The Greenard Group’s 10 principles on how we pick stocks

Over the years I have been asked several times how we pick our stocks. The process for picking stocks really begins with our overall investment philosophy. All decisions are made in the context of achieving the best risk adjusted returns for the entire portfolio over a medium to longer term. Returns can be achieved through both distributions to shareholders (i.e. dividends) and share price appreciation. Here are a few principles we consistently have used over the years:

1) Zero speculation

Nearly all of our clients have one primary investments objective — capital preservation. Our clients have worked really hard for their money and they don’t want to lose it.

One of the guiding principles we believe in when picking stocks is investing for long term rather than speculating on any short term volatility. Sometimes people have asked me what the difference is.

One of the ways that I have described it is the mind set of thinking longer term (investing) and avoiding the temptation of shorter-term (speculating). It can be tempting to jump on the latest craze or hot stock pick suggested by a friend or neighbor in the hope of a significant gain in a shorter period of time.

One client told me years ago that he likes to grow wealthy slowly. He was willing to forgo all short term significant gain opportunities to ensure his capital was prudently invested in solid well-known companies. Avoiding the mistakes was more important than trying to hit home runs.

Although we steer away from giving advice for clients wishing to purchase speculative names, our general comment is to keep the position size small, hold it in a non-registered account (to claim the loss if it does not work out) , as future performance data will be impacted if our model portfolio recommendations are not adhered to.

2) Large capitalized companies only

Another guiding principal is avoiding smaller and medium capitalized companies. From our experience, the smaller and medium sized companies often have greater levels of volatility and greater risk.

Our equity selection process focuses 100 per cent on the largest capitalized companies within Canada, United States, and outside of North America. Our screening process first begins with approximately 1,200 constituents companies as follows the 500 largest companies in the U.S., the 350 largest companies in Europe, the 250 largest companies in Canada, and the 100 largest companies in the Asia/Pacific region.

We feel that a portfolio biased only to Canada has, and will continue, to underperform other markets over time. Although 1,200 individual companies may still seem like a lot, once the other principles below are applied the subset of companies narrows and becomes reasonable.

3) Corporate profitability

We will never purchase a company that is not profitable. The most simple of ratios to look at when assessing profitability is Earnings Per Share (EPS). If a company is not making money, it is automatically excluded. Projected growth in earnings or future outlooks provided by analysts can provide a good rationale for what will drive growth in earnings for the company.

We spend a significant amount of time reviewing internal and external research reports from analysts — with both positive and negative comments. Past profitability normally gets a company on the initial subset of companies to be considered, though future and current profitability are even more important.

4) High capital efficient companies

What does “high capital efficiency” mean? Let’s break it down to two terms we use returns on invested capital (ROIC), and free cash flow (FCF). All companies finance operations either through the issuance of debt or equity. The cost is the interest rates on the debt and dividend expectations on the equity.

Leverage is perhaps the one component we will focus on. A company that has internally sourced capital is always in a better situation then one that relies on external capital. A company that has low financial borrowing costs and leverage will have less dependence on external financing and external events. The more predictable a company’s ROIC and FCF are the better.

5) Lower leverage

If a company is profitable it can naturally expand its operations organically (with its own profits). If a company wishes to grow faster than the current profits allow, then it must choose to issue additional equity or debt to finance assets purchases or acquisitions.

Many advisers will look at various ratios to screen for good stocks. The financial leverage ratio is definitely worth looking at. It is relatively easy to calculate. From the financial statements you must determine the total debt of the company and the total equity held by shareholders. You simply divide the total debt by total equity. The normal rule of thumb is that this should not be above a level of 2.0, though some exceptions exist.

Leverage is essentially when a company borrows money with the expectation that the profits made from borrowing the money will be greater than the cost of the amount borrowed (i.e. the interest costs) . If a company is financing its operations by continually taking on debt and other liabilities then naturally it is riskier than a company with less leverage. This is especially the case in periods when interest rates are rising.

6) Prudently managed

Investing in companies that are prudently managed is a key component to any quality stock. This is particularly important as the landscape is constantly changing and we have to feel confident that management will make prudent changes to stand the test of time. Understanding what the company does is fundamental to selecting the stock. Management of the company should be able to provide information that makes sense.

A simple starting point is the company’s annual reports which are all available on each company’s website. My favourite section to read in financial statements is the “Management Discussion and Analysis”, also referred to as the MD&A.

An independent auditor must prepare and audit the company’s financial statements. The information is historical which immediately discounts its use from a planning standpoint.

The one exception is the MD&A statement. Although this statement is not audited it does give the management’s opinion on the current results (compared with previous results) and provides a forecast of future operations. Thoughts and opinions can be expressed that should include both positive and negative information. After reading the information you still don’t understand what the company does, or you do not agree with the future direction, then it’s best to avoid.

7) High cash in-flow

High net cash in-flow, consistent cash flows, and predictable cash flows are all attractive features to equities we add to the portfolio. If a company has a “burn rate” (term used to describe a company losing money and how quickly the company’s shareholder equity will be used up) it is automatically excluded on several grounds. A company must have high net cash-in flows to be considered in the model portfolios.

If companies have consistent earnings that are also predictable, we often refer to this as having an annuitized income stream. Royalty rights, contract obligations, licensing, subscription revenue, locked in contracts, membership fees, renting/leasing can all be sources of annuitized cash flow.

8) Competitive advantages

Within Canada, our favourite companies to invest in are those with a competitive advantage. We love companies that have a natural monopoly. Any business or industry that is capital intensive and has a high cost to entry is worth considering. In Canada we have some examples, such as banks, telecommunication, railways, and utilities.

We feel that well established companies that have competitive advantages are generally lower risk and have more predictable cash flows. They are lower risk in the sense that they do not have the immediate threats of new entrants to replace the product or service.

9) Corporate governance

One of the components we review is overall transparency and how that may impact shareholder returns. Transparency begins with the company policies, controls, compensation for executives, and communications to shareholders. We ask ourselves, is management providing clear information on the direction of the company that is understandable?

We always use caution if activities are overly complex and are not transparent. The more complex the accounting policies, the more scrutiny that needs to be put on a company. Are the executives and managements objectives also aligned with shareholder interests? Do we understand the direction the company is taking with any mergers, acquisitions or spinoffs?

10) Complimentary to other holdings

Our model portfolios typically have 30 to 35 holdings when fully invested. When we add or remove a stock from the model portfolio we must assess the impact of diversification and correlation. Typically when a stock is removed from a particular sector, we would replace it with a better holding option within the same sector.

Strategically we may change the weighting of sectors depending on our outlook for the economy and the stock market cycle. When adding stocks to a portfolio it is important to also look at how they are correlated to each other.

It’s important to have a disciplined approach to your criteria by which you pick stocks. If those criteria’s are stuck to consistently we feel that you’ll have fewer losses and more successes.

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 Times Colonist. Call 250-389-2138. greenardgroup.com

 

 

Inheritance enhances retirement and estate plan

Over the years we have helped new clients and existing clients deal with inheritances. In the majority of cases the inheritances are coming from parents. These can be done upon the parent’s passing away but are also done while they are alive in more and more cases. In other cases we have clients receiving inheritances from uncles/aunts, siblings, friends, and other individuals.

The greater the inheritance the more critical it is to get some professional advice. One positive part of receiving an inheritance in Canada is the money is not taxed. Following are some topics we would discuss when a client receives an inheritance.

Paying off debt

We like the idea of paying off debt, especially personal mortgages, credit cards, and lines of credit that are not tax deductible.

To begin with, we obtain a summary of all loans, current rates, and repayment penalties, if any.

If only some debt is repaid, then the highest non-deductible interest rate debt should be paid off first. If fees or penalties apply, it is important to obtain an understanding of these and your wealth adviser should be able to map out the best options.

If you still would like to invest some, or all, of your cash then you’re best to take a new loan out for the specific purpose of investing.

The interest expense incurred from the money borrowed is generally tax deductible if the purpose of the use of the borrowed funds is to earn income in non-registered accounts.

Increased income

One of the results of receiving an inheritance is that your annual taxable income is likely to increase. If you purchase GICs and bonds, you will have to factor in the interest income received. If you purchase equities, you will have tax efficient dividend income to report and some deferral options.

We provide an estimate of what the income will be once the investments are selected and calculate an estimated income tax liability if the funds are invested in a non-registered account.

Type of non-registered account

If you feel a non-registered account is your best option you should determine the type of account.

If you are single the choice is easy; an individual account. If you are married or in a common-law relationship, you may consider to open an individual account and keep the funds only in your name. Alternatively, you may open a joint-with-right-of-survivorship (JTWROS) account with your spouse or common-law partner.

The person who received the inheritance would be primary on the account. If a non-registered account is already opened then we have a discussion regarding the risk of commingling funds in the event of a marriage breakdown.

This discussion has many other components to talk about including tax, income splitting, and estate wishes. Consulting a family law attorney may be required in cases of marital breakdowns.

