Articles

These unfair tax policies are putting a burden on women and seniors and need to be changed now

0 Comments

Here’s a scenario I’ve seen several times in my career as a wealth manager. A retired couple that receives two full CPP payments and two full Old Age Security (OAS) payments is able to fully split their income for tax purposes. Then one spouse dies. The survivor only receives one CPP payment, no OAS, and often has a higher tax rate on less family income because they now have one combined RRIF account that must withdraw more funds on a single tax return. It hardly seems fair, because it isn’t.

The scenario highlights just one of a number of thoroughly unjust tax policies that negatively affect hundreds of thousands of Canadians each year. Many of the policies are particularly harmful to older women because they hit those who are single/widowed and over the age of 65 — a group that contains a much higher percentage of women than men.

As we head into a new decade, and in the spirit of eternal optimism, I am providing a list of four main offending policies in the hope that some political titans vow to fix them.
Without further ado, here are the festering four:

1. Income splitting of a defined benefit pension, prior to age 65

THE SITUATION: If you receive a defined benefit pension at any age, you can split the income with your partner for tax purposes. However, if you convert some or all of your RRSP to a RRIF and withdraw money before age 65, you can’t split the income. You have to wait until age 65.

WHY IT MATTERS: Income splitting is another way of simply saying “pay less in taxes.” If you can income split you will most likely keep more of your pension money than if you can’t. As a simple example, if one person earns $120,000 in Ontario, their tax bill will be $32,895 (with no deductions). If instead, that person is able to fully split income and two people now show $60,000 in income, the total tax bill is $22,050. On the same amount of income, the tax bill is $10,845 lower.

WHO IT AFFECTS: Everyone who does not have a defined benefit pension. These days, most employees who have a defined benefit pension work for the government or a quasi-governmental organization. The private sector now has a very low percentage of employees in a defined benefit pension. To oversimplify, working for the government provides a sizable unfair tax advantage for those under 65 compared to those working in the private sector, without a defined benefit pension. It also benefits couples over singles.

HOW TO FIX IT: Apply the same income splitting age on RSP/RIF withdrawals as on defined benefit pension payments. If that is deemed too expensive for the government, do an income-splitting cap of something like $20,000, but apply it equally to all those of a specific age regardless of what type of retirement pension plan they have.

2. Couples tend to receive more dollars per person than singles in Old Age Security (OAS)

Older woman calculating her taxesTHE SITUATION: Current OAS is more than $7,300 per person per year. If you are collecting OAS starting at age 65, your income can be up to $79,000 before any of your OAS is clawed back. At an income of $128,000 it will be fully clawed back.

WHY IT MATTERS: This is significantly unfair to retired singles. If you are single and your income is $130,000, you will collect no OAS. If you are a couple with household income of $130,000, and you can fully split your income, you will collect about $14,700 of OAS every year indexed to inflation.

WHO IT AFFECTS: Single/widowed seniors get the short end of the stick, and they are more than twice as likely to be female. I have seen many cases where a couple receives two full OAS payments. When one passes away, the survivor suddenly receives $0 in OAS because all of the income (usually RIF income) now sticks to one person instead of being split. According to Statistics Canada roughly 70 per cent of those in long-term care and retirement residences are female. As far as private residences (houses, apartments, condos), 40.2 per cent of women aged 80 to 84 live alone, while only 18.6 per cent of men in the same age group live alone. However you slice it, it appears that at least twice as many single seniors are woman as opposed to men.

HOW TO FIX IT: Have the OAS clawback be based on a dual-person rate or a single-person rate, such that two-person families might see a little more clawback and single-person families see a little less. Given that the current clawback kicks in at $79,000 for one person, the two-person ‘family’ rate could be set at a little less than double that, say $145,000 (with full splitting, the current cutoff for two people is effectively $158,000). The new single-person clawback cutoff could then be raised to about $85,000. The idea is to massage the clawback criteria so that people are much less likely to go from double OAS payments to zero when one dies or gets divorced.

3. Effectively losing the CPP Survivor Pension

THE SITUATION: If two people in a couple are both collecting a full Canada Pension Plan benefit and one of them dies, the other will receive a one-time $2,500 death benefit, and then they will lose the entire CPP payment of the person who died. On the other hand, if the same couple has one person who is collecting a full Canada Pension Plan and their partner never paid into the plan and collects $0 of CPP, and either of them die, the net result is that they will continue to collect one full CPP amount. The reason is that no individual is able to collect more than 100 per cent of a CPP benefit. However, if one person is currently receiving less than 100 per cent, and let’s say her partner dies, that person is able to top up her CPP payment up to 100 per cent out of the amount that was being collected by her partner.

WHY THIS MATTERS: A full share of CPP in 2019 is over $13,800 a year. This is a significant amount of money. To go from receiving up to $27,600 a year and having it drop to $13,800 is a big impact when both people have contributed a lot to CPP over the years.

