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The golden opportunity of a pension windfall might be slipping away as interest rates rise

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You have been told time and again that you are one of the lucky ones. You have a defined benefit pension — meaning that when you retire you will get a fixed monthly payment for as long as you live.

I agree you are one of the lucky ones, but not exactly for the reason that you might think. You are one of the lucky ones because you might be able to get an extra-large lump sum payout when interest rates are close to their historic all-time lows. But this opportunity could be slipping away.

As you may be aware, a low interest rate at the time you take what is called the commuted value payout of your pension, can add hundreds of thousands or even millions to the value of that payout depending on the size of your overall pension. As interest rates rise, that payout gets smaller.

The key interest rate for most Canadian pensions is the Bank of Canada five-year bond yield. This is often the number used to help calculate your commuted pension value. On Feb. 10 2016, the five-year yield hit an all time low of 0.41 per cent. That was the best day for a commuted value pension (or best month as they are usually valued monthly). As I write this, the five-year yield is now 1.14 per cent — or almost triple where it was in mid-February.

Before you think the pension opportunity is now gone, keep in mind where it has been: In March 1990, the five-year yield was 11.6 per cent. We are still at unbelievably low bond yields, and you are still in a golden period for getting huge lump sums in place of your pension. Time will tell if this golden period is coming to an end, but some analysts believe that we will never see a rate as low as 0.41 per cent again in our lifetimes.

To better understand the power of interest rates on your pension value let’s start with the humble annuity. A pension is essentially like buying an annuity. In this case you would pay a lump sum today and in return you would receive a monthly payout for the rest of your life. An annuity is also kind of like buying a lifetime GIC and locking in the rate. Today, you wouldn’t get very excited locking in a lifetime GIC that pays out 2 per cent. You also wouldn’t get that excited locking in an annuity with that type of return. For example, today you would need to put in $1 million as a 65-year-old couple in order to guarantee a payout of $51,000 a year until you both pass away. As unexciting as those rates and payouts would be, a pension commuted value is the opposite. Today it is tremendously exciting.

Thinking about that same $1 million it would cost you to receive $51,000 a year, if you take the commuted value or cash today instead of your pension, you are essentially getting paid $1 million today instead of the $51,000 a year. Another way to look at it would be how much needs to be invested at 2 per cent to pay out $50,000 a year. At 2 per cent, you would need to invest $2.5 million in order to get $50,000 a year in income. At 5 per cent, you would need to invest $1 million in order to get $50,000 a year in income. Today, your same pension commuted value payout might be $2.5 million, but if interest rates jumped to 5 per cent, it would be $1 million.

I am definitely oversimplifying a complicated formula here, and the math wouldn’t work out quite as above, but it is meant to show you the directional impact of interest rates on your pension commuted value calculation, and why this golden opportunity might slip away if interest rates meaningfully rise.

I find that many people never even consider taking a commuted value lump sum. After all, their monthly payout in retirement is what they have been working for their entire working careers. However, would you think of it differently if you knew that your employer was really hoping you would not consider taking the commuted value now?

In some cases the opportunity to take the commuted value or “take the cash” is not an option. Sometimes this is an option only at retirement or if taken prior to age 55 or prior to age 50. It is certainly worth finding out what options you have in your own plan.

When thinking about what route you would want to take in addition to thinking about your health, the companies’ health, tax planning etc., one of the key questions is whether you could earn more from the commuted value than from the pension payouts. One set of analysis that we normally do is a break-even comparison. We set things up to be as much an apples to apples comparison as possible.

In most of our pension reviews at the moment, the break even rate of return required is in the range of 3 per cent to 3.75 per cent to age 86. What this means is that if you invested your commuted value, and did monthly withdrawals at the exact same rate as you would have for your pension, you would only need to have earned say 3.5 per cent a year return to fund everything to age 86. If instead of 3.5 per cent, you actually received a 5.5 per cent long-term return, which we believe is extremely doable, you will have not only been able to match your pension payouts dollar for dollar, but would likely have several hundred thousand dollars left at the end for your estate instead of the $0 left with a standard pension.