Topping up RRSPs

One way to defer some of the above income is to deposit funds into a tax sheltered Registered Retirement Savings Plan, if contribution room exists.

The greater your income, the better this option is. If your income is at or below the lowest tax bracket then there may be other options you would want to consider.

The determining factor is your future income expectations. As an example: John received $250,000 as an inheritance. He is using $150,000 to pay off all debt and would like to invest the remaining $100,000. John has accumulated a $140,000 RRSP deduction limit, as he has never contributed the maximum each year. John plans to work for the next five years and earns approximately $80,000 in T4 income.

One option we may suggest to John is to contribute the $100,000 into his RRSP and claim $20,000 a year as a deduction over the next five years assuming that there is no extra cash flow for additional contributions. One of the main benefits of putting funds in the RRSP (and not claiming the full deduction right away) is that all income is tax sheltered.

Tax Free Savings Account

Any income earned within the TFSA is tax free, if you have never set up a TFSA, the cumulated TFSA contribution limit for 2019 is $63,500. It may be worthwhile to understand the advantage of this type of account and top up to the maximum limit. Starting in 2019, the annual limit is $6,000, indexed to inflation thereafter.

If you have both non-registered account and TFSA, then we would recommend you to transfer your assets (up to the maximum limit) from the non-registered account into the TFSA, to take advantage of the tax-free feature.

Skipping a generation

Sometimes the people receiving the inheritance do not need the funds themselves. In these situations we often map out a strategy that will skip to the next generation. Sometimes this will help younger generations pay off mortgages, purchase a home, or build up retirement savings

Structure of accounts

Many Canadians only have RRSP or TFSA accounts. Often when significant funds are received (inheritance, sell of a business, life insurance proceeds), people open their first non-registered account.

One thing that we see is people buying GICs and bonds where the interest income is fully taxable in a non-registered account while leaving the equity investments which have tax-efficient dividend income within their RRSP. When this happens, the structure of investments is backwards.

There are many benefits of consolidating investments at one institution, including lower fees and more account options. It is beneficial to deposit the inheritance cash into a non-registered account at the same institution as the RRSP. If this is done then the structure can be corrected.

We are able to do a series of trades that will correct the overall structure will ensure that interest income on fixed income is tax sheltered within the RRSP. By holding Canadian equities in the non-registered account, you will receive the benefit of the dividend tax credit, and taxation of capital gains and losses.

Updated documents

Obtain the appropriate forms to update your investment accounts, Powers of Attorney, beneficiaries and ownership. We always encourage people to update their Will and other legal documents (if necessary).

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 Times Colonist. Call 250-389-2138.

 

Rebalancing helps manage risk

Wouldn’t you love a strategy of selling high and buying low?

Naturally we have the tendency to want to let our winners run without taking profits.

On the flip side, a good stock might be going through a rough patch and, rather than sell the stock, adding to it might be the right move.

Creating a disciplined rebalancing process begins with determining the portion of your investments in cash, fixed income and equities.

Below we have mapped out our general structure rule with respect to the equity component. A holding is common shares in a single company (for example, Canadian Pacific Railway or Apple).

Clients who have between $500,000 and under $2.5 million will typically hold a minimum of 25 holdings. An optimal number of holdings is 30, and no greater than 35 holdings.

Portfolios between $2.5 million and $5 million we recommend holding a minimum of 30 holdings, optimal number of holdings is 35, and no greater than 40 holdings. We use the term “optimal” to describe the dollar amount invested in each company in normal markets conditions.

Reba Watson has a portfolio valued at $1.4 million. She has a moderate growth portfolio where 80 per cent, or $1,120,000, are held in equities. Based on her portfolio size and being moderate growth, we can illustrate rebalancing.

Optimal positions size

$37,333 (essentially the equity portion of $1,120,000 divided by 30). Without going through this exercise, one would not know what a normal position size is. I have heard people say I purchase 100 shares of everything. That simply does not work for a host of different reasons. The most obvious reason is that some stocks trade at very low prices/share and others at much higher prices.

Half position size

$18,667 (essentially half of the optimal position size). Sometimes we wish to underweight a holding or overweight a holding from a strategic sense in the short term. If we feel that the markets are getting long in the tooth, or late in the bull market cycle, then reducing position sizes can be a strategic decision. This reduction would help if markets declined or had a correction. Another example of utilizing half position sizes may be a new client that has never invested before, to get the level of comfort up we may suggest half positions sizes to begin with. As time goes on, we would typically work toward optimal positions sizes.

Rebalance position size

$44,800 (essentially the equity portion of $1,120,000 divided by 25). If the long term goal is no fewer than 25 names this is a natural starting point to calculating your rebalancing number. Whenever we are reviewing portfolios, one of the first items we look at is position size and if any holdings need to be rebalanced. For example, we purchased $35,000 of Microsoft initially for a client. Today, we see that the position size for Microsoft has increases to $47,744. At a minimum, we would recommend to reduce the position by $2,944 (down to the rebalance positions size) or reduce the position by $10,411 (down to the optimal position size).

Excessive position size

$70,000 (this is calculated taking the total portfolio value of $1.4 million and multiplying by five per cent). If a client chooses to take an excessive holding in one company we document the extra risk incurred within the Investment Policy Statement (IPS).

Rebalancing frequency

Over the years, several studies have been done to determine the frequency of rebalancing reviews. Should investors rebalance quarterly, semi-annually or annually? As the markets vary from year to year, the frequency should be adjusted based on current conditions. Rebalancing asset mix and individual position size can normally be done at the same time. Rebalancing to your optimal asset mix should be done at least once a year. Prior to rebalancing, it is important to periodically review your Investment Policy Statement (IPS) to ensure that you are comfortable with the asset mix. Changes in market conditions and interest rate outlook are factors to discuss with your wealth adviser when revising the asset mix within your IPS. Your personal goals, need for cash, and knowledge level may result in your optimal asset mix needing to be adjusted.

Rebalancing to Investment Policy Statement

When an Investment Policy Statement is set up the optimal asset mix is outlined. To illustrate, we will use Reba, who invested in a portfolio with the following asset mix —fixed income 20 per cent and equities 80 per cent. Asset classes do not change at the same rate. Over the last year, equities grew faster than fixed income making the growth in her portfolio uneven. If after a year we meet with Reba and her portfolio is $1.6 million. Based on the optimal asset mix outlined in her IPS, 20 per cent, or $320,000, should be in fixed income. The remaining $1,280,000 should be in equities. When we looked at Reba’s portfolio, she had $283,000 in fixed income, and the remainder in equities. A disciplined approach would result in us selling $37,000 of equities and purchasing fixed income.

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. Rebalancing also helps smooth out volatility over time.

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 has 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.

Other forms of rebalancing

A more complicated component of the rebalancing process looks at geographic and sector exposure. Often at times, investors will have no clear benchmark at the beginning to assess the geographic and sector exposure. Without these parameters outlined at the beginning it is more challenging to have a discipline approach to rebalancing. Professional judgment and current conditions often move the benchmark of how funds are invested. Interest rates, political news, government policies and other factors can determine geographic and sector weightings.

Tax efficiency rebalancing

When a client opens up new accounts or makes significant deposits and withdrawals, this is an ideal time to look at all levels of rebalancing. Even with smaller deposits into an RRSP or TFSA account, it may be a good time to rebalance. In some situations, certain investments have better tax characteristics in different accounts. For example, we try to put interest-bearing investments and those that pay other income (such as foreign income) within an RRSP/RRIF. Investments that generate capital gains and obtain the dividend tax credit are often better situated within a non-registered account.

Act today to minimize a massive final tax bill

Taxpayers, naturally, are fixated on trying to minimize tax in the current year. This is a classic scenario of someone not being able to see the forest for the trees. The forest is your ultimate final tax liability. The trees are the current year taxes. The final tax bill in Canada consists of any income up to the time of death, accrued gains are deemed to be realized at the same time and estate administration tax (probate fees).

Annually, in early June we will look at our client’s tax returns and see the level of taxable income and tax payable they incurred in the current year. When the current tax payable is too low we may schedule an estate planning meeting.

The estate planning meeting typically starts off by a rough tax calculation of what your final tax liability would be today, based on your current assets, if you were to pass away. If you have not gone through this exercise, then it is worth doing. In some cases, the government stands to inherit a significant portion of your net worth if not structured appropriately. The conversation is setting the framework for a more detailed analysis done as part of the financial planning process.

Throughout our working lives we commonly reduce our annual tax bill by making Registered Retirement Savings Plan (RRSP) contributions. An important item for people to understand is the tax consequences when withdrawals are made and also the tax consequences upon death.

Withdrawals from registered accounts are generally considered taxable income in the year the payments are made. Over time your RRSP account may have generated different types of income including dividend income, interest income and capital gains. All of this income would have been deferred. All RRSP and Registered Retirement Income Fund (RRIF) withdrawals are considered ordinary income taxed at your full marginal tax rate regardless of the original type of income.

