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.

Models underscore risks and rewards

A model portfolio is a basket of holdings – cash, fixed income and equities – an advisor combines to achieve an investment objective or risk tolerance level.

Not every adviser uses a model portfolio approach.

The ones that do will often have more than one model portfolio to reflect the appropriate investment objectives and risk tolerance of each person. Objectives are usually classified as income, long-term growth, and short-term growth. Risk tolerance may be as simple as low, medium and high. Investment objectives and risk tolerance help establish which model portfolio is most suitable.

Our model portfolio approach includes three different broad options – income, income and growth, and growth. The best way to illustrate this is to use the situations of three individuals. John, Wendy and Alex each have $500,000 to invest and fall into a different model portfolio. The chart below summarizes the asset mix and number of equity holdings within each model.



  • John was referred by his accountant. He is 60, recently retired and withdrew the commuted value from his pension plan, valued at $500,000. In listening to John’s investment objectives and risk tolerance, it was clear the income model portfolio was the most appropriate for his needs. He did not have a lot of experience with investing and was nervous about investing too much in the stock market. He also wanted to immediately withdraw a monthly amount from the account to live on. The income model portfolio would have an optimal asset mix of 60 per cent fixed income and 40 per cent equities. The fixed income would have a larger short-term component to meet his cash flow needs. Within the equity portion, the number of individual companies John would acquire is 20 and the targeted position size is $10,000 per company. These 20 equities would all be large blue-chip equities, diversified by sector, and that pay dividend income. We were able to give John an estimated income report for the income model portfolio along with a discussion regarding risk and reward.
  • Wendy recently received an insurance payout of $500,000 from an accident she was in three years ago. She is 50 and planning to work for the next 10 to 15 years. It was apparent the income and growth portfolio was most suitable. Given that Wendy was moderately comfortable with assuming risk, her portfolio would have 40 per cent in fixed income and 60 per cent in equities. The number of individual companies Wendy would own is 25 and the targeted position size is $12,000 per company. These would be large companies that have both growth and income components. Wendy did not require immediate income, so we set up the dividend reinvestment plan on the equities she will be holding longer term.
  • Alex sold his shares in a private technology company and netted $500,000 after tax. He’s 40 and looking for tax-efficient growth and is comfortable assuming more risk to achieve greater long-term rewards. The growth portfolio is the most suitable for Alex and has only 20 per cent in fixed income and 80 per cent in equities. The number of individual companies Alex would own is 30 and the targeted position size is $13,333 per company.

Model portfolios help new clients understand the total investment costs, income, sector weighting, and structure like the number of holdings and position size.

Without these models it can be difficult for people new investors to visualize how their money can work best for them. The ranges shown above are important as it allows customization for each client.

If an investor wishes to invest in something that is not within the model portfolio, it is still be possible. We establish ranges outside of the optimal position size. For example, if a person transfers in a large position from an employer they may purposely want to overweight that name and have a greater position size than the optimal amount.

Another example is a person who has large gains on some stocks and wishes to continue overweighting them.

Some investors may wish to purchase investments that are not within a model portfolio. The ranges above usually provide flexibility to do this. A person may phone us for an unsolicited trade to purchase small companies or emerging markets which may not be part of any model. Or a person who chooses to overweight a particular sector which can also increase the risk of a portfolio.
Models help set the parameters for the portfolio within reasonable ranges while still allowing customization for each client. It assists an advisor in establishing a methodology to manage and explain risk and reward. By comparing all three models, new clients can work with advisors to select the portfolio that they feel best reflects their wishes.

Rebalancing investments in two steps

A disciplined investment process begins with determining the asset mix that is right for you. By asset mix we refer to the portion you have in one of three broad categories of investments, including cash, fixed income and equities. Fixed income includes guaranteed investment certificates, term deposits, bonds, bond exchange traded funds, debentures, preferred shares, etc.. Equities are what many would refer to as the “stock market”. Life, markets and your asset mix all change with time. Decisions you made yesterday may not hold true with new information tomorrow. This is the reason that your investment strategy is not just about the markets. When you buy a house, have a child or approach retirement, your investment goals will change. As your goals change, so might your asset mix. For example, the asset mix of a very aggressive investor would not be suitable for someone who is retiring in the coming years. Just as major life events change us, we can also look at major market events as changing the way we look at our portfolio. For some investors this may be an opportunity for reflection. You may ask yourself if your “normal” asset allocation is still valid once you have considered any changes in your life. If that answer is yes, then when markets change as they do, it may also be time to consider rebalancing your portfolio back to its original mix.