WHO IT AFFECTS: These rules almost provide an incentive to only have one working partner over the years. It hurts couples in which both partners worked full time. It especially affects couples who both work and in which the male is much older than the female, as this will lead to a longer period of one CPP payment as opposed to collecting two.

HOW TO FIX IT: Most defined benefit pensions have a survivor pension that pays out 60 per cent to 70 per cent of the pension to a surviving partner. You could change the CPP so that if a survivor is already receiving a full CPP payout based on her own contributions and her partner dies, she should receive 60 per cent of their partners’ CPP as well. Essentially make the maximum payout to an individual up to 160 per cent of a full CPP payout. In order to fund it, we could slightly lower a full CPP payout for everyone. In cases where only one person contributed to CPP, and one of the couple dies, then that person would be capped at receiving 100 per cent of the CPP. In this way, a lifetime of CPP contributions doesn’t go for naught if one spouse dies.

4. The Canadian dividend gross up costs OAS dollars

THE SITUATION: In simple terms, Canadian dividends from public corporations are more tax efficient than interest income and foreign dividends. For example, at $70,000 of income in Ontario, the marginal tax rate on income or foreign dividends is 29.65 per cent but the marginal tax rate on eligible Canadian dividends is just 7.56 per cent. This is a very big positive for investing in Canadian stocks that pay dividends. However, there is one nagging problem. The CRA likes to make things complicated, and in order to sort out something called tax integration for corporations, they have set up a complicated way to tax Canadian dividends. The tax formula is to ‘gross up’ a dollar of Canadian dividend income by 38 per cent and then apply a dividend tax credit to get to the right amount of taxation on the dividend. When the CRA determines your income for a variety of income tests, they take your net income — which includes the grossed up dividend income.

WHY IT MATTERS: We discussed the minimum OAS clawback at net income of $79,000. Let’s say you have $70,000 of taxable income from RRIFs, interest and global dividends. At this amount you would receive full OAS. Instead, if you had the same $70,000 of income but it was all Canadian dividend income (an unlikely scenario but good for making this point), it would be grossed up by 38 per cent, and your net income would be considered $96,600. Now your OAS would likely be clawed back by $2,640 a year.

WHO IT AFFECTS: This is an issue that exists for no good reason. At the end of the day, it isn’t the worst of the festering four, but does slightly punish seniors who invest in Canadian companies that pay dividends, especially those who check in around the $80,000 income bracket and are already having some OAS clawed back.

HOW TO FIX IT: I am sure that the strategies around corporate tax integration are complicated, but on a personal tax return, is it that hard to simply tax Canadian dividends using personal tax rates without any gross up? If there was no gross up calculation on a personal tax return, then there is no longer an OAS net income issue. Problem solved.

Reproduced from the National Post newspaper article 23rd January 2020.

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

FINANCIAL FACELIFT: Can Olivia and Larry retire early with an ideal income of $10,000 a month?

0 Comments

Below you will find a real life case study of a couple who are looking for financial advice on how best to arrange their financial affairs. Their names and details have been changed to protect their identity. 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:
Special to The Globe and Mail
Published January 10, 2020

People with ambitious financial goals are wise to start planning well in advance. So it is with Olivia and Larry, both 38, who hope to retire from work in their late 50s with substantially more discretionary spending power than they have now.

Larry brings in $125,500 a year plus bonus in a senior management job. Olivia earns $65,000 a year in education. They have a daughter, 4, whom they want to help get established financially when the time comes.

First, though, they plan to sell their Toronto-area house and move back to Montreal soon to be close to family and friends. Larry’s income is not expected to suffer in the move, but Olivia’s could be cut in half. Also, her defined benefit pension entitlement will be lower than if she stayed in her current job.

In 20 years or so, when they retire from work, Olivia and Larry hope to travel extensively, which partly explains why they have set their retirement spending goal so high: $120,000 a year.

“Can we retire early with an ideal income of $10,000 a month after tax?” Larry asks in an e-mail.

We asked Matthew Ardrey, a financial planner and vice-president at TriDelta Financial in Toronto, to look at Larry and Olivia’s situation.

What the expert says

Mr. Ardrey starts by reviewing the couple’s cash flow. According to Larry and Olivia, they spend everything they earn and sometimes have to dip into their tax-free savings accounts (TFSAs) to keep up with their car payments.

Yet when Mr. Ardrey runs the numbers, Larry and Olivia provided, he finds they actually have a surplus of $12,800 a year. (Income includes tax refunds from RRSP contributions.)

“This is a significant difference and does not even account for Larry’s variable bonus, which he requested to keep out of the projection,” the planner says. Because most people know what they earn and save, “we can assume the difference lies in the spending part of their budget,” Mr. Ardrey says. “Thus, a full review of their budget and spending is recommended.” In his analysis, the planner assumes they are spending the extra $12,800 a year on outlays not listed in their monthly expenditure form. That would include items such as household maintenance and repair, for example.