When a registered account owner dies, the total value of their registered account is included in the owner’s final tax return. The final tax return is often referred to as a terminal tax return. The proceeds will be taxed at the owner’s marginal tax rate. The highest marginal tax rate (British Columbia and federal) is currently 49.8 per cent. An individual that has $800,000 in an RRSP/RRIF account may have to pay $398,400 of that amount to Canada Revenue Agency in income taxes. If the RRSP names the estate as beneficiary, then an estate administration tax or probate fee of approximately $11,200 would apply. Accounting, legal, and executor costs can result in less than half being directed to your beneficiaries and more than half going to taxes and other fees.

These taxes must be paid out of the estate. CRA considers you to have cashed in all of your registered accounts in the year of death. Paying over 50 per cent of your retirement savings to CRA is not something investors strive for. There are a few situations where this tax liability can be deferred or possibly reduced.

Spouse

Registered assets can be transferred from the deceased to their spouse or common law spouse on a tax-free rollover basis provided they are named as beneficiary. The rollover would be transferred into the spouse’s registered account provided they have one. If the spouse does not have a registered account, they are able to establish one. The registered assets are brought into income on the spouse’s return and offset by a tax receipt for the same amount. This rollover allows the funds to continue growing on a tax-deferred basis. The rollover does not affect the spouse’s RRSP contribution room.

If your spouse is specifically named the beneficiary of your RRIF account, then you should consider designating your spouse as a “successor annuitant.” As a successor annuitant, the surviving spouse will receive the remaining RRIF payment(s) if applicable and obtain immediate ownership of the registered account on death. These assets will bypass the deceased’s estate and reduce probate fees. You should discuss all estate settlement issues with your Wealth Advisor and financial institution to obtain a complete understanding.

Minor child or grandchild

Registered assets may be passed onto a financially dependent child or grandchild provided you have named them the beneficiary of your registered account. In order to be financially dependent, the child or grandchild’s income must not exceed the basic personal exemption amount. A child that is under 18 must ensure that the full amount is paid out by the time that child turns 18.

Financially dependent child

A child of any age that is financially dependent on you can receive the proceeds of your registered account as a refund of premiums. This essentially means that the tax will be paid at the child’s marginal tax rate, likely to be considerably lower than your marginal tax rate on the terminal tax return.

Rollover to Registered Disability Savings Plan

In 2010, positive changes occurred to help parents and grandparents who have a financially dependent disabled child or grandchild. Essentially this enables the RRSP accounts of parents and grandparents (referred to as the annuitant) to be rolled over to the RDSP beneficiary. The estate benefit is that up to $200,000 of the annuitant’s RRSP can be transferred to the beneficiary’s RDSP. Care should be taken to make sure the transfer qualifies under current tax rules and thresholds. The end goal is to minimize tax and hopefully your beneficiaries receive a larger inheritance. We recommend you speak with a Wealth Advisor if you are considering naming a disabled child or grandchild the beneficiary of your registered account.

Rollover to Registered Retirement Savings Plan

The RDSP is my favourite option for rollover, but what happens if the RRSP/RRIF is greater than $200,000 (the maximum rollover for the RDSP)? Another good option to explore if the child is dependent on you by reason of physical or mental infirmity is the tax free rollover of the registered account (i.e. RRIF) into the disabled child’s own registered account (i.e. RRSP). With disabled children there are no immediate tax consequences and there is no requirement to purchase an annuity. You may want to discuss the practical issues relating to having your registered account rolled into registered account in the name of a disabled child.

Other planning options for children with disabilities

A combination of the RDSP and RRSP rollover is normally sufficient if the annuitant has a small to medium sized RRSP/RRIF account. Other planning options are available if you have a sizable RRSP and are worried about disabilities payments from the government.

Beneficiaries

Care should be taken when you select the beneficiary or beneficiaries of your registered accounts. If you name a beneficiary that does not qualify for one of the preferential tax treatments listed above, then it could cause some problems for the other beneficiaries of your estate. An example may be naming your brother as the beneficiary of your RRSP and your children as beneficiaries of the balance of your estate. In this example, the brother would receive the full RRSP assets and the tax bill would have to be paid by the estate, reducing the amount your children would receive.

Important points

Every individual situation is different and we encourage individuals to obtain professional advice. Below we have listed a few general ideas and techniques that you may want to consider in your attempt to reduce a large tax bill:

  • Pension credit — you should determine if you are able to utilize the pension tax credit of $2,000. If you are 65 or older, then certain withdrawals from registered accounts may qualify for this credit. Rolling a portion of your RRSP into RRIF would allow you to create qualifying income. For couples this credit may be claimed twice – effectively allowing some couples to withdraw up to $4,000 per year from their RRIF account(s) tax-free (provided they do not have other qualifying pension income).
  • Single or widowed — single and widowed individuals will incur more risk with respect to the likelihood of paying a large tax bill. Single and widowed individuals should understand the tax consequences of them dying as no tax deferrals are available.
  • Charitable giving — one of the most effective ways to reduce taxes in your year of death is through charitable giving. Those with charitable intentions should meet with their professional advisors to assess the overall tax bill after planned charitable donations are taken into account.
  • Life insurance — one commonly used strategy is for individuals to purchase life insurance to cover this future tax liability. The tax liability created upon death coincides conveniently with the life insurance proceeds. This would enable individuals to name specific beneficiaries on their registered account without the other beneficiaries of the estate having to cover the tax liability.
  • Estate as beneficiary — if you name your estate the beneficiary of your registered account then probate fees will apply. An up-to-date will provides guidance on the distribution of your estate.
  • Life expectancy — Individuals who live a long healthy life will likely be able to diminish their registered accounts over time as planned. Ensuring your lifestyle is suitable to a longer life expectancy is the easiest way to defer and minimize tax.

A wealth adviser should be able to generate a financial plan to review with you and your accountant. The financial plan should outline the tax your estate would have to pay if you were to die today. This will begin a conversation that may allow you to create a strategy that reduces the impact of final taxes on your estate and throughout your lifetime.

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 Times Colonist. Call 250-389-2138.

 

Measuring your tolerance for volatility and risk

People are often told not to invest in equity markets unless they have a long-term time horizon. While for some people one to two years might seem like a long time, most investment professionals feel a long term time horizon would be seven years or greater.

Here is some perspective as to what the markets have done over the past two decades in Canada. Between Jan. 1, 1999, and Dec. 31, 2018, the S&P/TSX Composite Index returned a total of 260.50 per cent. This represents an annualized compound rate of return of 6.62 per cent. Most decades the compound rate of return for equities has been declining.

The actual annual percentage returns (losses) of the S&P/TSX Composite Index were as follows:

  • 1999 (29.7)
  • 2000 (6.2)
  • 2001 (-13.9)
  • 2002 (-14.0)
  • 2003 (24.3)
  • 2004 (12.5)
  • 2005 (21.9)
  • 2006 (14.5
  • 2007 (7.2)
  • 2008 (-35.0)
  • 2009 (30.7)
  • 2010 (14.4)
  • 2011 (-11.1)
  • 2012 (4.0)
  • 2013 (9.6)
  • 2014 (7.4)
  • 2015 (-11.1)
  • 2016 (17.5)
  • 2017 (6.03)
  • 2018 (-11.64)

To summarize, we noted that in the past 20 years there have been six years where the S&P/TSX Composite Index posted declines. For the same time period, the S&P/TSX Composite Index posted 14 years in which there were positive returns. We also noted the extremes of a loss of 35.0 per cent in 2008 immediately followed by a gain of 30.7 per cent in 2009. The above information reinforces something we already know — the stock market does not move in a straight line.

An important component to investing is having an Investment Policy Statement (IPS). One component to an IPS is establishing your investment objectives and risk tolerance for each account and outlining the type of portfolio you want.

The above annualized 6.62% rate of return over the last 20 years assumes a 100 per cent Canadian Equity portfolio mirroring the index. Of course, many investors may have fixed income and investments outside of Canada. With interest rates being at low levels, many investors would have opted to decrease fixed income and increase the equity component to achieve greater long term returns.

We encourage most investors wishing to overweight equities to focus on well selected medium risk securities. The higher annual growth you desire, the greater degree of risk you will have to assume. Normally this means increasing the equity portion of the portfolio. The types of equities you purchase are almost as important as the asset mix you choose. Increasing risk in your portfolio does not always equate to higher returns. When you add speculation and high risk into the portfolio, then you also add the possibility of severe corrections if the markets move in a negative direction. High-risk and speculative portfolios run the possibility of experiencing an extreme negative year (i.e. 2008 and 2015).

How does a negative year in the markets impact the investor’s portfolio? The table below shows how the first year investment returns effects the average annual returns required to reach respective targets of six, eight, and 10 per cent.