Now this analysis will come to different conclusions in a higher interest rate world. If the break even needs to be 5 per cent+, in many cases I would consider taking the certainty of the pension. However, as long as the break evens we are seeing are in the 3 per cent range, it means you are giving up returns every year. We believe that taking the commuted value of a pension, if you are lucky enough to be able to do so in today’s interest rate environment, is something to consider strongly.

I am not suggesting that it is always wrong to keep your pension. In most cases, a government or quasi-government pension provides you with certainty on income for the rest of your life. If you and/or your spouse have good genes and are in good health, it is quite possible that you will receive the pension for extra years compared to your peers. There are also sometimes health benefits attached to a pension that provide some real value and peace of mind.

The decision of whether to receive a pension in monthly amounts for life as opposed to taking a lump sum is a complicated matter. What I do know is that your employer believes that paying out the commuted value today will cost them too much, and would likely prefer you don’t even consider it. That is reason enough for you to explore it further.

Reproduced from the National Post newspaper article 6th February 2017.

Ted Rechtshaffen
Written By:
Ted Rechtshaffen, MBA, CFP
President and CEO
tedr@tridelta.ca
(416) 733-3292 x 221

Our housing market – is this the top?

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The explosive growth of the Canadian housing market in the last decade may finally be coming to an end.

Interestingly there is good logic on both sides of the debate and it is anyone’s guess where markets go in the short term:

The reasons for it to continue growing:

  • Foreign buyers remain very active despite a slowdown in Vancouver due to the new 15% BC foreign buyers tax. This has however likely boosted Toronto sales.
  • Three decades of low interest rates.
  • Job growth in the major centres outpaces the national average, particularly Toronto and Vancouver, which collectively accounted for all of Canada’s increases in 2016
  • Demographics reflect that there are more people aged 25 to 40 in these two cities and they have grown faster relative to other age groups. This segment is also in their prime home buying and child producing years, further stimulating home sales.
  • The number of single detached homes built in Toronto in 2015 was the lowest since 1979 according to a BMO report. This imbalance in supply and demand is a big reason prices for single-family houses are experiencing double-digit price jumps. In May 2016 the average detached home price jumped 18.9%, while condos only saw a 5.9% increase.
  • Housing market speculators flipping properties are very much part of this process although hard data on this activity is sparse.
  • A continued weak Canadian dollar is stimulative to the housing market. Since 2011, the Loonie has lost 27% of its value against the greenback, while Canadian homes appreciated by 26%.
  • If houses were priced in U.S. dollars, a very different perspective emerges. Canadian home prices aren’t appreciating, but show a decline of about 9% against the average benchmark price. The same trend is evident when pricing Canadian homes in Chinese yuan. This is worrisome because Canadians are actually being devalued on a global scale.

Among reasons for the long boom to end:

  • Steven Poloz, head of the Bank of Canada says the Canadian housing boom is unsustainable for a number of reasons including overall household financial stresses and climbing debt.
  • The anticipated interest rate trend, changing from the past three decade decline to a rising rate environment, appears to have already started in the U.S.
  • Continued weakness in the price of oil as is anticipated by many given slow global growth and excess oil supply.
  • Asset prices inevitably revert to their historical mean, which is overdue in Canadian housing prices.
  • Buyers believing the real estate market is different this time.  Canada’s housing market dropped about 15% in 1957 over six years and a whopping 25% in the early ‘90’s so maybe this market needs to digest some of the recent gains, which are more than double our long-term averages.

The correction may already have begun. Consider that the Teranet-National Bank index of house prices in Canada’s 11 largest metropolitan regions rose 6.1% in November, yet only four cities—Toronto, Hamilton, Vancouver and Victoria actually posted gains. Values in the other seven cities contracted, suggesting that a correction is well underway.

Here are two recent articles that provide more food for thought on our real estate market:

The first article from Maclean’s suggests that population growth isn’t driving Toronto house prices as many have claimed.

The second article from MoneySense magazine, takes a broader approach and provides the Canadian Real Estate Associations (CREA) perspective.

Anton Tucker
Compiled by:
Anton Tucker, CFP, FMA, CIM, FCSI
Executive VP and Portfolio Manager
anton@tridelta.ca
(905) 330-7448

Where to Invest Your RRSP Contributions

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Lorne on BNNLorne Zeiler, VP and Portfolio Manager at TriDelta Financial and Investment Counsel was the guest on BNN’s The Street on February 13th to discuss RRSP Investing, TFSAs and where to invest your RRSP contribution.