Interest rate changes and market movement results in fluctuations between asset mix. From the day you begin investing, your asset mix is constantly changing. To illustrate, we will use Thomas and Heather Bennett who invested in a portfolio with the following asset mix: Cash 0 per cent, Fixed Income 40 per cent, and Equities 60 per cent. Asset classes do not change at the same rate. Over time, stocks may grow faster than bonds making the growth in your portfolio uneven. For example, the Bennett’s portfolio that started with 40 per cent bonds and 60 per cent equities could drift to 30 per cent bonds and 70 per cent equities if the stock markets rise, or alternatively the other way to 50 per cent bonds and 50 per cent equities if a stock market correction occurs. Regardless of the direction of the change in your portfolio, it is necessary to remember the importance of the reasoning behind your original asset allocation. Although it may seem counter intuitive to sell an asset class that is doing well or buy one that is not, however that is precisely what is required if the fundamental principle of “buy low – sell high” is to be followed. By rebalancing your portfolio, you are staying the course and increasing the potential to improve returns without increasing risk.

Disciplined rebalancing can provide comfort by taking the emotion out of your investment decisions. It does not seem natural to sell a portion of your investments that have done well and buy more of those that have been more sluggish. This discipline allows a reassuring way to buy when it is difficult and sell when it seems counterintuitive. When markets are down, human nature would have us get out rather than buy low, but a disciplined rebalancing process can prevail in the long run.

Although at times, the changes in the market may not be large enough for an investor to feel that there is any need to rebalance, the benefit to doing so can be significant over the long run with compounding returns. It is important to talk to your advisor initially to determine your optimal asset mix that you are comfortable with, often documented in an Investment Policy Statement (IPS). Once you have a documented IPS then your advisor can establish a customized portfolio that matches your IPS.

Rebalancing to your optimal asset mix should be done at least once a year. Prior to rebalancing, it is important to periodically review you IPS to ensure that you’re comfortable with the asset mix. Changes in market conditions and interest rate outlook are factors to discuss with your investment advisor when revising the asset mix within your IPS. Your personal goals, need for cash, and knowledge level may also result in your asset mix needing to be adjusted.

The asset mix is the macro decision within the IPS and is the first step in rebalancing. Step two of rebalancing is looking at the micro items, such as sector exposure and individual companies you have invested in. It also may involve looking at geographic exposure, credit quality and duration of fixed income, and mix between small, medium, and large capitalized companies. Up above, we noted that the Bennett’s initially wanted 60 per cent in equities and started with total investments of one million. The equity portion of $600,000 was divided into 30 companies with approximately $20,000 invested in each company. Over the last year, the Bennett’s now have a portfolio valued at $1,080,000 with 63 per cent in equities and 37 per cent in fixed income. Step one for the Bennett’s rebalancing of the asset mix would result in them selling three percent of equities, or $32,400, and allocating this to fixed income.

Step two in the rebalancing process highlighted that several stocks performed very well and are above the new individual recommended position size of $21,600 ($1,080,000 x 60 per cent divided by 30 companies). We also noted that stocks in two sectors performed very well and have resulted in the portfolio being too concentrated in those sectors. Step two of the rebalancing process resulted in the Bennett’s selling a portion of the star performers in the overweight sector.

When significant deposits and withdrawals are made then this is an ideal time to look at both macro (step one) and micro (step two) rebalancing. This could be when you are making an RRSP or TFSA contribution or when you have to decide what to sell to raise cash for your goals. If no deposits or withdrawals are made then periodic meetings with your investment advisor should have ‘rebalancing your portfolio’ as an agenda item. Some people may want to rebalance quarterly while others may feel an annual check up is sufficient.

Watch costs when buying real estate

Real estate is a popular topic for discussion when it comes to investments.   While real estate investments are appealing for their rental income and property value appreciation, most people seem to forget that their own personal residence can be another investment opportunity. 

We make decisions whether to rent or own, and we also make decisions whether to sell or hold.  Just like selling equities, before making the decision to sell your home, or even if you are looking to buy a new home, timing is everything if you hope to realize a gain.  If you feel real estate will decline in value, then it may be prudent to sell your home and rent until market conditions improve.