Potential reward for risk-tolerant investors

 

Annual First Year                  
Growth   Actual Time horizon to meet your annual growth target *    
Target Returns          1          2          3          4          5          6          7          8          9
                     
  15%    (2.3)      1.8      3.2      3.9      4.3      4.6      4.8      4.9      5.0
6% 5%      7.0      6.5      6.3      6.3      6.2      6.2      6.1      6.1      6.1
-5%    18.3    12.0      9.9      8.9      8.3      8.0      7.7      7.5      7.3
  -15%    32.2    18.4    14.1    12.0    10.8    10.0      9.4      9.0      8.6
  15%      1.4      4.7      5.8      6.3      6.7      6.9      7.0      7.2      7.2
8% 5%    11.9      9.5      9.0      8.8      8.6      8.5      8.4      8.4      8.3
-5%    22.8    15.2    12.7    11.5    10.8    10.3    10.0      9.7      9.6
  -15%    37.2    21.7    17.0    14.7    13.3    12.4    11.8    11.3    10.9
  15%      5.2      7.5      8.4      8.8      9.0      9.2      9.3      9.4      9.5
10% 5%    15.2    12.6    11.7    11.3    11.0    10.9    10.7    10.6    10.6
-5%    27.4    18.4    15.5    14.1    13.3    12.7    12.3    12.0    11.8
  -15%    42.4    25.1    19.9    17.3    15.8    14.8    14.1    13.6    13.2
                     
* Required average annual return to reach stated annual growth target (with different outcomes)

An investor who began investing in early 2001 or 2002 may have a significantly different outcome then an investor who began investing in early 2003 or 2009. When we have new clients that have a lump sum to invest from selling a home or receiving an inheritance, we communicate the importance of reducing market risk. Several simple strategies exist to reduce this risk.

To illustrate, we will use a made up example of John Smith, 50, who plans to retire in five years. John has been managing his own investments and has determined that he requires annual growth of six per cent each year to reach his retirement goals.

A positive outcome after year one would be growth of six per cent or greater. Assuming markets are good, let’s say John’s portfolio returns 15 per cent in the first year. If we look at the table we see that John can now reach his objective by returning only 3.9 per cent for the remaining four years. John should consider shifting his portfolio to be more conservative based on the lower annual growth requirement to reach his goal and rebalance his portfolio.

The attached table is very effective in illustrating the impact of negative outcomes. Instead of earning 15 per cent in the first year, what if John’s portfolio declined 15 per cent? In order for John to get back on track he would have to earn 12 per cent each year for the next four years. Although this is achievable, it is significantly more difficult to achieve than six per cent annually.

The key point to take away is that portfolios should be structured with the appropriate amount of risk.

As your return expectations increase, so does your exposure to the stock market. Although the stock market is biased in the long run to increase, there will likely be both positive years and negative years over your time horizon.

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 Times Colonist. Call 250-389-2138. greenardgroup.com

 

It’s tough to get it right on both sides of the equation

During the last quarter of 2018, the TSX/S&P Composite declined 10.11 per cent on a total return basis while the first quarter of 2019 the TSX/S&P Composite posted gains of 13.27 per cent on a total return basis.

 

 

When the stock market takes a sharp downward correction, the natural response from investors is to try to anticipate the decline and sell off before this happens.

It sounds easy when you are looking in the rear view mirror. Timing when you are in or out of the markets is in essence basing your investment strategy on a speculative approach rather than a disciplined investing approach that incorporates a long-term vision and goals. Short-term emotional thinking can cloud long-term investment decisions.

 

 

The best way to illustrate the challenges of trying to time the stock market is by looking at an investor who is currently fully invested.

Mr. James has $1 million invested in a non-registered account and is currently earning $35,000, or 3.5 per cent, in annual income (primarily dividend income and minimal interest income). In addition to this income, Mr. James’s investments have averaged 4.5 per cent annually in capital gains over time.

 

 

The total annual average rate of return is the sum of both of these parts — the income and capital gains. The total average annual rate of return over the last five years has been approximately 8.0 per cent annually.

Mr. James decided that he wanted to be a market timer. By market timer, I mean that he felt he could predict the direction of the stock market and would sell his investments if he anticipated a decline in the markets.

If Mr. James sells off his investments and converts his portfolio to 100 per cent cash, then his income will drop to $16,000 per year, assuming that savings accounts are earning 1.60 per cent.

The downside to savings accounts is that interest income is fully taxable each year in a non-registered account. Mr. James currently has the majority of his investments earning tax-efficient dividend income with some tax deferred growth. As a result of the difference in taxation between interest income and dividend income, the impact on income would be even greater than 1.90 per cent (3.50 to 1.60).

For purposes of this article, we have assumed that both interest income and dividend income are equal. In additional to the differential in the income lost, Mr. James would not have potential for capital gains while out of the market.

Mr. James should also factor in that if all of his investments are sold then he would have to report all the realized gains on his investments and lose the deferral benefits that exist with non-registered equity investments. If you have stock that has increased in value, you do not have to pay tax on the capital gain until it is sold.

If Mr. James has a stock that has declined in value and he realizes a loss then he has to use caution when timing transactions. He must wait at least 30 days before repurchasing a stock sold at a loss or risk violating the superficial loss rules and having the original loss declined.

From an income standpoint, Mr. James will immediately see his dividend/investment income drop $19,000 a year ($35,000 to $16,000). He will also possibly be losing capital growth on his portfolio. The potential tax liability, superficial loss rules and loss of income are the easy components to quantify for Mr. James. It is the change in the capital side or growth that is the tough part to compute in order to determine if Mr. James made the right decision to liquidate.

If the markets increase, Mr. James clearly made a mistake. He will have lost the differential in the income and the capital growth. If the markets remain flat, Mr. James still made a mistake with the differential as his income will drop $16,000 a year.

If the stock market goes down, it’s not necessarily a given that Mr. James will benefit from having liquidated his account.

If Mr. James makes a correct prediction that the stock market declines then for him to benefit he has to also make another correct timing decision to buy back into the market at lower levels to potentially be better off.

If the markets decline and Mr. James does not have the insight to buy back in (before it rises back to the level that Mr. James originally sold at) then he would still be worse off. In essence Mr. James has to make two correct timing decisions: (1) selling before the markets decline, and (2) buying back before they rise.

Mr. James should also factor in the timing in which he feels his predictions for the market will unfold. To illustrate this component we will assume no transaction costs, only the income component (we will exclude capital changes) and no tax impact to the trades for simplification purposes.

The difference between the current income Mr. James is earning of 3.5 per cent and the new income of 1.60 per cent if he converts everything to cash is 1.90 per cent. Depending on how long Mr. James is out of the market impacts how much the stock market would have to decline to make the strategy of going to cash successful.

Let’s assume that Mr. James waits six months, one year, two years and three years before buying back into the stock market. If every year Mr. James is losing 1.90 per cent in income then the longer he waits the greater the stock market has to decline. At the six month point, the markets would have to decline 0.95 per cent (1.90 x .5) or greater, at the one year point the markets would have to decline 1.90 per cent (1.90 x 1) or greater, at the two year point the markets would have to decline 3.80 per cent (1.90 x 2) or greater, and at the three year point the markets would have to decline 5.70 per cent (1.90 x 3) or greater.

Making two correct short-term timing decisions against a stock market that has a long term upward bias is not as easy as it may seem. The markets can rebound incredibly fast — the 13.27 per cent increase in the first quarter of 2019 is only one example. From a psychological standpoint, most people would have the tendency to fear that the markets will decline further after the 10.11 per cent decline in the last quarter of 2018. Most investors would not have had the natural tendency to purchase investments at the beginning of this year. Sticking to a long term disciplined strategy helps deal with the short term quarterly swings of the market.

Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director of wealth management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the Times Colonist. Call 250-389-2138.

 

 

Asset mix should be tied to cash-flow needs and market conditions

The term asset mix refers to the portion of your investments that are held in cash, fixed income, and equities. Asset mix has historically been touted as the most important decision with respect to managing risk adjusted returns. We don’t disagree.

The key question that many people should be asking themselves is the portion of their portfolios that should be in these three categories. Every decade we feel investors have had to shift how they look at asset mix to maintain the best risk adjusted returns. This has largely been the result of declining interest rates.

Rather than rely on older textbook solutions to asset mix we feel clients should focus on cash flow needs and current market conditions. When we meet with clients, one of the first questions we ask them is if they need any cash from their portfolio. Essentially we are asking them the time horizon of a portfolio and whether they are planning to make a significant withdrawal of funds. In more than 90 per cent of times when we ask clients this question, the majority of the investment portfolio is to be invested for the long term (greater than seven years).

We also ask clients whether they have any income requirements from the portfolio, or smaller withdrawal requirements. Many of our retired clients will request that we send them monthly cash flow from their investments. If a client desires $5,000 per month from their portfolio then we would typically put aside 12 to 24 months of cash as a “wedge” earmarked for these smaller withdrawals. This is done to ensure that investments do not have to be sold at the wrong time in the market cycle.

We also ask clients if they will require any significant withdrawals from their portfolio in the next three years. Examples of significant withdrawals will be funds to repair home (i.e. roof), renovations, new vehicle, recreational (i.e. boat, motorhome) and real estate purchases. These amounts are also documented within an Investment Policy Statement and earmarked as part of the “wedge” to ensure the funds can be liquidated and sent when needed regardless of market conditions.