 

Lorne Zeiler
Written By:
Lorne Zeiler, MBA, CFA
VP, Wealth Advisor
lorne@tridelta.ca
416-733-3292 x225

TriDelta Investment Counsel Q4 Report – In 2017 while the noise gets louder, facts matter more than ever.

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10 Facts for 2017 and what it means to you

2017

  • For a 65 year old couple, there is a 90% chance at least one will live to age 80.
  • For a 65 year old couple, there is a 48% chance at least one will live to age 90.
  • Since 1926, average returns for the S&P500 have been 9.8%. 4% came from dividends and 5.8% from capital appreciation.  41% of total return came from dividends.
  • In 2006, the top Corporate tax rate in Canada was 34%. In 2016 it was 27%.
  • In 2006, the top Corporate tax rate in the U.S. was 39%. In 2016 it is still 39%.
  • The U.S. unemployment rate is now 4.7%. The last two times the unemployment rate was that low, the 10 year bond yield was at 4.14% and 5.24% respectively.   Today it is at 2.37%.
  • In the past 14 years, when comparing returns to volatility, High Yield bonds have been among the best asset classes averaging a return of 9.2% while maintaining a relatively low level of volatility compared to all major asset classes. Commodities have had a 1.2% annual return with a much higher level of volatility.
  • In 1990 the 5 year GIC rate was 11%. Today at the Big banks, 5 year GIC rates are only 1.5%.  In order to generate $50,000 in annual income using 5 year GICs, you would have needed $454,000 of savings in 1990.  Today you would need $3.33 million.
  • There is $12.3 trillion sitting in cash and money markets in the U.S. today vs. being efficiently invested.
  • The asset mix of the Ontario Teachers’ Pension Plan at December 31, 2015
    1. 2% Canadian Stocks
    2. 44% Non-Canadian Stocks
    3. 41% Bonds
    4. 6% Natural Resources
    5. 14% Real Estate
    6. 10% Infrastructure
    7. 11% Absolute Return Strategies
    8. -28% Money Market (or borrowing to invest)

What the facts above mean to us is that while short term interest rates are heading higher in the United States, we live in a time of increased longevity and very low risk free returns on investments like GICs.  In order to achieve positive investment returns after inflation and taxes, that will carry through a long life, you need to look at stocks that pay dividends and you should have meaningful exposure outside of Canada and Commodities.  You also want to have exposure to high income investments that reduce volatility and do not act so much like stocks, such as high yield debt and alternative income strategies.  While stock markets today are trading at historically higher valuations in the U.S. and Canada, clients should still be invested because earnings are expected to rise, there is the positive potential impact of meaningful corporate tax cuts in the U.S., and the massive amounts of money that remain invested in cash and money markets that need a higher return.  If you think that the people that manage the Ontario Teachers’ Pension Plan are pretty smart (they are), then why are they borrowing $47 billion to invest?  The answer is that they believe so strongly that cash is a bad investment today and that with cash being so cheap to borrow, why not borrow to invest?

These facts don’t change under President Trump.  What does change is that in a world of unfiltered tweets that reach around the world in a second, we will have some days or weeks or months in 2017 that may shake investors’ faith in these 10 facts.  Despite the noise, facts still count in life, in financial plans and in investing.

How Did TriDelta Do in Q4?

While we certainly saw gains across our stock portfolios, we did not get the full benefit of the surprising Trump election win, and the surprising Trump rally.  We always find it surprising how many people state that they expected both to happen….. after the fact.  It is worth noting that for the small percentage that thought Trump would win, there were even fewer that thought the stock market would rally on the news.

On the stock side, most clients were up between 1.25% and 2.25% on the quarter.

On the bond side, TriDelta’s active management really shone brightly.  While broad bond indexes had a terrible quarter, down over 3%, the TriDelta Fixed Income Fund was down just 0.6%.  Our Fund was up nearly 6% over the course of the year.  Among the reasons for this outperformance was a focus on Corporate Bonds, Preferred Shares as well as some higher exposure to High Yield Corporates.