Another factor to consider in deciding whether to buy, sell or hold is to consider the transaction costs of buying and sell.  These costs are high and should always be factored in when looking at options.

You’ve heard the terms “good debt” and “bad debt.”   Bad debt would be credit cards and other debt associated with purchases of goods that are expected to immediately decline in value.  Good debt is the type of debt assumed on purchases that are expected to appreciate in value greater than the interest rate that you are paying on the debt.

Julie and Brent have saved up a little money and have also gone to the bank.  They have decided to purchase a home for $560,000 with a 10 per cent down payment.  In addition to the purchase price, they had other costs:

  • On a $560,000 home, the property transfer tax is one per cent of the fair market value up to $200,000, plus two per cent on the portion of the fair market value that is greater than $200,000.  The total property transfer tax is $9,200.
  • As Brent and Julie are only putting 10 per cent down (or $56,000) on the home, it is considered a high-ratio mortgage and they will have to cover the costs of Canada Mortgage and Housing Corp. insurance at two per cent of the loan amount.  The cost of the insurance is $10,080 ($504,000 x two percent).
  • The legal fee for buying the house is estimated at $800.
  • The building / house inspection is $500.
  • The bank also charged $400 for the house to be appraised for financing.
  • They will also have to purchase all the landscaping and gardening tools, including a lawn mower, weed-eater, garbage cans, hoses to name a few in order to maintain the yard.  They have set aside $840.
  • Household appliances are a significant cost.  Brent and Julie have estimated the cost of a fridge, stove, microwave, washer and dryer at $3,800.
  • The house Brent and Julie purchased was an older home that required some immediate basic repairs and maintenance.  They have set aside $800.
  • One of the additional costs for being a home owner is the insurance costs required for this significant asset.  The bank required home owners insurance which resulted in an initial cost of $800 for basic coverage.  Earthquake insurance was declined to reduce insurance costs.
  • Although Brent and Julie are only moving 19 kilometres from where they are renting, they’ll incur an additional expense to move their personal possessions.  They have hired professional movers for the day costing $690.
  • In addition to the initial cash outflow they needed funds to cover the upcoming annual property taxes of $2,480 and other utility bills.
  • Brent and Julie had to budget a further $1,150 to purchase curtains.

The total estimated costs incurred prior to moving in are $591,540.

Before even buying the home, Brent and Julie should budget for all of the initial costs.  They should also be aware of the breakeven number for some reason they wished to sell it.  The legal fee for selling the property is estimated at $660.  There can also be some harsh penalties for prepaying a mortgage early.  In the above case we will assume no early prepayment penalties.   Real estate fees are generally the biggest cost when selling.  As an estimate for Brent and Julie, a realtor could charge seven per cent on the first $100,000 of the sale price, plus 2.5 per cent on the remainder.   In this case, if Brent and Julie hoped to recover the total costs they initially put into the home ($591,540 they would have to list for $612,000 before commission.  The listing would include all appliances.  If they got the list selling price then the commission would be $19,800 which would be shared with their agent and the buyer’s agent.   If they subtract the real estate commissions and legal costs, the couple breaks even.

The above numbers highlight that to break even, the real estate market would have to increase 9.3 per cent or $52,000 ($612,000 – $560,000). Another factor that Brent and Julie should be aware of is that an increase in interest rates is typically negative for real estate in the short term.  After thirty years of declining interest rates, the best case scenario for Julie and Brent would be if rates stayed low for an extended period.

If interest rates rise then this typically results in fewer buyers being qualified to buy homes and a greater number of home owners defaulting on mortgages – both of which could cause real estate to decline rather than rise in price.   When it comes to selling or buying a home, use some caution, factoring in all transactional costs to ensure you’re able to protect your home as a good investment.

TFSA equities can yield big dividends

Many people are still keeping their Tax Free Saving Account in cash or in a low interest bearing vehicle, not realizing there are other options available.

There are plenty of advertisements this time of year encouraging people to open new accounts with the promise of teaser high interest rates for six months or a year, or a $50 bonus. Seems like a no brainer to sign up for the new account, right?