We feel cash flow needs and current market conditions should be the primary determinate for asset mix. To give you an example of older guidance often used with respect to asset mix we have outlined a few observations by decade below.

The 1980s

In the 1980s, interest rates were high and many advocated for retirees to transition portfolios to 100 per cent fixed income. This was during a period when bonds, GICs, CSBs, CPBs, and term deposits actually returned a decent level of interest income to live off. Purchasing annuities was a popular option as yields were significantly higher and translated to higher payouts. Financial plans which make long term assumptions based on 1980s high interest rates were materially over stated when interest rates subsequently declined in future decades.

The 1990s

In the 1990s, the strategy most promoted was to encourage investors to have the fixed income percentage equal to their age. The idea was that as you are aging your portfolio would shift into more conservative investments that paid income to you in retirement. Fixed income still generally had higher income than equities.

The 2000s

In the 2000s, many promoted the strategy of laddering your bonds and fixed income. A bond ladder means you have different bonds with varying maturity dates. This was a way of spreading out interest rate risk. As bonds matured in the ladder, you could use some of the capital if necessary and reinvest the remainder.

The 2010s

Bond laddering started to decline as interest rates started to bottom out. Most economists, and fixed-income bond managers, were recommending to keep the bond duration (term to maturity) shorter. The reason for this is the inverse relationship that bond yields have to the bonds actual price. For example, if interest rates go up, most existing bond prices would decline. The greater the duration of the bond, the greater the decline typically.

To deal with this uncertainty of interest rates, many hybrid type investments were created that had features (resets, call dates). Most of these types of investments lack significant volume and can have material price swings which was not typical of fixed income type investments.

The present and the 2020s

Fast forward to today and what we anticipate in the decade ahead. The following are the top ten bullet points we discuss with our clients:

1) Many chief investment officers and economists feel that central banks simply can’t afford to raise interest rates significantly above current levels. The level of government debt would only spiral out of control further. Interest rates are most likely to stay at low levels for a long time.

2) In Canada, we have raised interest rates five times since the historic lows reached in 2017. If the economy softens, the Bank of Canada is in a position to cut interest rates.

3) The term “fixed income” seems rather archaic when many fixed income rates can shift with many of the new fixed income products. The term step up and floating are just a couple of the terms using in fixed income today.

4) It is ironic that most equities have a higher level of dividend income then the interest yields on fixed income. If investors want high income they can typically achieve this with good quality dividend paying equities.

5) Most bonds pay “interest income,” which is fully taxable in non-registered accounts. Canadian equity investments pay tax efficient dividend income (eligible for the dividend tax credit). All equity investments in a non-registered account can provide deferral of unrealized gains and tax preferred treatment on disposition (only 50 per cent is taxed).

6) Bonds trade outside of an exchange and the price transparency is not as good as equities which trade on an exchange. With most bond purchases, the financial firm you are dealing with is acting as principal, rather than as agent. With a principal transaction, the firm will buy the bond off of the client and put it in their own inventory of bonds to either hold or resale.

7) Fixed income often lacks a high volume of transactions (i.e. preferred shares) and is also susceptible to material price fluctuations. Some fixed income lack liquidity (i.e. longer term GICs and term deposits).

8) Increased scrutiny by regulators of suitability of asset mix on investment portfolios. This creates a natural tendency to possibly be overly conservative unless a full discussion is done with your portfolio manager or wealth adviser. Importance of communicating cash flow needs (both short term income requirements and required significant withdrawals).

9) Conservative investors choosing to have asset mixes heavily weighted in fixed income should have lower return expectations for the next decade ahead. Interest rates will likely stay at low levels for a long time. With even a moderate level of inflation and full taxation on income, after tax returns will not be the same as the past several decades.

10)In order to achieve the best risk adjusted returns, investors will have to invest more heavily in equities than past decades. This means that investors will have to deal with more market volatility and stick to a disciplined plan. Our recommendation for retirees who are opting to increase equity components in their portfolio is to avoid high risk and speculative positions.

It is crucial when working with a portfolio manager or wealth adviser to map out cash flow needs and any significant withdrawals. It is only after that is completed that an appropriate asset mix can be set up and the best decisions can be made on where to draw on those cash flow needs.

Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director of wealth management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the Times Colonist. Call 250-389-2138.

 

 

The benefits of consolidating investment accounts

In the last 10 years, there have been a number of changes to investments and regulations. Many of these changes have an impact on your financial plan and tax situation. All firms have been spending significant amounts of capital to become compliant on the disclosure rules and upgrading technology and systems.

These systems are designed to generate reports which assist wealth advisers in managing clients’ accounts.

Most clients today may have several types of accounts, including Registered Retirement Savings Plans, Locked-In Retirement Account (LIRA), Joint-With Right of Survivorship Account (JTWROS or Individual / Cash Account), in-trust for account, corporate account, Registered Education Savings Plan, Registered Disability Savings Plan (RDSP), and Tax Free Savings Account (TFSA).

Registered accounts all have specified limits that you must stay within; the tracking of the limits is complicated enough even if all of your accounts are held at one institution.

When we meet with prospective clients, we notice that they may have their investments at multiple financial companies.

I am still puzzled as to why people want to complicate their life by having the same types of accounts noted above at multiple institutions. Is it because you were not happy with the first institution you opened accounts with? Was it the closest financial institution to make that last-minute RRSP contribution? Was it an inheritance that just seemed easier to keep at the same place? Maybe it was a short-term advertised special on a TFSA that brought them into another institution. It could be that you bought a proprietary product that could not be transferred after you purchased it.

Whatever the reason, there are many disadvantages for people having multiple accounts at different institutions. We recommend developing one good relationship with a portfolio manager or wealth adviser to better manage risk, reduce the time for regulatory and tax obligations and to simplify your financial life. Below, we have mapped out some good reasons to consolidate your accounts with one institution.

Foreign Income Verification Statement (T-1135)

There are harsh penalties for individuals who do not correctly file the Foreign Income Verification Statement, T-1135 with the Canada Revenue Agency. The form can be rather time-consuming to complete if you have multiple accounts at different institutions.

On an annual basis, we forward our clients their Foreign Income Verification Statement that contains information about their foreign holdings and income to report on T-1135.

If all of their non-registered investments are held within this one account, they can simply provide this statement to their accountant with minimal effort for reporting.

If they have multiple non-registered accounts, then clients or accountants will have to develop a system to integrate all of the totals for the foreign investments at each firm to come up with the required figures.

Over-contribution Penalties

There is no restriction to the number of TFSA and RRSP accounts you open.

If you open a TFSA with a financial firm, I would suspect they would be contacting you annually to make your contribution for the year. If you inadvertently say yes to more than one institution, then it would be fairly easy to over-contribute to your TFSA.

If you over-contribute to a TFSA, or any registered plan, then you may be subject to a tax penalty equal to one per cent per month of the over-contributed amount. If you have more than one TFSA as an example, it is important that you tell the adviser at each institution what you have contributed.

T5008

Years ago, financial firms did not have to report dispositions to CRA. Now, each disposition in a non-registered account is reported on a T5008 form.

These forms are not necessarily sent to clients in the mail, but can be accessed on My Account with CRA online.

We always caution clients who do their own tax return to carefully review the auto-fill function that transfer the T5008 information automatically to your return. The information transferred in from T5008 is just the proceeds amount and do not include the adjusted book value. It is important to also input the adjusted book value manually.

We send our clients a tax package that includes a Realized Gain (Loss) Report, which contains both the adjusted book value and the proceeds. We encourage clients to refer to the information on the Realized Gain (Loss) Report and use the T5008 slips to verify completeness and accuracy of the proceeds.

Average Cost

In Canada, we have to use average cost. Tracking the average cost of the investment assets can be straight forward if all of your investments are at one institution.

If Darlene bought 100 shares in 2015 of ABC Company at $70/share and another 100 shares in 2018 at $100/share, she would own 200 shares with a combined adjusted cost base of $17,000 (or $85 “average cost” per share). If Darlene sold 100 shares then the adjusted cost base per share is $85 and would be reflected correctly on the realized gain (loss) report if both blocks of shares were purchased at Institution A.

Let’s say Bill bought 100 shares in 2015 of ABC Company at $70/share at Institution B. In 2018, Bill buys another 100 shares of ABC Company for $100/share at Institution C. Neither Institution B or C would know about the other purchase and both Realized Gain (Loss) Reports would be incorporate the average cost of the shares sold.

Individuals who have more than one cash account must ensure holdings are not duplicated. If they are duplicated, then care must be taken to adjust the book values on dispositions as you cannot rely on the Realized Gain (Loss) Reports for tax purposes. This is one of the reasons why financial firms put a disclaimer on reports as they cannot provide assurance that you do not own additional shares elsewhere.

Asset Mix

An important component of investment performance is asset mix. Consolidation can help you manage your asset mix and ensure that you have not duplicated your holdings and are therefore, not overexposed in one sector.