Preferred Shares continued their strong rebound, especially on the rate reset side of things.  TriDelta’s preferred holdings were up over 6% on the quarter and over 14% on the year – handily beating Preferred share indexes over both time frames.

The TriDelta High Income Balanced Fund ended off a great year, with a decent fourth quarter gain of 1.25%.  For the year, the fund was up 15.6%.  It has had 11 consecutive positive months.

Our Investment View for 2017

The million dollar question is whether Trump will accomplish most of what he says.  If that is the case, there will be lower corporate tax rates, higher inflation, higher interest rates, greater infrastructure spending, more protectionist trade policies and less regulation on the Energy, Financial Services and Health Care industries.  The market has already assumed that much of this will take place, and has acted accordingly.  If some of these don’t take place or take place much more slowly or in a watered down way, the market will adjust back a little bit in the affected sectors.

We believe the following:

  • While there will likely be higher inflation and interest rates in the United States, this will not likely be the case for Canada. Canada is in a different place economically than the U.S. and along with the possibility of a tougher export environment to the U.S., Canadian increases on inflation and interest rates will likely be muted to non-existent.
  • While there will likely be higher inflation and interest rates in the United States, it will not be as high on either front as some are predicting, at least not in 2017. Among the constraints on increased Government spending will be the debt ceiling (remember that issue from yester year?) to pay for greater infrastructure.  This will not be easy to push through a Republican House, and will likely slow the growth and inflation some currently predict.
  • Large cap dividend payers will remain a popular investment. In the weeks since the Trump election, there was a pullback in some of the traditional large cap dividend paying utilities, health care, consumer staples, and telecoms.  We believe that there remains a great deal of interest in these stocks for two reasons.  The first is that all of those bailing out of bonds need to go somewhere.  If you were 60% invested in bonds and now you are 40% in bonds, what type of stocks might you buy?  It is most likely for a bond alternative, you would buy the highest quality stocks that pay a decent dividend yield.  The second reason is that as per point number two, we believe that some of the U.S. growth story is overdone, especially in terms of expected infrastructure spending.  If that is the case, the shift to higher risk stocks that we saw this past quarter may shift back.    
  • Oil will struggle to top $60 for a long time. This is tied somewhat to lowering regulatory hurdles on various ‘dirty’ energy sources, and also tied to the opportunities for increased supply at $60 Oil.  There are more and more U.S Shale energy sources that are ramping up again as the Oil price increases.  In addition, supply will likely increase in Canada and other oil exporting nations outside of OPEC.  Lastly, OPEC members have not proven themselves the most disciplined bunch in the past decade.  It is unlikely that they will be able to hold back on supply if they can get decent prices.  As new supply hits, it will significantly constrain meaningful growth in prices.  This will also limit the opportunities for the Canadian market to do nearly as well as in 2016.
For 2017 we believe:

US Dollar will be stronger than the Canadian Dollar – U.S. interest rate hikes while Canada remains steady.  Some possible trade issues for Canada.  Lower commodity price growth than 2016.  All of these point to Canadian dollar weakness.

Canada will not be a top performing equity market in 2017 – In 2016, the TSX was up 18% after declining 11% in 2015.  In Canadian dollars, the S&P500 was up 6%.  Most of Europe and Asia were negative.  We believe that for Canadians, there will be better Canadian dollar returns found in Europe and Asia and the U.S. than in the TSX.

Preferred Shares will continue to provide good returns.  Preferred shares should continue their ascent, following a strong year as the fear of lower rate resets recede.  There remains the allure of tax preferential preferred yields and the prospect for potential capital gains in an asset class that has been deeply disadvantaged in 2014 and 2015. 2017 looks to be shaping up for another friendly year for this asset class as investors continue to search for 5%+ yield in an environment where interest rates may have found a bottom.

Canadian interest rates and inflation will remain quite low – The catalysts for growth don’t seem to be there at this time.  Despite lots of U.S. news media talk on rising rates and inflation, we need to remain focused on the Canadian experience.