They are saving $650 a month to Larry’s RRSP, which his company matches 100 per cent, $160 to their child’s registered education savings plan (RESP) and $150 each to their respective TFSAs. Olivia contributes $600 a month to her work pension plan, an amount that is estimated to drop to $300 a month when she begins working in Montreal.

Some time in the next couple of years, Olivia and Larry would like to leave Ontario and return to Montreal. They would sell their house and purchase a smaller home in Montreal for about $600,000. “If we assume selling/moving costs of 10 per cent of the selling price, and that they pay off all their existing debts, they will need only a small mortgage of $30,000 for this transaction, which they can pay off in a few years at $1,000 a month,” Mr. Ardrey says.

The move to Montreal will affect their financial situation both positively and negatively, the planner says. Olivia’s income will drop about 50 per cent, which will also affect her DB pension. But their ability to save will increase because of the lower debt obligations. The planner assumes they direct these savings to their TFSAs and Larry’s RRSP. Any remaining surplus could go to a non-registered investment account.

The couple want to retire at the age of 57. Mr. Ardrey’s forecast assumes that at 65, Larry and Olivia will get 80 per cent and 60 per cent, respectively, of CPP/QPP (Quebec Pension Plan) benefits, and full Old Age Security benefits. Olivia’s pension estimate at age 57 is $27,182 a year in today’s dollars because of her reduced income. The couple’s baseline retirement spending target is $7,000 a month, plus $1,000 a month for five years to help their daughter, and another $2,000 a month for 25 years for travel.

Next, Mr. Ardrey looks at what Olivia and Larry can expect to earn from their investments. Their portfolio is 90-per-cent stocks and 10-per-cent fixed income, which produced a historical return of 6.1 per cent a year, he says. In retirement, he assumes their mix becomes more conservative (60-per-cent stocks/40-per-cent fixed income) and that they earn 4 per cent a year net of investing costs.

“Based on these assumptions, they fall short of their retirement goal,” Mr. Ardrey says. “They run out of savings in 2059 when they are 78.” (They would still have Olivia’s pension, their government benefits and their residence.)

If Olivia retired at 57 and Larry worked to 59, “they will reach the break-even point in their retirement spending,” the planner says. To have a surplus, they would have to work even longer, spend less or achieve a better rate of return.

To generate better returns, they could make some improvements to their investment strategy, he says. Larry’s group RRSP is well diversified, but their other investments are almost solely in five Canadian large-cap stocks. This lack of diversification “is adding significant risks,” the planner says.

As long as their portfolio is less than $500,000, they should consider broad-based exchange-traded funds, he says. ETFs offer low-cost diversification by company, asset class and geographic location. Once their portfolio passes the $500,000 threshold, they could consider hiring an investment counsellor or portfolio manager, Mr. Ardrey says. These firms charge a fee based on the size of the portfolio and have a fiduciary duty to act in their clients’ best interests. Investment counsellors tend to offer their clients investments that are not available on publicly traded markets – such as private debt and equity funds – designed to provide steady returns that are not subject to the ups and downs of financial markets.

Client situation

The people: Larry and Olivia, both 38, and their daughter, 4

The problem: Can they afford to retire at the age of 57 and spend $10,000 a month even if Olivia’s income drops?

The plan: Olivia retires as planned, but Larry works another two years to 59. They take steps to diversify their holdings and improve their net returns.

The payoff: Goals achieved.

Monthly net income: $11,685

Assets: Cash $3,120; his TFSA $74,020; her TFSA $66,350; his RRSP $125,510; her RRSP $16,210; estimated present value of her DB pension $42,250; RESP $13,160; residence $1.1-million. Total: $1.44-million

Monthly outlays: Mortgage $3,165; property tax $505; home insurance $60; utilities $300; transportation $650; groceries $570; child care $510; clothing $265; car loan $660; gifts, charity $540; vacation, travel $415; dining, drinks, entertainment $660; personal care $145; other personal $145; life insurance $150; cellphones, internet $170; RRSP $650; RESP $160; TFSAs $300; her pension plan contribution $600. Total: $10,620 Surplus of $1,065 is spending unaccounted for.

Liabilities: Mortgage $526,640; line of credit $26,865. Total: $553,505

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

TriDelta Q4 Review – Back to ‘normal’

0 Comments

Overview

At the end of December 2018, markets had just completed one of the worst quarters in several years.  The general view was very weak.

Today, many investors are much more positive after very strong returns in 2019.

Where that leaves us today is much more in the middle in terms of our outlook for 2020.

On the positive side, interest rates remain very low and the general trend is for them to remain at these levels for a while.  In addition, global growth is showing some signs of improvement after real slowdowns in 2019.

On the negative side, U.S. markets are now at the high end of their valuations, and there isn’t a lot of room to go higher unless corporate earnings pick up strongly.  Of interest, most other equity markets, including Canada, have much more reasonable valuations at the moment.

