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

 

 

Part II – RRSP Turns 60: Still a Good Bet for Retirement

Registered Retirement Savings Plans (RRSPs) were first introduced 60 years ago, created by the federal government to help people who didn’t have a work pension to save for retirement by socking away pre-tax money.

In 1957, the threshold for the RRSP was the lesser of 10 per cent of income or $2,500.  Over the years the threshold methodology has changed.  Over the years, the threshold methodology has changed. Since 1991, the income threshold of 18 per cent of income has been used.

Starting in 1996, and continuing to today, the new contribution ceilings were indexed to the rise in average wages.

For 2017, the annual maximum, or contribution ceiling, is $26,010, which is reached when earned income is at $144,500 for the prior year.  After you file your 2016 tax return, the government communicates to taxpayers their 2017 RRSP contribution limit on the Notice of Assessment.

The calculation for the RRSP contributions limit is adjusted for individuals who have a work pension.   This reduction is referred to as a pension adjustment and also shows up on your Notice of Assessment.

A pension adjustment is done for both Defined Benefit Plans, where employers bear the risk of market-value changes, and Defined Contribution Plans, where employees bear the risk.

Pension plans have been deteriorating over the last decade.  Individuals who either do not have a pension through work, or do not have a good quality pension, should consider having an RRSP.

Outside of the two types of pensions, some employers will offer a program to help build up your RRSP, or other accounts.  In some cases, these are matching type programs, where you can put in a certain percentage of your salary, and your employer will match it, up to a defined threshold.  These are often referred to as a group RRSP and it is worth participating in.

If you have an RRSP program at work, then having that one is a must.  As you are typically restricted by the types of investments you can invest in with a group plan, we encourage people to also have one external RRSP account.

The external RRSP account would hold all the contributions done outside of your group plan.  In some cases, individuals can transfer funds from a group RRSP to an external RRSP.  In other cases, the funds must stay in a group RRSP until you cease employment with the sponsoring company.

You should receive a statement for any company sponsored pension.  Reviewing this statement is especially important if your plan is a Defined Contribution Plan where you had to make investment choices.

You have made decisions to determine the percentage to invest in fixed income versus equity and whether to have Canadian equities versus foreign equities.

If you have a group RRSP plan, you likely can view information electronically and also receive statements more frequently.

All of this information should be provided to your financial advisor, prior to making any financial decisions regarding your external RRSP.

As the quality of pension plans has deteriorated, the methodology of how to invest funds within an RRSP has changed for some investors.  The three broad categories are cash equivalents, fixed income, and equities.

In 1957, a 90 day treasury bill (cash equivalents) could be purchased with an interest rate of 3.78 per cent, climbing to 17.78 per cent in 1981.

Investing RRSPs in conservative investments, such as cash equivalents, provided decent enough returns during this period.  The latest T-Bill auction of 2016 had the 90 day treasury bills paying a yield of 0.50 per cent.   Most would agree that putting the investments within your RRSP into cash equivalents would not provide the returns to keep pace with inflation, especially after tax is factored in.

Bonds are a type of investment that is classified within fixed income.   The reason most investors purchase bonds is for capital preservation and income.  In order to achieve the goal of capital preservation, it is advisable to invest in investment-grade bonds.  Yields on these bonds are at historic lows.  The yield curve is also very flat, so purchasing a longer term investment grade bond does not increase the yield significantly enough to warrant the potential risk if interest rates rise.   The primary reason to hold bonds in an RRSP portfolio today is capital preservation.

Equity investments provide both growth and income.  In fact, the right types of common shares can pay dividend income that exceeds the interest income on most investment-grade bonds.  Portfolio values will fluctuate greater as the equity portion increases.

An advisor can put together a portfolio of lower risk stocks, often referred to as “low beta” that can reduce this volatility.  We feel those who tolerate increased volatility will be rewarded in the long run by holding the right equity investments.

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

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

Exploring the world of fixed income investments

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

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

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

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

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

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

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

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

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

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

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

 

Behind the scenes with trade execution

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

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

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

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

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

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

Depth of Quote/Level II

Orders          Size           Bid

14                       700            $15.57

22                     1,600           $15.54

  9                     4,200           $15.50

  3                      9,000           $15.40

15                    10,000           $15.37

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

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

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

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

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

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

 

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

 

Portfolio manager can act for clients more quickly than traditional adviser

Over the years, I have had great discussions with people about financial decision-making. It is tough for most people to make decisions on something they don’t feel informed about. 