China’s tightening rules on the foreign flow of money will lower housing prices in Vancouver and likely Toronto – I know this one is a tough prediction for Toronto considering it hasn’t had an annual decline in 20 years.  The point is that foreign funds from China are a significant driver on the real estate market in Vancouver and Toronto.  Toronto has had a bigger push of late because we do not have a Foreign Buyers Tax (yet).  The view is that this will have a bigger impact overall than some people predict.  There is also the continuing impact of tighter mortgage rules and slightly higher mortgage rates.  If we do see lower prices (they won’t likely be large declines), it will be another small weakness on the Canadian economy overall.

Alternative Income Investments remain a strong investment option for a part of your portfolio.

Given the low yields offered on most bonds, we have focused considerable time and energy reviewing and incorporating alternative assets, particularly in private investments, into client portfolios.  These investments offer favourable economics, along with high levels of income that are typically in the 6-10% range.  These investments have very low volatility and provide additional diversification benefits as they have low correlation with stocks and bonds.  These benefits will continue to be valuable in 2017 and for the foreseeable future.

Summary

The year ahead has more uncertainty than most.  As a result, we will continue to try to reduce overall volatility of portfolios and to reduce the downside risks that can come up in any market cycle.  Steady income – whether from solid dividend growers, preferred shares or alternative income investments – will be a good friend in 2017.  It is an even better friend if the yields achieved are meaningfully higher than inflation rates – and are not very connected to the ups and downs of the market.

As a final comment, we wanted to thank our clients for their trust and confidence in us.  We appreciate it greatly, and will work hard to earn that trust and confidence in the year ahead.

All the best to all our readers for a healthy and prosperous year ahead.

TriDelta Investment Management Committee

 

Cameron Winser

VP, Equities

Edward Jong

VP, Fixed Income

Ted Rechtshaffen

President and CEO

Anton Tucker

Exec VP and Portfolio Manager

Lorne Zeiler

VP, Portfolio Manager and
Wealth Advisor

FINANCIAL FACELIFT: At start of big earning years, couple face lack of retirement savings

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Below you will find a real life case study of a couple who are looking for financial advice on when they can retire and how best to arrange their financial affairs. The names and details of their personal lives have been changed to protect their identities. The Globe and Mail often seeks the advice of our VP, Wealth Advisor, Matthew Ardrey, to review and analyze the situation and then provide his solutions to the participants.

gam-masthead
Written by: DIANNE MALEY
Special to The Globe and Mail
Published Friday, Dec.30, 2016

retirement_planningAfter nearly a decade in grad school toiling as a research assistant, Chris has reached his big earning years. He is 39 and grosses about $180,000 annually as a self-employed medical consultant.

“I began my private practice one year ago,” Chris writes in an e-mail. It has taken off and is generating a lot of money, he adds – so much that his wife, Rachel, stepped away from her job “and is now trying to forge a career as an author,” Chris writes. Rachel, who is 40, is also taking care of their three children, whose ages range from 10 to 13.

In the fall, after a generous gift from their parents, they bought a house large enough to accommodate a family of five and a writer. Over the next few months, they want to buy a new car, renovate their bathroom and put in a gas fireplace. They have not yet begun to save for retirement in any meaningful way and are concerned about that. They’d also like to travel.

“How much should we allocate to our RRSPs and tax-free savings accounts to make up for the years when we didn’t contribute?” Chris asks. “How aggressively should we pay down our mortgage, and how do we balance this against our dream of purchasing a cottage within the next 10 years?”

We asked Matthew Ardrey, vice-president at TriDelta Financial in Toronto, to look at Chris and Rachel’s situation. Mr. Ardrey holds the certified financial planner (CFP) designation.

What the expert says

Chris and Rachel want to renovate their bathroom and put in a gas fireplace at a combined cost of $35,000. Mr. Ardrey assumes they will use part of their $83,000 in savings to pay for this. As for the car, they could finance the purchase at or near zero interest and pay the loan off over five years.

Because they live in Quebec, their children’s tuition fees for postsecondary education will be much lower than in other provinces. Rachel and Chris are saving $2,500 a child a year to their registered education savings plan, which has a balance of $51,000. Mr. Ardrey assumes a cost of $10,000 for each child a year to cover additional costs such as textbooks and the like. So their savings should be enough to cover the majority of the costs of four-year undergraduate degrees for each of their children, the planner says. They will fall a little short in the final year of schooling for the youngest child and will need to add about $8,500 of their own money.