Unless your wealth advisers have been given a copy of all of your investment portfolios, it will be difficult for them to get a clear picture of your total holdings.

Even if you were able to periodically provide a summary of each account to each Advisor, as transactions occur you would still need to update every advisor with those changes.

Technology

Most financial firms provide access to view your investments online. If you have accounts at different institutions, you will need to get online access from each. It is not as easy to get a snapshot of your total situation when you have multiple accounts spread across multiple institutions.

Many firms provide paperless statements and confirmation slips. As time goes on, most people will gravitate to the benefits of paperless. You do not have to worry about your mail getting lost or delivered to your neighbor. You will get your statements quicker. You don’t have to worry about storing older statements or shredding them. You can easily forward information to your accountant in PDF form if required. You can be travelling, or in your home, and have the access to your investments. If you had one online platform this process is even easier.

Tax Receipts

If you hold non-registered investment accounts at several institutions, you will receive multiple tax receipts.

By consolidating your accounts, you will receive a limited number of reporting slips for income tax each year. Reducing the number of tax receipts may also reduce the amount of time your accountant will spend completing your tax return.

Tax information can also be set up to paperless at many firms. You can log onto the communication centre of the website and retrieve updates on when your information will be available.

Managing Cash Flow

Projected income reports from different institutions will be presented in various formats and at different points in time.

For you to obtain a complete picture of your financial situation, you will have to manually calculate the total income from your investments. In situations where you have instructed your financial institution to pay income directly from an investment account to your banking account, it becomes more complicated to manage when there are multiple investment accounts.

We like to have a detailed Investment Policy Statement which clearly states the required cash flow and from which investment accounts that cash flow is being derived.

Estate Planning

One of the steps in an estate plan is to deposit all physical share certificates and to reduce the number of investment accounts and bank accounts. Having your investments in one location will certainly simplify estate planning and the administration of your estate. It also assists the people helping you as you age.

Monitoring Performance

Some investors may be comparing the performance of one firm or adviser to another. Investors should be careful when doing this to ensure they are really comparing apples to apples.

One investment account may have GICs while another may have 100 per cent equities. It is easier to understand how all of your investments are performing when you receive one consolidated report from one adviser.

When you have all accounts consolidated with one financial institution it is easier to obtain a consolidated report.

Conversion of Accounts

If you have multiple RRSP accounts and are turning 71, you may want to consider consolidating now and discussing your income needs. If you have three RRSP accounts, you will have to open up three RRIF accounts. It is easier to consolidate all of the RRSP accounts before age 72 and open one RRIF account.

Mapping out whether to select the minimum RRIF amount or elect a greater payment when you have only one account is significantly easier.

Account Types

Fee-based accounts are usually suitable for a household that has total investment assets of $250,000 or more at one institution.If you have $100,000 at Institution A, $130,000 at Institution B, and $50,000 at Institution C then you would not be exposed to the fee-based option. Consolidating allows these types of accounts to be an additional option.

In addition, most financial firms have a declining fee schedule. As your account value grows, the fees as a percentage may decline.

Service

In a perfect world, all clients’ at all financial institutions are treated equal. The reality is that the largest clients get better service.

By having $100,000 at six different institutions you are probably getting minimal service at each institution. If you consolidated these accounts at one institution we would suspect that you would get significantly better service.

Other Benefits

When you have all registered and non-registered investments at one location it is easier for financial planning purposes. Consolidation enables you to fund RRSP contributions through in-kind contributions.

Sometimes it is recommended to change the structure of your investments between accounts to improve the overall cash flow and tax efficiency standpoint — this can only be done if your accounts are at one financial firm.

Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director of wealth management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the Times Colonist. Call 250-389-2138.

When to stop contributing to an RRSP

Most articles are written about “contributing” to an RRSP. This one highlights that many people should either avoid RRSPs or stop contributing to them.

Going a step further, calculations should be made to determine if you should withdraw funds from an RRSP.

In many cases, we will recommend that people convert their RRSP to a RRIF before age 71. Age 64 or 65 are common ages for conversions to a RRIF, which we will explain below.

For some people, the decision to convert an RRSP to a RRIF early is purely for cash flow reasons and out of necessity. For individuals in the top tax brackets, taking the regulatory approach and keeping the funds in an RRSP until age 71, for maximum deferral, is normally the best option.

The transition to retirement often coincides with your final RRSP contribution. It could be your last high-income earning year, or it could be offsetting the retiring allowance by using up your RRSP Deduction Limit. In some cases, if you arrange to retire early in the year, an RRSP contribution may not be necessary. In years where your income is uncertain, then we do not recommend contributing early in the year. Closer to the end of the year, you can determine whether contributing to an RRSP makes sense.

If taxable income is on the lower end, then you should consider converting your RRSP early, especially if you are 65 or older. If you are not maximizing your Tax Free Savings Account (TFSA), then pulling funds out of an RRSP and funding a TFSA can reduce your tax bill in the long run. If you are not receiving eligible pension income, then we advise individuals 65 and older to covert a portion of their RRSP to a RRIF. Those 65 years and older can claim up to $2,000 as a pension income amount, effectively allowing each individual to pull $2,000 out of their RRIF tax free.

Another very important factor is that couples can income split RRIF income beginning at age 65. Individuals who are collecting Old Age Security, and earn more than $77,580 in 2019, will have to repay (often referred to as clawback) 15 per cent of the excess up to the total amount of OAS received. If possible, care should be taken to withdraw funds out of an RRSP so that the combined taxable income is below the annual clawback threshold.

If the goal is to minimize tax in the current year, contributing the maximum to RRSPs and delaying RRIF withdrawals until age 72 may provide this outcome.

Let’s change the focus from minimizing tax in the current year to minimizing tax during your lifetime. The key variable on whether or not you minimize tax during your lifetime is life expectancy. To illustrate, we will use a hypothetical client, Jill Jones.

Jill is single and has recently retired at age 65 with $500,000 accumulated in her RRSP. We have projected that CPP, OAS and investment income will result in Jill receiving annual income of $22,000. Jill also has access to non-registered cash, so cash flow is not an issue.

Jill does not have to convert the RRSP to a RRIF early for cash flow. We ran some preliminary projections for Jill with two broad scenarios: 1) convert RRSP to a RRIF immediately and begin pulling out $28,000 annually, and 2) waiting until age 71 to convert to a RRIF and withdrawing the minimum required payments beginning at age 72. To illustrate the estimated tax on both of these scenarios, we used different life expectancy, being age 65, 71, 77, 83, 89, and 95. Below are the 11 outcomes we outlined with Jill. For purposes of this illustration we used a conservative four per cent rate of return.

Option 1 — Convert RRSP early

Planned conversion age Annual end of year withdrawal Deceased age Estimated estate tax
Outcome 1 65 $28,000 71 $184,261
Outcome 2 65 $28,000 77 $149,486
Outcome 3 65 $28,000 83 $105,485
Outcome 4 65 $28,000 89 $51,370
Outcome 5 65 $28,000 95 $2,525

Outcomes 1 through 5 have Jill beginning to pull funds out slowly starting at age 65. By beginning to pull funds out immediately at low levels, Jill will have more funds at her disposal to enjoy her retirement. She will be able to claim the pension income amount and top up her TFSA. She can invest any residual income to generate tax efficient dividend income and capital gains. Jill is reducing the risk of a significant tax bill as a result of a shortened life, especially in outcomes 3 to 5 when compared to option 2 below.

Option 2

Planned conversion age Annual end of year withdrawal Deceased age Estimated estate tax
Outcome 6 71 0 65 $225,687
Outcome 7 71 0 71 $294,394
Outcome 8 71 Minimum 77 $261,243
Outcome 9 71 Minimum 83 $212,211
Outcome 10 71 Minimum 89 $142,742
Outcome 11 71 Minimum 95 $51,089

Outcomes 6 through 11 have Jill keeping her funds within an RRSP until age 71. In the reviewing the above numbers with Jill, we outlined the biggest risk in deferring the conversion to a RRIF is if she passed away in her late 70s or early 80s. The tax rate on the majority of what is left in the RRSP is taxed at 49.8 percent (assuming tax rates remain at current levels). If Jill lives to age 95, then keeping to minimum withdrawals over the years has turned out to be a good decision. Delaying conversion and withdrawing the minimum payments help those investors who are concerned about living too long and running out of funds.

Many other options exist for Jill. Often the right answer is in-between, including a partial conversion or a full conversion between the ages of 65 and 71. When clients ask for my advice, I normally begin the conversion with planning for the most likely outcome. Genetics, current health condition and lifestyle are also factors. Asking clients this question, “What concerns you most, the thought of living too long and running out of money or potentially having to give half of your hard earned money to Canada Revenue Agency?”

 

50 questions to consider before making an RRSP contribution

An RRSP could be an important vehicle in reducing the amount of tax you pay in your lifetime.

However, an RRSP may not be for everyone.