Regrettably, many are missing the fine print where it is disclosed there is a $125 fee should you decide later to transfer. Those teaser rates don’t last forever, and the firms offering the teaser rates may have limited investment options.

Your TFSA is not limited to just cash. There are other investment product options available, such as equities. Managing equities in your TFSA is a little riskier, but the potential for bigger dividends should offset this risk.

You can have as many TFSA accounts as you wish provided they do not go over the annual limits. The Canada Revenue Agency is on top of people who over-contribute. When the TFSA was first launched, the CRA were more lenient on waiving interest and penalties for those who inadvertently over-contributed. The penalties and tax are severe and could quickly wipe away any benefit of the TFSA if you make an over contribution.

My advice for anyone with a TFSA is to have only one and to have a strategy for the account.

By maintaining one TFSA, you can easily manage the amount you contributed and you don’t have to remember all the details of each of your other TFSA accounts. I also recommend that the TFSA account is with the same advisor and financial firm as your other investment accounts. The investments within the TFSA should have a strategy and should compliment your other investment holdings. Your financial advisor will also have the financial planning software that has been updated in recent years to include the impact of contributing to a TFSA over time.

On March 23, 2011, I wrote an article about having a conservative blue chip stock in the TFSA. I illustrated this using Clare, who purchased TransCanada Corp (TRP). In the article, we assumed that Clare purchased shares in TRP with her maximum contribution limit at the beginning of each year. The maximum contribution amount for 2013 was raised to $5,500, so as of February 28, 2013, Clare’s TFSA is valued at $34,103.

Back in 2009, Clare’s husband, John, chose to buy Royal Bank of Canada (RY) shares instead of TRP. Every year, John has added to his Royal Bank shares in his TFSA by simply transferring shares that he already owns in his non-registered account. He understands with each transfer from his non-registered account that he has to pay tax on the realized gain from the shares transferred into the TFSA. Similar to Clare, John has built up a sizable TFSA using one stock. The strategy was suitable for John and Clare as they wished to hold equities within their TFSA, have combined investments of $1 million, and wished to assume the concentration risk in one account.

Together John and Clare have seven accounts – two joint with right of survivorship non-registered (one with John as the primary, and the other as Clare as primary), two TFSA, two RRSP, and one locked-in RRSP (resulting in the transfer of a registered pension plan from John’s former employer).

John and Clare could see the benefits of having their TFSA accounts at the same institution of their other holdings. We were able to ensure that the investments in the TFSA are complimentary to the other holdings they have and to manage overall position size of each investment.

Sixty per cent of John and Clare’s total investments are in equities, or $600,000. For John and Clare’s combined portfolio we have recommended 30 equities with initial positions being approximately $20,000. John and Clare’s TFSA accounts have investment risk tolerance set at high on both accounts as a result of their concentration in one holding.

If the position exceeds five percent of the portfolio, we would recommend reducing the position, also called rebalancing. If John and Clare wish to continue holding an investment that exceeds five per cent or $50,000, we would have them sign a specific letter stating that they understand the risk associated with more concentration in this investment..

During our March meeting, we suggested that John and Clare each consider selling half of their shares and buying a second stock in a different sector that compliments the total portfolio. Individuals that wish to have equity exposure within their TFSA accounts should understand the associated risks of concentrating and different options of investing.

Investors with less capital than Clare and John or who have a lower risk tolerance, should look at a different approach for the TFSA. Once investors obtain a total portfolio of $250,000 or greater, then I encourage people to look at the benefits of direct equities within a TFSA.

Let’s use a household with total investments of $250,000 with 60 percent in equities, or $150,000. In this case we would recommend 20 equity holdings at $7,500 each. The TFSA would likely have three to four companies. Capital gains and income are “tax free” in a TFSA. Losses within a TFSA cannot be claimed.

In other words, if an investment goes down in value more than the income it has generated, it would have been better off to hold it in a non-registered account to be able to have the loss carry-forward.

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.

Control investment costs, increase your net return

Many people don’t pay too much attention to the costs associated with investing. If we look at both your returns and cost of investing, we can create what is called your net return.  Your net return can potentially increase by either improving your return, or lowering your cost of investing.