Even when you are informed, investment decisions can be challenging.

When you work with a financial advisor, you have another person to discuss your options with. In the traditional approach, an advisor will present you with some investment recommendations or options.  You still have to make a decision with respect to either confirming the recommendation and saying “yes” or “no,” or choosing among the options presented. As an example, an advisor may give you low-, medium-, and high-risk options for new purchases. An advisor should provide recommendations that are suitable to your investment objectives and risk tolerance.

Another option for clients have is to have a managed account, sometimes referred to as a discretionary account.  With this type of account, clients do not have to make decisions. The challenge is that very few financial advisors have the appropriate licence to even offer this option.   To offer it, advisors need to have have either the Associate Portfolio Manager or Portfolio Manager title.

When setting up the managed accounts, one of the required documents is an Investment Policy Statement (IPS). The IPS outlines the parameters in which the Portfolio Manager can use his or her discretion. As an example, you could have in the IPS that you wish to have a minimum of 40 per cent in fixed income, such as bonds and GICs.

Portfolio Managers are held to a higher duty of care, often referred to as a fiduciary responsibility. Portfolio Managers have to spend a significant time to obtain an understanding of your specific needs and risk tolerance. These discussions should be consistent with how the IPS is set up. Any time you have a material change in your circumstances then the IPS should be updated. At least every two years, if not more frequently, the IPS should be reviewed.

The nice part of having a managed account with an up to date IPS is that your advisor is able to make the decisions on your behalf. You can be free to work hard and earn income without having to commit time to researching investments. You can spend time travelling and doing the activities you enjoy. Many of my clients are intelligent people who are fully capable of doing the investments themselves but see the value in paying a small fee. The fee is tax deductible for non-registered accounts and all administrative matters for taxation, etc. are taken care of. A good advisor adds significantly more value than the fees they charge. This is especially true if you value your time.

Many aging couples have one additional factor to consider. In many cases one person has made all the financial decisions for the household. If that person passes away first, it is often a very stressful burden that you are passing onto the surviving spouse. I’ve had couples come in to meet me primarily as a contingency plan. The one spouse that is independently handling the finances should provide the surviving spouse some direction of who to go see in the event of incapacity or death. In my opinion, the contingency plan should involve a portfolio manager that can use his or her discretion to make financial decisions.

In years past it was easier to deal with aging clients. Clients could simply put funds entirely in bonds and GICs and obtain a sufficient income flow. With near historic low interest rates, this income flow has largely dried up for seniors. When investors talk about income today, higher income options exist with many blue chip equities. Of course, dividend income is more tax efficient than interest income as well. A portfolio manager can add significant value for clients that are aging and require investments outside of GICs.

Try picturing a traditional financial advisor with a few hundred clients. A traditional financial advisor has to phone and verbally confirm each trade before it can be entered. The markets in British Columbia open at 6:30 AM and close at 1:00 PM. An advisor books meetings with clients often weeks in advance. On Tuesday morning an advisor wakes up and some bad news comes out about a stock that all your clients own. That same advisor has 5 meetings in the morning and has only a few small openings to make calls that day. It can take days for an advisor to phone all clients assuming they are all home and answer the phone and have time to talk.

A Portfolio Manager who can use his or her discretion can make one block trade (the sum of all of his clients’ shares in a company) and exit the position in seconds.

Sometimes making quick decisions in the financial markets to take advantage of opportunities is necessary. Hands down, a Portfolio Manager can react quicker than a traditional advisor who has to confirm each trade verbally with each client.

Extra due diligence on private investing

The private market is used by public and private companies to raise money. Most of the money raised comes from investment funds and institutional investors. However, a relatively small percentage is used to finance venture companies and start-ups, which can be risky investments for the average retail investor. This is especially true when compared to investing in long-established companies that trade in the public market.