In Canadian Dollars – Total Stock Market Returns in 2019:

*TSX (Canada) 22.9%
*S&P500 (U.S.) 25.7%
*European Stocks 18.6%
*Nikkei (Japan) 16.3%
*Emerging Markets 13.2%
*Hang Seng (Hong Kong) 8.4%

Other key 2019 Returns included:

* FTSE Canada Universe Bond Index 6.9%
*BMO CM50 Preferred Shares 2.1%

What do we see for 2020 and why

We do not believe that a bear market is imminent.

Last quarter we said that historically, bear markets occur when at least two of the following four circumstances are found:

  1. Economic Recession – Two consecutive quarters of negative growth.
  2. Commodity Spike – A movement in oil prices of over 100% over an 18 month period.
  3. Aggressive Fed Tightening – Unexpected and/or significant increases in the Fed funds rate.
  4. Extreme Valuations – When S&P500 trailing 12 months price/earnings levels were approximately two standard deviations higher than the long term average.

As of the moment, we are seeing reasonable growth with expected real GDP growth of 1.8% in the U.S. and 1.6% in Canada, so no economic recession, although certainly not stunning growth either.

There was no major commodity spike in oil prices, even with the recent Iran conflict.

No meaningful increases in interest rates are envisioned.  We expect rates to remain flat or to be slightly down in 2020.

The only bear market risk at the moment is high stock market valuations, but even the overvaluation is not significantly large.  Focusing on the S&P500 in the U.S., the measure is a trailing 12 months Price/Earnings ratio two standard deviations higher than the long term average.  While not trailing, on a forward P/E basis, the S&P500 is at 18.5 vs. a 25 year average of 16.3.  This is 0.7 standard deviations higher than average. 

It is definitely something to be aware of, but not enough, especially in light of the other three criteria to put us in real concern of a bear market.

In addition, other global markets are valued more cheaply than the U.S.

This chart from J.P. Morgan highlights 25 years of the Forward P/E ratio of the S&P 500.

Interest rates fairly flat with slight downward pressure

On the interest rate side of things, the Central Banks in Canada and the U.S. are both signaling little movement for the time being, although the U.S. could lower rates again before Canada does. 

Strengthening of Canadian dollar vs. the U.S.

Our current view is that the CDN$ will strengthen further against the US$ this year.  The main reasons being that the U.S. Fed has lowered rates and may lower further, while Canada has not lowered rates and is less likely to lower them in 2020 vs. the U.S.  As a result, on the short end of the yield curve, Canada is now paying more than the U.S., and that is where much of the international money flow invests in (short term bonds).  The other driver is that there is more relative growth momentum in Canada than the U.S.  What we mean is that in 2018 U.S. growth was about 0.9% higher than Canada.  In 2019, it was only 0.7% higher.  This year, the U.S. GDP growth is forecast to be only 0.2% higher than Canada, despite a much higher Federal government deficit and more accommodative central bank.  We believe that this shift in growth momentum will be positive for the CDN$ vs U.S.$.

Trade Wars

It looks like we are finally seeing some warming on the trade wars.  As expected, the Trump White House is looking for some trade wins heading into the election.  With the imminent passing of the USMCA (what we will still call NAFTA), and the first phase of a China and U.S. agreement, there are signs of some confidence that may support global growth.

Corporate Earnings

Corporate earnings are expected to grow year over year by 16% according to Bloomberg, but the sentiment is for earnings growth to be lower than that.  This tells us two things.  The first is that strong earnings growth is not likely going to help ‘fix’ the high valuations in the U.S. market.  The second is that with reasonably modest earnings expectations, it is a little easier for companies to meet and exceed expectations.  Overall, we see corporate earnings numbers growing but not driving the markets higher.

Oil Prices

According to the U.S. Energy Information Administration, global demand for oil continues to increase.  In fact, the global demand chart below is remarkably steady for a commodity with a price that can be so volatile.  This is important to remember, because with all of the focus on alternative energy it can be easy to believe that Oil consumption is in decline.

Price expectations for oil are pretty flat, in the $55 to $60 per barrel range for West Texas Intermediate, although the general trend over the past 5 years has been higher.

For energy stocks, which have struggled for several years, this stability, and even the belief of stability, can lead to some modest gains for a depressed sector.

How does this impact your portfolio?

Based on this, we are starting to trim our U.S. stock weighting, and returning some of that back to Canada.  We will maintain our Global Stock weightings.  In addition, we see modest returns for bonds in 2020 and would look to be a little higher weighted in fixed rate preferred shares (with 5%+ dividend yields) as well as rate reset preferred shares, which should benefit from flattish interest rates.

Alternative investments remain an important part for our client portfolios and may be even more important given the more modest expectations from stocks.

On a sector basis, we will likely be lightening up on U.S. Health Care and looking for strong Canadian dividend growers.