To illustrate we will use Mr. Lee, a 55 year old investor who has $500,000 in an RRSP account.  Mr. Lee has explored the following four options with various costs of investing (increasing at one per cent increments with each option) and service levels:

Option 1:  Self managing investments through Exchange Traded Funds (ETFs) – often referred to as couch potato investing.  With this approach, you receive no planning or investment advice.  This approach is passive as it holds the investments that are in the respective index and are not actively managed.  The annual cost of investing for this option can be around 0.5 per cent, or $2,500 in the first year.

Option 2:  Working with an advisor owning direct holdings in a fee based account.  The fees for this option can fluctuate depending on the advisor and the amount invested.  The fee often decreases as the account value increases.   The benefit of this option is that an advisor is able to assist you with both planning and your investments.  Option 2 is the most transparent with respect to fee disclosure of all options.  If Mr. Lee put the $500,000 into a balanced portfolio, it would typically be priced at 1.25 to 1.5 per cent.  For our example we will use 1.5 per cent, or $7,500 in the first year.  It is important to note that a good advisor is well worth the additional fee over the ETF approach.

Option 3:  Purchasing mutual funds is another commonly used investment approach.  Mutual funds are actively managed by a portfolio manager that has a specific skill set in the fund(s) that you’re buying.  Mutual funds have embedded annual fees called a Management Expense Ratio (MER).  In addition to the MER, funds may be sold on a front end basis with addition fees of up to 5 per cent initially, or sold on a back end basis where you are typically not charged a fee initially but would be charged a fee if you sell the fund within the applicable Deferred Sales Charge (DSC) period, often seven years.  The fee may be as high as 6 per cent initially if sold in the first year, and declining every year until the DSC schedules is complete. An advisor selling funds may look at Mr. Lee and think his time horizon is ten years and that he may be invested in the funds through the DSC schedule.  If Mr. Lee is sold funds on a back end basis where DSC may apply, he is somewhat squeezed into a corner if he is not happy with his performance, or would like to make a change within the DSC period.  For purposes of this illustration we will assume that the only fees Mr. Lee pays is the 2.5 per cent annual MER, or $12,500.

Option 4:  Mr. Lee has heard about some guaranteed insurance products called segregated funds.   The primary difference between mutual funds and segregated funds is that the later is an insurance product.  Being an insurance product, the investments can be set up with different maturity and death benefit guarantees.  Another feature is segregated funds have the ability to name beneficiaries to bypass probate and public record.  In the case of Mr. Lee the funds he has are registered.  With registered accounts it is not necessary to purchase an insurance product to get this benefit as he already has the ability to name a beneficiary, his spouse, which also will assist them in avoiding probate on the first passing.  There is a cost to have the insurance benefit noted above. For illustration purposes we will assume the annual MER for a basket of segregated funds is 3.5 per cent, or $17,500 annually.

The long term effect on accumulated savings can be quite shocking when different net returns are explored over a ten year period.  To help with the illustration, we will make the assumption that investment returns over the next ten years will be six per cent for all four options.

Option 1:  ETF approach – net return is 5.5 per cent (6.0 per cent less the 0.5 per cent fee). A net return of 5.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $854,072 at the beginning of retirement.  He would have been responsible for all of his choices of ETFs and have no planning advice.  Although costs are low with option 1, there is a high degree of involvement to determine timing of when to buy the ETF and which ones to buy.

Option 2:  Direct Holdings in Fee-Based Account – net return is 4.5 per cent (6.0 per cent less the 1.5 per cent fee). A net return of 4.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $776,485 at the beginning of retirement.  The additional cost of investing over option 1 would more than likely be offset by higher returns with a good advisor.  A knowledgeable advisor is also able to provide you financial planning tips, and service that enables you to do other things in retirement.

Option 3:  Holding a Basket of Mutual Funds – net return is 3.5 per cent (6.0 per cent less the 2.5 per cent fee). A net return of 3.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $705,299 at the beginning of retirement.

Option 4:  Holding a Basket of Segregated Funds – net return is 2.5 per cent (6.0 per cent less 3.5 per cent fee). A net return of 2.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $640,042 at the beginning of retirement.

The above illustrates a one per cent change in the cost of investing for each option – it clearly shows how these small changes can have a material impact on your long term financial success.  The same exercise can be done assuming different percentage returns (i.e. four, five, six, and seven).

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.