Private start-up companies have a high probability of failure. It’s also possible for fraudsters to exploit investors who don’t understand this type of investment. However, whether a private market investment is a fraud or simply fails, the financial impact is equally devastating. Investors need to be aware of the risks involved in the private market and protect themselves by researching their investments, and understanding their risk tolerance. When it comes to the private market, don’t invest more than you can afford to lose.

PUBLIC MARKET

The public market is effectively the stock market, where investments trade openly. In order for a company to issue the securities (as part of an Initial Public Offering), they must issue a document called a prospectus. The prospectus includes the company’s audited financial statements, and must disclose aspects of the investment such as relevant risks and material information about officers and directors. The issuance of the prospectus is required for the shares to trade on the stock market. Public companies are also required to make ongoing disclosure of material facts and changes to their business.

PRIVATE MARKET

Also commonly referred to as the exempt market, this is where companies sell their securities under various exemptions from the prospectus and registration requirements outlined in The Securities Act and Rules. Many private real estate investment corporations and mortgage pools would be considered the private market. The Securities Act and Rules provide for a number of exemptions from the registration and prospectus requirements of publicly traded companies. Some examples of exemptions used by the private market include selling to the following individuals: close family, friends, business associates of a principal, people with a minimum of $1 million in financial assets, individuals with net income before taxes of more than $200,000 (or $300,000 when combined with spouse), and individuals with net assets of at least $5 million. One of the bizarre exemption rules is that if you can invest $150,000, and pay cash at the time of the trade, then you are exempt (even if this means that you pulled every dime together to make the purchase happen).

If someone doesn’t qualify for one of the above exemptions, then there is always the offering memorandum exemption. The “OM” can be used to sell securities to anyone, provided the investor sign a risk acknowledgement form. At times, the people selling private investments have abused these exemptions in order to have the uninformed investor become eligible.

RESALE RESTRICTIONS

One of the biggest challenges with private investments is trying to sell the investment after you have purchased it. Private investments are normally illiquid and have restrictions on resale. 

GREATER DUE DILIGENCE

When considering a private investment you should ask if the person is licensed with the Investment Industry Regulatory Organization of Canada (IIROC) or the Mutual Fund Dealers Association (MFDA). These can easily be confirmed by phoning IIROC or the MFDA directly. Another method to check registration is to go to the Canadian Securities Administrators (CSA) website (www.securities-administrators.ca). Unregistered salespeople are allowed to sell private securities. Many investors are unaware that unregistered salespeople are not bound by the same suitability requirements as registrants and are under no obligation to ensure that the investment is suitable for your investing needs. You will have very little recourse if the investment goes badly. If you are dealing with an unregistered salesperson then more due diligence is required.

POSITION SIZE

If a client calls with a request to execute an unsolicited buy order on a higher risk stock, I always suggest keeping the position size small. Unfortunately, when it comes to private investments, the above disciplined position size approach is often ignored. Putting all of your savings into one investment is simply not prudent risk management, but this happens more often than it should. The saddest stories involve individuals who were encouraged to take out a home equity loan and use the proceeds to purchase the private investments. It is so important for investors to be honest with themselves about their risk tolerance, and to thoroughly understand the level of risk they are taking on with their investments.

ACCOUNTING

Many private investments do not have audited financial statements provided to investors, although these are required if the investments are sold under an offering memorandum. Compounding this lack of accountability, we often hear of a complex web of companies or transactions that would be impossible for outside investors to obtain a clear picture of the financial stability. A good rule of thumb is to remember that there is rarely a good business case to be made for complexity. If an investment is difficult to understand, or if the person offering it can’t explain it clearly, you might be better to walk away.

SECURED VS. UNSECURED

Prior to investing, understand where you rank in the hierarchy if the investment fails. Owners of common shares are usually the last investors to be paid if things go wrong. Primary and secured creditors (often large financial institutions or institutional investors) will be first in line to be repaid. Primary creditors may have specific security over the main assets. The individuals or companies that are first in line would force a liquidation event on various grounds such as violation of covenants, if they felt they were not going to get their full piece of the pie. This often leaves nothing for the average retail investor.

Before investing in the private market, I suggest reading the BCSC’s Private Placement Guide and reviewing investright.org, the BCSC’s consumer protection sight. If you suspect that an investment may be a fraud and need assistance, phone the commission at 1-800-373-6393.