Our fearless predictions for 2020:

Before we do our 2020 predictions, it is worth reviewing our 2019 predictions, which came in quite accurate overall:

  1. Better than average stock market returns in most major markets including Canada and the U.S.
  2. Interest rates being mostly flat with maybe one ¼% increase in both Canada and the U.S with a real possibility of an interest rate decline in Canada before the year is out.
  3. The Canadian dollar being fairly flat, but being tied more to oil than we have seen in the recent past.
  4. Oil rising but only slowly, and not a significant recovery.
  5. Preferred Shares having a strong year, bouncing back from their late year steep declines.
  6. Marijuana stocks will see a general decline overall as high valuations and uncertain revenues work their way through, but with increasing gaps between the winners and losers. In fact, we expect to see several bankruptcies in 2019 among the weak players in the market, and at least one major blow up of a more established firm (we just don’t know which one).
  7. Cryptocurrencies – need we even comment?

For 2020, our predictions are:

  1. Average stock market returns in most major markets including Canada and the U.S. – likely in the 5% to 10% return range but with more typical volatility.
  2. Canada will outperform the U.S. market for the first time since 2016.
  3. Interest rates will remain mostly flat to small decreases in both Canada and the U.S.
  4. The Canadian dollar will see reasonable gains vs. the U.S. dollar.
  5. Oil prices will mostly trade within a range of $60 +/- $5..
  6. Preferred Shares will have a stronger year as more investors look for bond alternatives.

Based on these short term beliefs, we have a little higher than average  cash weightings in our stock funds, and will lower our weight on U.S. stocks, increasing the weighting in Canada.  We will also more actively use options to protect against downside risk.

In the Growth fund, which is more active in terms of adjusting industries, we will be adding to Canadian Financials and Utilities and reducing U.S. Health Care.

How Did TriDelta do in 2019?

Our 2019 returns were as follows:

TriDelta Pension Pool (Stocks) 17.3%
TriDelta Growth Pool (Stocks) 20.3%
TriDelta’s Selection of Alternative Income Funds +5.5% to +10.5%

TriDelta Private Funds

In mid-January the Private Fund 1 will do another cash distribution.  Over 9% of the remaining value of the TriDelta Private Fund 1 (Fixed Income Fund) will be distributed out as cash.  We expect to pay further distributions on the fund next quarter as more of the underlying investments mature or are sold.  On the TriDelta Private Fund 2 (High Income Balanced Fund), we didn’t pay a distribution this quarter, after distributing over 30% in the previous two quarters.   

Nine Quick Hits of news and items of interest

  1. The TriDelta Alternative Performance Fund is launching later this month. It will provide a diversified mix of our top growth Alternative Investments in one fund that can be held in any account.  To learn more, please contact your Wealth Advisor.
  2. A reminder that now is a great time to top up TFSA’s. There is another $6,000 per person in contribution room for 2020.  If you have never contributed to a TFSA, the lifetime limit is now likely $69,500 for you.  If you have the funds, January is also a good time to do 2020 contributions to RRSPs, RESPs and RDSPs, as appropriate, as it will help you to tax shelter for a full year.
  3. If you like to save money on gas, a great website to look at is gasbuddy.com. The website shows gas prices at individual stations in your area, and includes prices for standard and high octane as well.
  4. Since the S&P 500 market peak in October 2007, the Technology index is up 348.1%. During the same period the Energy index is up just 6.5%.
  5. S. Household Debt Service Ratio is lower today at 9.7% that at any time in the past 30 years. In Canada it is at 13.3% and higher than it has been for many years.
  6. According to the U.S. Census Bureau, average income for those whose highest education was a High School graduate or less was $38,900, Bachelor’s Degree was $71,200 and Advanced Degree was $99,900.
  7. According to the U.S. Bureau of Economic Analysis, the US Trade Deficit stands at 2.3% of GDP. Despite all of the Buy American initiatives and Trade discussions, this level has been quite constant since 2013.  The Trade Deficit peaked around 2006 at 6%.
  8. While it has come down meaningfully from the peak in mid-2019, there is still over US$11 trillion of debt globally that ‘pays out’ a negative yield, meaning the investor is paying the bond holder for the right to own the bond.
  9. The current interest yield on the full Canadian Bond Index today is just 2.15%.

Summary

We expect a slightly lower than average year in stock markets overall, but do not believe that we are heading into a bear market, at least through the U.S. election.

This type of market can bring a relative premium to investments that pay decent dividends and other income returns, especially given the overall low return on cash and GICs.

Volatility is expected to be higher in 2020, and the reasons for volatility can crop up from anywhere, as we have seen with the Iranian conflict already this month.

Our goal for our clients is to build peace of mind through financial planning and developing portfolios that have much less volatility than stock indexes with a focus on income.  While stock markets are historically down three out of every ten years, we aim to have client portfolios that are rarely negative.  This is part of the reason for our Alternative Income weighting in portfolios.