Staying competitive on a global stage

Downward economic cycles can be frustrating for some people as they generally result in layoffs and declines in average wages. In an effort to stay competitive in a downward economic cycle, companies will sometimes choose to eliminate benefits (such as medical or dental), modify pensions in a negative way, or simply keep wages the same as the cost of living increases. However, when economic conditions improve then the upward cycle of hiring and increased salaries follows. Beyond these normal economic cycles are some considerations for future generations for how the global marketplace will impact their employment and financial opportunities.

It is clear that the emerging markets, such as China, India, Brazil, etc are outpacing developed countries in the area of growth. The labour market in the emerging countries is significantly cheaper and most manufacturing facilities have moved abroad. Developed countries have also used technologies and automation to work smarter – not harder. The opportunities for increasing employment in Canada with the other emerging global markets are challenging.

Perhaps this decade will be classified as the period of equalization between emerging and developed markets. The decade ahead will likely go down in history as a period of higher unemployment and a stagnant period of growth if we continue on the current path. We are living in a global market place that is becoming increasing competitive. The five biggest obstacles I see with the current employment situation are: 1) Organised labour demanding higher wages and benefits, 2) Attitude towards doing certain type of work, 3) Environmental attitudes, 4) Companies hoarding cash and not taking as much risk, and 5) Continued advancements in technology. 

It seems there are daily announcements regarding how unsatisfied some fully employed individuals are. A common complaint is not having a wage increase that matches the cost of living. Organised labour has become very powerful in developed countries demanding increased salaries and benefits. On the opposite spectrum we know about the poor employment standards and human rights issues in some of the emerging countries and how people are working for a fraction of what developed country workers make. As employees demand more, are they effectively pricing themselves out of the global market? What is the economic incentive for companies to continue their operations in Canada when other overseas markets will allow for lower costs to produce the same goods?

Some Canadians are choosing not to work because they do not want to do certain types of work. Attitude towards accepting certain types of work as well as salary levels should be adjusted if we want lower unemployment. In this period of equalization is it reasonable to force higher minimum wages, or for university graduates to expect six figure salaries immediately. If we want companies in Canada to hire people here, it has to make sense for them, relative to the global marketplace.

There is always a balance between economic progress and the environment. This is especially the case for a country such as Canada, where 45 per cent of the publicly traded companies on the S&P/TSX Composite Index are in the resource sector. It would not surprise me to see this percentage exceed 50 per cent in the next couple of years. There are economic consequences if we put up too many environmental road blocks for companies. As investors we also have to see how this impacts the companies we invest in. Other countries all over the world are continuing to develop their resource sector with less environment regulations. We continue to send raw resources to other countries that create pollution on route and in processing – a prime example of this is shipping coal to Asia.

Investors have to monitor the changing political landscape. Stringent employment and strong environmental standards have an impact on the companies we invest in. The great country we live in was built during a period where environmental and employment standards were significantly different then today. Most people drive a car to work, take a jet on vacation, enjoy lower energy and power costs to run their home, etc.. None of these activities can occur without an impact to the environment. Shoppers are often looking for the lowest price. The lowest price item is often manufactured in a country outside of Canada. The majority of Canadians would buy something made in a country that lacks appropriate human rights and environment standards if they could save money. In many ways Canadians are being hypocritical when they complain too strongly about projects that may impact the environment. If the product is going to be bought or consumed anyways, then one could argue that we should focus on getting the most economic benefit ourselves.

In controlling growth activities in our own county, we have better control over the standards that are put in place. If we continue to only consume goods manufactured abroad then we have limited control. We have people who can analyse project costs, reduce risks, and address the legitimate concerns people have.

One quote that I recently heard that I liked was the problem in North America today is not that we are taking too much risk, it is that we are not taking enough risk. The excitement of corporations expanding in years past with new ideas has largely been replaced by fear and preservation by many companies. Companies are hoarding cash and operating in regions that have fewer regulations, absences of organised labour, less litigation, and fewer environmental complexities.

Advancements in technology can be both a positive and a negative. The obvious negative is that jobs can be lost through automation. There is a cost to automating through machines to replace manual labour. As labour costs rise then companies have a greater long term incentive to automate. Machines do not go on strike to demand more, and do not require pensions and benefits.

Political announcements and regulations are having an increasingly important role to consider when monitoring the economy and picking investments. As the emerging markets continue to outpace our Canadian marketplace, we should expect the employment challenges to continue on the same path unless our attitudes change, and we become more competitive. Might our current levels of unemployment be closer to the new norm? As one wise person once said, “you can not have your cake and eat it too.”