Last week, we reviewed marginal tax brackets and took a mathematical approach to determine whether you should contribute to an RRSP. Incomes below $39,676 in 2018 could save between zero cents and as much as 20 cents on each dollar contributed. Incomes above $205,842 save 49.8 cents on each dollar contributed.

Many individuals have taxable income above $39,676 and below $205,842. We will refer to this as the grey zone. The mathematical approach has many shortfalls.

Below are fifty questions to help those in the grey zone determine if making an RRSP contribution is right for them.

1) How old are you?

Typically the younger you are the longer you have tax deferral. Tax deferral is the number one benefit of an RRSP, not the immediate tax deduction for the contribution. A 40 year old could have over 30 years of deferral. A 65 year old has six years.

2) What is your income level?

If your income is very low then it may not make any sense to contribute. If you are in higher marginal income tax brackets, then the income tax savings can be significant. Last week we outlined the math for those will regular forms of income.

3) Does your income level fluctuate year to year?

Certain professions have income levels that fluctuate year to year. With some years being so low that dipping into savings is necessary. The greater the fluctuations in income the more important it is to have some emergency funds outside of an RRSP.

4) Do you have future large income tax years?

In cases where clients have moderate levels of income today but intend on selling an asset such as a rental property for a significant capital gain in the future, building up and saving the contribution room or building an “unused” component, to offset the large income tax years can often be a good strategy.

5) Are you looking to purchase a principal residence?

If one of your goals is to purchase a principal residence then the majority of your savings should be done in either a non-registered account or a TFSA for easier access. The one exception could be the RRSP Home Buyers Plan (see below).

6) Are you eligible for the RRSP Home Buyers Plan (HBP)?

First time home buyers can participate in the RRSP Home Buyers Plan(HBP). This program allows you to withdraw up to $25,000 in a year from your RRSP towards a qualifying home. If your income is higher and you do not yet have $25,000 in an RRSP then contributing to an RRSP up to this level and then withdrawing the funds under the HBP can be a good strategy for new home owners. A RRSP can not only help you save for retirement — it can also help you save for your first home.

If you and your spouse both borrow the same amount from your RRSP accounts you can put up to $50,000 combined towards a down payment. The HBP enables you to get access to the money you saved, the investment growth, and receive the tax savings.

With the HBP you are essentially borrowing from yourself. You have to pay the amount you borrowed back within 15 years. If you took out $25,000, you must pay back into your RRSP $1,666.66 annually. If you miss these repayment amounts then you will be taxed on the missed payment.

7) Have you contributed to an RESP for any minor children?

Often I see parents not taking advantage of the Canada Education Savings Grant (CESG) linked to RESP contributions. The government matches 20 per cent on the first $2,500 contributed annually per child, up to age 18.

8) How old are your children?

If cash is limited, often at times an RESP contribution is a better use of funds, especially if the children are approaching 18 and have not yet obtained the lifetime maximum of $7,200 CESG.

9) Have you set up a Registered Disability Savings Plan (RDSP) for a minor or adult child with a disability?

The RDSP has benefits even for those who do contribute. The government also give funds under a matching program which is dependent on the beneficiary’s family income. If funds are limited then Contributing to an RDSP often is a better option.

10) Do you have a Tax Free Savings Account (TFSA)?

Individuals with lower income today are generally better off to contribute to a TFSA. If income levels rise then you can always move the funds out of the TFSA and contribute to an RRSP in the future.

11) Have you maximized contributions to your TFSA?

An RRSP contribution can assist you in reducing the current year income but will eventually be taxed when the funds are pulled out. On the other hand, the TFSA grows tax-free but does not assist you in deferring any of your earned income in the current year. By taking a longer term view, the TFSA for those with lower income, and amounts to save, should seriously consider a TFSA over an RRSP.

12) Are you, or dependents, attending post-secondary education?

Often at times these costs can help with lowering your taxes payable. Obtain an estimate of all potential deductions and factor this in when determining what amount, if any, to contribute to an RRSP.

13) Are you claiming any disability deductions and credits?

The disability tax claimed either for self, or others, can significantly lower your income tax liability. It is important to factor these credits in when making RRSP contribution decisions.

14) Did you know that your RRSP can help you get an education?

The RRSP program is called Lifetime Learning Plan (LLP). Your RRSP can help pay for the education and training you may need to build a new career or make a change.

The LLP enables you to take out up to $10,000 per year ($20,000 maximum) from your RRSP to pay for tuition for you or your spouse.

With the LLP you are essentially borrowing from yourself. You have to pay the amount you borrowed back within 15 years. If you took out $10,000 you must pay back into your RRSP $666.67 annually. If you miss these repayment amounts then you will be taxed if you miss a payment.

15) Do you have family, child care, and caregiver expenses?

If you have these types of expenditures then you may be eligible for deductions and/or credits on your income tax return. These deductions and credits should be factored in when looking at the amount of RRSP contributions to make. It is important to know that some credits are non-refundable and contributing to an RRSP in some situations may not be as worthwhile from a deduction standpoint.

16) Do you have significant medical expenses in the current year?

If you had an unusually high level of medical expenses in a current, or a 12 month period, you should advise your financial adviser. It may be that these medical expenses have already helped reduce your projected taxes payable to an acceptable level that making an RRSP contribution is not necessary in the current period.

17) Do you have excess cash in the bank?

If you have excess cash that would otherwise be invested in a non-registered account and generating T3 and T5 income then an RRSP can help reduce two forms of income. By investing these funds in an RRSP you will not be receiving a T3 or T5, or have to report the capital gains on dispositions. These savings along with the deduction can make sense if the cash in the bank can be committed to retirement.

18) How did you intend to fund the RRSP contribution?

If you do not have money to fund the RRSP then that sometimes helps with the decision-making. Clients have asked me whether it makes sense to borrow money to put into an RRSP. Interest on RRSP loans are not deductible. Historically, there have been a lot of articles that discuss how to use a short term RRSP loan in February that can be partially paid back (provided you get a refund) once your tax return is filed and assessed. If the funds can be paid back quickly, with minimal interest costs, then it can make sense.

19) Do you have a spouse to name as the beneficiary?

If your spouse is named the beneficiary of your RRSP then you have less risk of an adverse tax consequence if you were to pass away (see question 50). Contributing to an RRSP, with your spouse named as the beneficiary, has two benefits in my opinion. The first obvious benefit is that it assists both of you in retirement should you live a normal life expectancy. The second benefit is that it provides assistance to your spouse in retirement in the event that you were to pass away before retirement.

20) Where can you find out how much you can contribute?

The most common approach is to look at last year’s Income Tax Notice of Assessment (NOA). The RRSP deduction limit table will provide these numbers. If you are unable to find the NOA then you can log into CRA My Account.

21) Are you aware of the different types of investments to put into your RRSP?

An RRSP is a type of an account and not a type of investment. The options for what you can put into an RRSP can vary significantly. Putting the cash into the RRSP is only the beginning. The most important part is ensuring the capital is protected and invested appropriately to grow for the decades ahead. We encourage you to do some research. Next week we will outline investment options for your RRSP.

22) If you make an RRSP contribution, have you estimated how much tax you will have deferred in the current year?

Many online RRSP calculators can compute the tax savings for a contribution. This works great if you have regular forms of income, such as T4 employment income. If you have certain other types of income, such as dividend income from a corporation, then it is best you have your accountant do the projections for you.

23) Are you aware that you can contribute to an RRSP and save the deduction (considered “unused”) for future years?

One might ask, “why would I contribute money into my RRSP and not immediately claim all of it as a deduction in that year?” Perhaps the best way to answer this is by looking at a real scenario where a couple may have worked hard for over 20 years to pay off their mortgage and become debt free. During all those years of focusing on paying down debt they accumulated a significant RRSP deduction limit. Unexpectedly this same couple receives a significant inheritance. They decide to move $50,000 into an RRSP account. By moving some of these funds into an RRSP they have immediately tax sheltered and obtained deferral of the income and growth. They have a goal of retiring in five years and have mapped out a plan of deducting $10,000 of the unused each year for five years.

24) Are you a member of any Registered Pension Plans?

If you are a member of an RPP then you will see a Pension Adjustment (PA) calculation on your annual Income Tax Notice of Assessment. Depending on your income level, and the quality of your RPP, some or nearly all of your RRSP deduction limit will be reduced by the PA. An RRSP was primarily design for individuals without an RPP. Those without an RPP should consider an RRSP more closely. Even those with an RPP, an RRSP is definitely worth considering if you have both the deduction limit and cash flow.

25) Do you have non-deductible debt?

A mortgage on your principal residence is normally non-deductible unless you have a business component operating from your home. Credit card charges and personal lines of credit are also normally non-deductible. The more non-deductible debt you have the less attractive committing your savings to RRSP contributions. Any high interest credit card or other debt expense should be a top priority to tackle before making RRSP contributions. This is especially true if the debt is non-deductible.

26) Do you have any deductible debt?