At TriDelta we will continue to be nimble while focused on a long-term plan, a steady and diversified asset mix that is built appropriately for the goals of each client, and an eye on tax minimization.

Here is to a good investment year in 2020 for everyone.

 

TriDelta Investment Management Committee

Cameron Winser
CFA

Senior VP, Equities

Paul Simon
CFA, FRM

VP and Head of Fixed Income

Lorne Zeiler
CFA®, iMBA

Senior VP, Wealth Advisor and
Portfolio Manager

Why investors should pay for all investment fees out of non-registered accounts

0 Comments

The Department of Finance Canada’s recent letter to the Canada Revenue Agency (CRA) stating that paying investment fees for registered accounts out of non-registered accounts does not constitute a tax advantage is a big win for investors, who are now free to pay their investment costs from any source they choose.

There are various advantages for investors to pay all investment fees out of a non-registered account. At the core, though, investors will end up with more money, after taxes, if they pay all the investment fees for a tax-free savings account (TFSA) or registered retirement savings plan (RRSP) from assets held outside of those accounts.

So, how did this all come about? In 2016, the CRA announced at a tax conference that its position on paying investment fees for registered accounts from non-registered accounts constituted an unfair advantage. Furthermore, the CRA stated that as of 2018, any taxpayer who engaged in this activity would be subject to a special advantage tax equal to the amount of fees paid outside of the registered account. The implementation was then postponed a couple of times pending a review from the Department of Finance.

Then, the Department of Finance sent a letter this past August recommending that the Income Tax Act be amended to reflect its finding that there is no advantage to paying registered fees outside of a registered account and that such a decision by a taxpayer may not necessarily be tax motivated. In effect, it means the CRA will not penalize a taxpayer for paying investment fees for a registered account from a non-registered account.

For financial advisors and investors, there are various benefits to taking this approach, which is a way to increase assets with no added risk.

For one, investors may have investments that are less liquid in the registered account. So, paying for investment fees from a non-registered account can provide ease of cash management over the portfolio. In addition, paying all investment fees out of one account rather than from multiple accounts may be easier from an administrative perspective.

The main advantage for investors, though, is that registered accounts have an ability for greater compounding of returns than non-registered accounts because of the registered accounts’ tax-deferred or tax-free nature. That was the CRA’s main issue with this practice.

As an example, let’s consider an investor who has $100,000 in a TFSA and $100,000 in a non-registered account. Each account incurs investment expenses of 1.5 per cent, or $1,500, annually.

If all expenses are taken from the non-registered account, it results in more assets growing tax-free within the TFSA, as they’re not impeded by investment costs. Furthermore, it helps the investor save taxes as the capital base in the non-registered account will be lower, which will result in lower taxes against the income within that account as well as lower taxes on the capital gains when the funds are withdrawn.

The strategy is similar for an RRSP, except that the income from the RRSP will be fully taxable when it’s withdrawn from an RRSP or from a registered retirement income fund (RRIF) once the investor reaches retirement. Thus, the investor reduces the capital in the non-registered account today in favour of a much larger payment from a RRIF in the future. Although that payment will be taxable, it will presumably be when the investor is retired and in a lower tax bracket. In addition, as inflation will erode the value of money, it’s preferable to pay $1 of taxes in the future than $1 of taxes today.

Although the advantage in the TFSA is clear, the advantage for the RRSP will be dependent on many factors, such as an investor’s tax bracket now and in retirement, inflation and even potential changes in tax policy.

For investors, this may not be the top tax-saving strategy available, but they should take advantage of every opportunity to improve their returns and reduce their taxes – especially when it can be executed with a simple administrative change.

 

Reprinted from the Globe and Mail, December 18, 2019.

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

Pensions 101: The importance of understanding your pension

0 Comments

I have been involved with the Financial Facelift articles since 2013 and in the financial planning industry since 2000. In my time working on the Financial Facelifts, I have been asked many questions about my calculations and recommendations; but bar none, questions about pension calculations have been the most frequent.

With that in mind, there is no time like the present to give a refresher course on how pensions work, how their value is calculated and why they are so important.

There are two main types of employee pensions in Canada, defined contribution (DC) and defined benefit (DB). Both are important to the financial well-being of their members in retirement, though they both work in different ways.

DC pension plan

The DC pension is more like a registered retirement savings plan (RRSP) in the way it works than what most people would traditionally think of as a pension. In this type of pension typically both employee and employer make contributions to the plan. They are usually based on a percentage of income, up to the contribution limit. These contributions are then invested in underlying investments directed by the employee and vetted by the employer.

How the contributions affect RRSP room is fairly straightforward to understand as well. For every dollar contributed, the employee accumulates a dollar of pension adjustment and thereby their available RRSP room is reduced by a dollar. This is regardless of who makes the contribution. The only difference in the contributions is the employee contributions are eligible for a tax deduction and the employer contributions are not.