The challenges of buy and hold

Technology has allowed investors split-second trades         – GETTY IMAGES

Technology has allowed investors split-second trades – GETTY IMAGES

As with all things in life, it is important to adapt as conditions change.  Like it or not, we are living in a fast changing, information overload, society.  It is tough to relax if one wants to stay current on all economic, political and financial news.

Different opinions exist with respect to what investment strategy works best in this technology driven environment.  Conventional wisdom has often supported the buy and hold approach with a focus on long term thinking.  Automated trading systems and a growing number of mutual and hedge fund managers with active strategies are on the other spectrum and often look for short term trades – sometimes fractions of a second.

We will look at some of the factors we consider when deciding whether the intention is to hold an investment longer term or shorter term.

  • Dividend yield is perhaps the easiest factor to look at when considering whether to hold a stock longer term.  If a stock has a dividend yield less than two percent then you’re really not getting paid to hold the stock on income alone.  If you’re buying a stock with a dividend yield less than two percent we feel you should have the belief that the underlying share price will appreciate to an appropriate level over the time horizon you wish to hold it.  Most stocks with a yield below two per cent would be classified as a growth stock and should be traded in our opinion.  Establishing a target price and a sell discipline will assist you in realizing profits.  It can be frustrating to see a low yielding stock appreciate and then subsequently decline without you earning income if the investment wasn’t sold at high levels.  The key with low yielding stocks is to not get too greedy and to set a sell discipline.
  • Sector is a very relevant factor for Canadians to look at when considering how long to hold a stock.  Within the ten investment sectors in Canada, the materials and energy sectors represent 18.4 and 26.7 per cent, respectively.  Combined, these two sectors alone make up 45.1 per cent of the TSX/S&P Composite Index (the “Index”).  Collectively, we refer to precious metals, commodities, materials, and energy as resources.  Resources have been steadily climbing as a combined weighting within the Index over the last decade.   When we review risk and reward charts with new clients resources are at the top meaning they have the highest potential return but also have the highest risk.     We would like to highlight some of the significant factors impacting the resource sector.  Advances in technology have made it easier for companies around the world to discover and extract resources with higher efficiency.  This has created more supply in this decade than previously expected.  Offsetting the supply side is an increasing demand from China and other emerging markets for resources.  A growing population, alternative energy solutions, environmental concerns, as well as political, economic, and natural events have all caused shorter term fluctuations in resources.  All of these factors have created a higher level of uncertainty surrounding both the shorter and longer term demand and supply for resources around the world.  Although Canadians may have a home country bias to investing, many of the investments within the Index are reliant on the world continuing to demand our resources. 
  •  The economy is the toughest component to analyse.  There is no hard number to look at or sector to classify.  What makes this challenging is that political announcements such as a stimulus package distort how people now analyse economic data.  We have seen days where bad economic data is released and the markets increase as people feel that governments will have no choice but to stimulate the economy through what is often referred to as quantitative easing.  Quantitative easing is effectively printing money which is inflationary and often causes materials, such as gold, to increase in price.  The flip side to this is when we have days where positive economic data is released and the markets have declined as the likelihood of quantitative easing is diminished.  With government bodies having provided stimulus in the past it does give investors another factor to consider.  What people actually do is often different from what they should do now that the potential for stimulus and government intervention is part of the decision on whether to buy, hold or sell. 
  • There are many other factors that determine the strategy of whether to hold a stock short term or long term.  Your risk tolerance and time horizon are key components to consider.  Your tax situation is also important as investors have the ability to carry net capital losses back three years and forward indefinitely.  Using strategy in this area often saves investors significant tax dollars.  Certainly it is nice when Canadians can take advantage of the taxation rules where unrealized gains on stocks are not taxed until they are sold.  Tax should always be secondary to making the right investment decision.  

In days past it was easier to buy a basket of dividend paying stocks and interest bearing bonds and hold them for a longer period of time.  A person could design a passive approach themselves and not worry about their investments during retirement.

It is more challenging to do this today given the increased volatility and low interest rates.  Investors have to work a lot harder these days.  Unless a person wants to be active every day monitoring their own investments it is advisable to have a professional you trust assist you.