To meet the couple’s travel goal, Mr. Ardrey doubled their travel budget to $14,000 a year starting in 2018 when the home renovations are complete.

So far, Rachel and Chris have almost no retirement savings. Chris has $34,000 of unused RRSP contribution room and Rachel has $61,000. Both have the maximum TFSA contribution room available.

Given their cash holdings and surplus of income over expenses, Chris should be able to make up his unused RRSP contribution room in the coming year as well as make the maximum contribution for 2017 and ensuing years. No RRSP contributions are factored in for Rachel because she has no income at the moment.

For the TFSAs, they can catch up on past contribution room by 2021. From 2021 onward, the planner assumes they make the maximum TFSA contribution every year. Both contributions will be made from Chris’s income. Because the money is going to a TFSA, the investment income from her TFSA will not be attributed back to him.

In preparing his forecast, the planner assumes it will take five years before Rachel starts earning an income from her writing equivalent to $20,000 in today’s dollars. Because Chris will be making substantially more than Rachel, Mr. Ardrey assumes that she saves all of her gross earnings to her non-registered investment account. The resulting investment income will be taxed at her lower marginal tax rate. In addition, Chris can pay any income tax Rachel might owe to allow her to save more.

Starting in 2021, Chris and Rachel will have some additional cash flow because they will have caught up on their TFSA contributions. Mr. Ardrey assumes they direct $1,100 a month to paying down their mortgage from 2021 to when they buy the cottage. He assumes they buy a cottage in 2028 for $400,000 in today’s dollars, adjusted for inflation. The make a down payment of 10 per cent from Rachel’s non-registered savings. The remainder of the purchase price is financed by a mortgage at 5 per cent. In 2037, when the mortgage on the principal residence is fully retired, they can increase the principal repayment on the cottage mortgage by $30,000 a year to retire the debt in 2043, in advance of their retirement in 2047.

Chris and Rachel plan to retire at the age of 70. Their savings and government benefits will be more than enough to meet their $55,000 a year after-tax spending goal, Mr. Ardrey says. He has factored in $20,000 a year for travelling until Chris is age 85. The planner’s forecast assumes a 5.4-per-cent rate of return on their investments, falling to 4 per cent once they have retired, an inflation rate of 2 per cent, and that they both live to the age of 90.

+++++++++++++++++

The people: Chris, 39, Rachel, 40, and their three children.

The problem: How to allocate the income from Chris’s growing consulting business. Can they buy a cottage?

The plan: Catch up on unused RRSP and TFSA contribution room, then shift to repaying the mortgage. Once the mortgage on their principal residence is paid off, they can shift the money to the cottage mortgage and have it paid off before they retire.

The payoff: A clear road map to a financially comfortable retirement with all their goals achieved.

Monthly net income: $9,380

Assets: Cash in bank $83,000; his RRSP $1,200; her RRSP $1,200; RESP $51,000; residence $765,000. Total: $901,400

Monthly disbursements: Mortgage $1,850; property tax $140; home insurance $140; utilities $175; transportation $335; grocery store $1,150; clothing $100; gifts $50; vacation, travel $585; dining, drinks, entertainment $260; grooming $60; pets $50; subscriptions $135; doctors, dentists $50; life insurance $75; disability insurance $20; cellphones $90; Internet $150. Total: $5,415. Surplus available for saving and investing: $3,965

Liabilities: Mortgage $417,000

Want a free financial facelift? E-mail finfacelift@gmail.com.

Some details may be changed to protect the privacy of the persons profiled.

Matthew Ardrey
Presented By:
Matthew Ardrey
VP, Wealth Advisor
matt@tridelta.ca
(416) 733-3292 x230

Lorne Zeiler, Guest Portfolio Manager on BNN’s Market Call December 23, 2016

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lorne_bnn_23dec16Lorne Zeiler, VP, Portfolio Manager and Wealth Advisor at TriDelta Investment Counsel, appeared on BNN to take viewer’s calls on Dividend Stocks, Portfolio Strategy and investment impacts of a Donald Trump presidency during Market Call on December 23, 2016.

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