If your interest costs are deductible then these costs also help lower your taxable income. If with your excess savings you choose to pay off deductible debt then this would result in lower interest costs for you (which is good) but also results in a lower interest expense deduction. If funds are dedicated to an RRSP then you have the benefit of both the interest expense deduction and the RRSP deduction.

27) What are the balances of all lines of credit, loans, and mortgages?

Looking at your pre-payment options and the interest rates on each form of debt is important. Also important is to focus on paying down the non-deductible debt before the deductible debt. If all the debt levels and interest rates are reasonable then considering an RRSP contribution can provide you the balance of both real estate and financial assets.

28) Have you made any significant donations?

If you have made, or are planning to make, a significant charitable donation then you should factor this into the amount to contribute to an RRSP. Both federal and provincial charitable tax credits are available which would reduce income taxes payable.

29) Were you intending to borrow funds to contribute to an RRSP?

Interest on a loan for an RRSP is not tax deductible. If the RRSP loan is at a good rate and you feel you can pay the loan off within a reasonable period of time (i.e. with tax refund) then it may make sense in higher income earning years.

30) What are the rates on your non-deductible and deductible debt?

When I meet with clients and they have questions about where to put the excess cash, TFSA, RRSP, paying down debt. One of the first items I’ll ask for is the terms of any existing debt (i.e. interest rates, prepayment privileges, and whether or not the debt is deductible.) Sometimes we are able to propose a series of transactions to make more of your interest costs tax deductible.

31) Should I set up a spousal RRSP?

A spousal RRSP contribution may make sense if there is a disparity between taxable incomes in the long term. I like to look at longer term projections and try to equalize taxable income throughout retirement to lower taxes as a household. Care has to be taken to ensure attribution rules do not kick in with withdrawals.

32) Do you and your spouse work?

One of the pitfalls to an RRSP for single people is the loss of employer or if a financial emergency comes up. Two income families can weather this risk often at times without having to dip into RRSP funds to pay the bills.

33) Are you intending to become non-resident of Canada in the future?

The strategy with respect to an RRSP can be impacted if the long term intention is to retire in a foreign country. Any withdrawals out of an RRSP if you are non-resident will be subject to a flat 25 per cent withholding tax or at a reduced rate pursuant to the tax treaty with the foreign country. If you are normally in the highest tax bracket, becoming non-resident before any withdrawals can work to your advantage. If you had planned to have retirement income within the first income federal income tax bracket then you are likely to pay close to twice the normal tax if you’re non-resident.

34) When are you planning to retire?

Providing details on your retirement to your financial advisor will also help with determining if an RRSP contribution makes sense. In some cases, your RRSP deduction limit can be used to roll in retirement allowances and offset a high income final employment year.

35) What is your ratio of non-registered funds to registered funds?

Prior to entering retirement, it is advisable to also have investments in a non-registered account and funds in the bank. If all of your investments are currently in an RRSP then you should talk with your advisor about TFSA and non-registered accounts. Ideally you should have the ability to adjust your cash flow needs without having adverse tax consequences in retirement. The non-registered account is often at times the solution to deal with these fluctuations.

36) Do you have a corporation where income can be tax sheltered?

The ability to tax shelter funds within a corporation has historically come with many benefits. In past years many accountants have advised small business owners to keep excess cash within the corporation and avoid RRSP contributions. Cash flow to the shareholder was often done in tax efficient dividends. Recent changes in tax rules has resulted in many business owners meeting with accountants to determine the best strategy going forward, including RRSP contributions.

37) Have you spent the time to invest the funds appropriately?

Investment options within an RRSP vary considerably. The choice of investments should reflect your risk tolerance, investment objectives, and time horizon. It goes without saying that if RRSP funds are invested appropriately you will achieve your retirement goal sooner. Next week we will discuss the various investment options within an RRSP.

38) Do you have the discipline to keep the funds invested through to retirement?

One of the biggest mistakes young investors make is pulling funds out of an RRSP early. RRSP withdrawals become taxable income when they are withdrawn. The RRSP room is lost indefinitely and cannot be replenished. Prior to making a contribution, you should determine if you can commit the funds for its intended purpose. If in doubt, you should consider a TFSA or non-registered account.

39) Are you aware of the pre-authorized contribution (PAC) approach to RRSP savings?

One approach to saving for an RRSP is to do forced savings every month. For a lower income client who still wishes to save within RRSP, coming up with a lump sum amount of cash can be difficult. If that client were to pay themselves $500 every month then slowly over time they would build up an RRSP nest egg. It is important with a PAC that you always keep an eye on your contribution limit and adjust the PAC accordingly. The benefit of a once a year lump sum is that you can always ensure that the amount contributed is equal, or below, your deduction limit.

40) Do you know the consequences for putting too much into an RRSP?

All over-contributions of more than $2,000 above your deduction limit will incur a penalty of one per cent per month. To avoid receiving brown envelopes from CRA, take extra care to not exceed your allowable contribution limits.

41) Does it make sense to have more than one RRSP account?

The Income Tax Act does not put a limit on the number of RRSP accounts you may have. For all intents and purposes we recommend having only one or two RRSP accounts. Having one RRSP account with an advisor will help them manage your asset mix, sector exposure, geographic exposure, and position size on each investment. If you have the option of a group RRSP that is matching then having two RRSP accounts makes sense.

42) How do I combine my RRSP accounts?

Unfortunately combining RRSP accounts comes at a cost most times. Nearly all financial institutions will charge a transfer out fee. An example of the fee may be $125 + tax. Let’s say Jack rushes to make a last minute RRSP contribution for $10,000. He is so rushed that he also agrees to put the funds into a two year GIC at two per cent. The next year Jack does the same thing but at a different financial institution. When I met Jack the first thing he said to me was he was not making a lot of money on his RRSP accounts. Jack showed me four different RRSP accounts at different financial institutions. Jack had intended on doing the right thing each year but had slowly created a bit of a mess that was not performing above inflation levels. I explained to Jack that we could diarize to consolidate the GICs once they mature. I also explained to Jack that this will come at a cost. The relinquishing institutions will each charge him $125 + tax wiping away over half of the interest amount he had made. In my opinion, having one well managed RRSP with all investment options available is the best approach.

43) When do I have to convert my RRSP to a RRIF?

The Income Tax Act states that your RRSP must be collapsed by the end of the year you turn 71. Most clients choose to convert their RRSP to a Registered Retirement Income Fund, or RRIF. Other options are to de-register the full account. This option may be okay for small accounts when your other income is low. Normally, this is not advisable as the entire value of the RRSP becomes taxable in one year. Another option, is to purchase an annuity.

44) How long can I have an RRSP?

In British Columbia, the age of majority is 19. An RRSP has to be collapsed at age 71. Mathematically, one could have deferral for 52 years within an RRSP and continue most of that deferral even further within a RRIF. The reality is that many do not start contributing as early as age 19 and many have collapsed their RRSP accounts before age 71.

45) Is it possible to contribute to an RRSP after the age of 71?

You may contribute to your own RRSP until December 31 of the year you turn 71. You can also contribute to a spousal RRSP until December 31 of the year your spouse or common-law partner turns 71. If your spouse is younger then you, and you still have RRSP contribution room, then you may contribute.

46) Should I participate in a Group RRSP plan?

The primary purpose of a group RRSP plan is to encourage you to save some of your hard earned dollars. Your employer may offer this option by enabling you to contribute through payroll deductions. Often at times the investment options are limit to those offered by the group provider. In some situations, your employer may offer a matching program where you put in a set percentage of your pay and they will match up to a maximum level. In nearly all cases when an employer is willing to match your contributions it is worth participating in the Group RRSP.

47) Do I have to wait until I retire to transfer part or all of my Group RRSP plan to a self-directed RRSP?

Not all Group RRSP plans are the same. In most Group RRSPs you are permitted to transfer the investments to another RRSP account provided the plan does not have any provisions preventing the transfer. In most cases we recommend that when a sufficient amount has accumulated in the Group RRSP that the amount is transferred to your other RRSP account.

48) What is one of the most common errors you see with RRSP accounts?

I think all too often individuals are so focused on wanting to save as much tax in the current year that they forget to look at the big picture of minimizing tax during their life time.

49) What happens if I need cash out of my RRSP before retirement?

The standard withholding rates are 10 per cent for amounts up to $5,000, 20 per cent for amounts over $5,000 and below $15,000, and 30 per cent for all amounts over $15,000. The actual level of tax that you pay will be dependent on your other forms of income and if you have any deductions or credits.

50) What happens if I passed away with money in an RRSP?

I left this question for last for a reason. If your spouse is listed as a beneficiary then your RRSP would be combined with the surviving spouses RRSP and you would have complete deferral of immediate tax on the first passing. For all others, single people and widows, the tax deferral ceases on the second passing. Canada Revenue Agency is likely to collect nearly half of the amount you have remaining in your RRSP.

The above is just a sample of the potential questions that could be asked as the RRSP conversation unfolds. Understanding the reasons for the above questions can help both you and your adviser make informed decisions.

Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director of wealth management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the Times Colonist. Call 250.389.2138. greenardgroup.com