The purpose of the pension adjustment is to equalize the retirement savings an employee with a pension can make versus someone who does not have a pension.

On retirement, the employee can transfer the value of the plan to a locked-in retirement account (LIRA), use it to purchase an annuity or a combination of the two. With recent federal budget changes a variable payment life annuity (VPLA) or an advanced life deferred annuity (ALDA) are also options to consider.

The current value of this pension is easily known by taking a look at the value of the underlying investments. What is unknown is what future income this pension will produce. As the name says, it is a defined contribution pension, which means the contributions to the plan are known, but the retirement income is dependent on the investment returns earned and contributions made.

One of the main benefits of a DC pension is that it forces the employee to make retirement savings. By having it as part of the employment culture, and the savings coming right off of one’s pay, it encourages employees to save for their future.

The other key benefit of the DC pension is the employer contributions to the plan. Each plan is different. Some employers may choose to match employee contributions, some may choose to make contributions regardless and some may combine the two in some fashion. No matter how they do it, the benefit is clear to the employee, it is free money toward their retirement savings.

The DB pension plan

The DB pension is what most people think of when they think of a pension. This type of pension provides a known future income stream to the employee – in other words, a defined benefit to the employee. For this benefit the employer, and sometimes the employee, make contributions to the plan that are invested to provide the future income stream. Depending on the investment performance, this may require more or fewer contributions from the employer.

While the end result – a guaranteed income stream – is easy to understand, getting there is a bit complicated. For starters, the DB pension adjustment is harder to calculate than its DC counterpart. Formulas that determine your future benefit involve such inputs as one’s yearly maximum pensionable earnings (YMPE), final average earnings (FAE) and years of service.

To further complicate the DB pension calculation, some pensions have Canada Pension Plan/Old Age Security integration. This is where a bridge payment is made between when the pension commences and age 65 to be later offset by the receipt of CPP and OAS. To note, this integration is not perfect, often being different than the actual CPP and OAS received.

There is also the matter of survivor benefits. If the pensioner is married/common-law, then the pension will pay out a survivor benefit to the spouse upon the death of the pensioner. The automatic selection is typically 60 per cent of the full pension amount, but a higher or lower percentage can be selected. This will raise or lower the actual calculated pension payment based on mortality rates.

So now that we have a base understanding of how the pension gets paid out at retirement, we can discuss the next problem: What is the pension worth today? Unlike the DC pension which has an easily determined value, the DB pension “commuted value,” is another matter entirely.

So, how much money is needed today to pay the employee a pension for the remainder of their life? The main factors that can influence this calculation include:

· Age at retirement

· Penalties for early retirement

· Mortality of the pensioner and, if applicable, the spouse

· Current age

· Expected rate of return on the investments (often called the discount rate)

· Pension indexed or not

· Rate of inflation

Change any one of these factors and the commuted value can change drastically. Why is this so important? For a number of reasons.

First, if the employee dies before starting the pension, often the surviving spouse does not receive a survivor pension. Instead they receive the commuted value of the pension eligible to transfer into their RRSP. This happens without tax implications, much like an RRSP rollover on death.

Even if the pensioner does not die but ceases employment with the employer who has the pension plan, then one option is to take the commuted value and transfer it into a LIRA in their name. Depending on the length of service, this is a common outcome versus waiting to take the pension at their normal retirement date.

Finally, at retirement the pensioner can choose to take the commuted value instead of taking the pension. Why would someone do that? I have gone through this exercise with many clients over the years and some of the main reasons for making this choice are:

· Financial flexibility – With pension unlocking rules available in some provinces, the pensioner can access more of their funds earlier or keep them tax-deferred longer. Either way, there is increased choice about how to deal with the asset.

· Limited life span – The commuted value can provide a larger death benefit for the surviving spouse. (With most survivor pension benefits being a percentage of the full pension payable or having to take an actuarially reduced pension to receive 100 per cent survivor benefits, the full commuted value can provide more value than taking the payments at a reduced level.)

· Company/pension concerns – though this is rare and there are some funding guarantees, one only has to look at the collapse of Nortel or, more recently, Sears Canada to see examples of where a DB is not fully secure.

· Increased wealth potential – As I mentioned previously, each pension is different. It is prudent to take a look at what the breakeven rate of return is. In other words, what would the portfolio created from the commuted value have to earn to match the pension payments. If the comparable rate of return is reasonable, the pensioner may consider in their best financial interests to take the lump-sum. This happens more often than you might think.

Regardless of what option is chosen, the benefits of the DB pension are apparent. Most of the savings required and all of investment risk in building the retirement portfolio is the responsibility of the employer. This takes the decision to save for retirement out of the hands of the employee.

The value of the DB pension – especially if indexed to inflation – of a long-standing employee will provide a solid base on which to retire, even if the employee has no other assets. If someone worked 35 years at an employer with a DB plan, they could conceivably replace 70 per cent of their pre-retirement salary if they had a pure 2 per cent pension formula. This would, of course, also drive a substantial commuted value if that option was chosen.

