also, an ATS may have different hours of operations than the primary exchanges. The Investment Industry Regulatory Organization of Canada (IIROC) regulates the above noted primary exchanges and the following ATSs: Canadian Securities Exchange, Alpha Exchange, Bloomberg Tradebook, Chi-X Canada, CX2 Canada ATS, Instinet Canada Cross Limited, Liquidnet Canada Inc., Lynx ATS, MATCH Now, Omega ATS, and TMX Select.

When an advisor enters an order it may be executed on the primary exchanges, an ATS, or a combination of both. The main factors effecting where the trade is ultimately filled is best available price, historical liquidity, and likelihood of execution. If a Canadian trade is executed on just one exchange then your confirmation slip would have a message something like “AS AGENTS, WE TODAY CONFIRM THE FOLLOWING BUY/SALE FOR YOUR ACCOUNT ON THE TORONTO STOCK EXCHANGE/CANADIAN VENTURE EXCHANGE/ALPHA/OMEGA/ etc.” If the Canadian security transaction was executed by a combination of exchanges/ATS then the message on the confirmation slip would reflect this by stating something like “AS AGENTS, WE TODAY CONFIRM THE FOLLOWING BUY/SALE FOR YOUR ACCOUNT ON ONE OR MORE MARKETPLACES OR MARKETS. AVERAGE PRICE SHOWN. DETAILS AVAILABLE UPON REQUEST“.

For example, a client wants to sell 2,500 of ABC Company at market after watching BNN and seeing the the price per share at $15.59. If all the shares were sold and executed at this price, the proceeds would be $38,975. The actual value once we enter the order is almost always different. The reason for this is both depth of quote and dark liquidity.

Depth of quote is when we can see the quantity of shares available and the current bid and ask at each price level. Prior to the above trade execution I outlined the depth of quote with my client (see table below). Advisors assisting retail clients typically have what is called Level II quotes where they can see both bid and ask at different price levels – I refer to this transparent part of the market as the “lit” system. Using the above example of a client wanting to sell 2,500 shares of ABC Company at market, the beginning few lines of the bid side of a depth of quote/level II would provide the following information:

Depth of Quote/Level II

Orders          Size           Bid

14                       700            $15.57

22                     1,600           $15.54

  9                     4,200           $15.50

  3                      9,000           $15.40

15                    10,000           $15.37

Orders represent the number of limit orders entered on the lit system. It is possible for the same client to enter multiple limit orders. Size is the number of shares available at the bid price on the lit system.

Using the above Level II table, 700 shares would be sold (also referred to as filled) at $15.57, 1,600 filled at $15.54, and 200 filled at $15.50. An Advisor could communicate to the client what is visible on the lit system and that the total estimated proceeds would equal $38,863. It is possible that once the sell button is pressed that the actual trade is executed at a higher price as a result of dark liquidity (also referred to as dark pools).

Dark liquidity is a term that relates to traders being able to enter orders without providing the above transparency to other market participants. Effectively, the trades are not transparent or lit; thus the term dark pool came about because the orders can not be seen. Retail clients and advisors typically do not have direct access to entering trades with dark liquidity. Most financial firms have traders that assist Portfolio Managers, Wealth Advisors and institutional clients with larger trades.

Traders can use dark pools on both the primary exchanges and ATS. Dark pool trades in Canada are nearly all limit orders, and are typically done for institutions executing large trades. Using the above table, if an advisor entered an order to sell 100,000 shares at market, the price would immediately get driven down to as low as $15.00 (assuming no dark pool orders to buy). The benefit of dark liquidity for institutions is that they do not have to “show their cards” before they are played. In other words, an institution may want to sell 100,000 shares of ABC Company with a limit price of $15.57. A trader could work the order with acquiring smaller fills without creating big swings in the price of the security. The trader could enter a limit order putting 20,000 shares on the lit system so it shows on level II, enter 50,000 in a dark pool at the same price so it is not displayed, and hold off entering the remaining 30,000 in order to continue to work the order.

Wealth Advisors must verbally confirm each trade with clients and then execute the trade right after they obtain confirmation. With frequent small trades at different points in time, dark pool trades are not generally used in Canada at the retail level. In the US, dark pools are much more common, even for smaller sized trades. Some individual clients may have large holdings in a particular security and the traders are available to assist. Portfolio Managers on the other hand often execute large block trades (combining all the shares for all clients) on a discretionary basis. Once a quantity of shares to buy or sell is determined the Portfolio Manager is often in direct communication with the traders.  Together they can choose to use dark pools, or not.

Dark liquidity is still relatively small in Canada when compared to the United States. Earlier this year, the US Securities and Exchange Commission noted that around 40 per cent of all U.S. stock trades avoid the exchanges. The increase in dark pool transactions make it more challenging to determine the true liquidity and price transparency of a security. Market makers assist in the lit market but are non-existent in the dark pool. The Canadian Securities Administrator and IIROC have already implemented a few rules with respect to dark liquidity and I would suspect that further rules will be unveiled in the future.

 

Kevin Greenard CA FMA CFP CIM is a Portfolio Manager with The Greenard Group at ScotiaMcLeod in Victoria. His column appears every second week in the TC. Call 250-389-2138.