For those of you lucky enough to have a workplace pension plan, understanding how it works is an important first step in financial literacy. They don’t teach this in school, though I think they should. Whether it is the more straightforward DC pension or the more complex DB pension, understanding how to maximize the benefits and choose the best options available are important steps on your road to financial independence.

++

The DB plan: crunching the numbers

The pension adjustment (PA) for a defined benefit pension is more complicated to calculate than its defined contribution counterpart.

The calculation for the PA equals nine times the value of the benefit earned for the year (2 per cent of final average earnings is the maximum value of the benefit permitted by the government in pension calculations – someone with a 2 per cent pension who works for 35 years would have 70 per cent of their former income in pension) minus $600.

  • For example, if the employee had a 2 per cent pension with a $100,000 salary, the PA = 9 x ($100,000 x 2%) – $600 = $17,400. Note: While the PA will reduce the amount of available RRSP contribution room available, only a portion – the employee’s contributions to the pension – is tax deductible.

So, based on this example, the DB plan will reduce this person’s RRSP contribution room by $17,400.

The formula to calculate the future benefit varies as well. Most DB pensions work on a percentage of earnings. Often the earnings are a final or best average of some time period, such as three or five years.

Next, a percentage is applied to the average earnings figure. As stated above, 2 per cent is the maximum per year, though the percentage can be lower than this. Plans may also have tiers of earnings often separated by the average year’s maximum pensionable earnings (YMPE) over the final three or five years.

(YMPE is the earnings level set by the government – $55,900 for 2019 – where an employee maxes out on their CPP contributions. So any income above YMPE does not require a payroll deduction for CPP. It is often used in pension formulas as part of a CPP offset.)

Lastly, are the years of service an employee has in the DB pension. The formula of earnings and percentage is multiplied by the years of service.

  • A typical formula for an employee with a salary of $100,000 and 30 years of service may look like this: (1.4% of Final Average Earnings (FAE) up to YMPE plus 2% of FAE above YMPE) x Years of Service, or
  • (1.4% x $55,900 + 2% x 44,100) x 30 = $49,938 for $100,000 of FAE.

So, in this example, the employee can expect to have a future benefit, or annual income post-retirement, of $49,938.

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

FINANCIAL FACELIFT: What can I do to be more financially successful as I enter my 40s?

0 Comments

Below you will find a real life case study of an individual who is looking for financial advice on how best to arrange their financial affairs. Their name and details have been changed to protect their identity. 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:
Special to The Globe and Mail
Published November 8, 2019

Philip has a well-paying government job with a defined benefit pension plan, for which he is “fortunate and grateful,” he writes in an e-mail. He earns $112,000 a year in salary plus another $9,500 a year, net of expenses, consulting.

At 40, though, Philip is feeling uneasy about his prospects and wondering “how to better manage my finances for the near and distant future.” His near-term goals are to buy a new car and, in five years, a larger condo than the one-bedroom he owns now. In pricey Toronto, this would mean taking on a much bigger mortgage. He still has 23 years left to go on his existing mortgage loan.

Long term, Philip’s goal is to retire from work at age 58 and maintain his lifestyle. He recognizes that these might be competing goals. “I’ve been managing my finances to the best of my knowledge, reading up on budgeting and investment strategies, and now worry if I’m on the right track,” he writes. “What can I do to be more financially successful as I enter my 40s?”

He asks, too: “Am I saving enough for retirement at 58 with a desired after-tax income of $70,000? Am I investing my money wisely? Will I be in a position to purchase a bigger condo in five years?”

We asked Matthew Ardrey, a financial planner and vice-president of TriDelta Financial in Toronto, to look at Philip’s situation.

What the expert says

In reviewing the initial numbers Philip submitted, Mr. Ardrey detected a few things that seemed out of whack. As it turned out, Philip had overstated his consulting income and understated his expenses. After adjusting his income, there is still some missing money, the planner says. Philip is saving about $850 a month outside his registered retirement savings plan. “The remaining $895 per month is real budget leakage,” the planner says. “The first thing Philip should do is a full and complete review of his budget.”

Philip acknowledged this in a follow-up e-mail. “I’m clearly not accounting for all my expenses and travelling,” he writes. “I need to be more mindful of this.”

Next, Mr. Ardrey looks at the car purchase. He assumes Philip buys a new car at the beginning of 2021, taking $5,000 from his savings for a down payment and making monthly payments of $300 for five years. If interest rates stay low, he could likely finance the car at zero interest “or near to it.”

Philip is contributing about $12,200 a year to his defined benefit pension plan, plus making $3,100 a year in additional voluntary contributions (AVCs) to a work RRSP run by his pension plan manager. He is putting $10,200 a year into a savings account.

When Philip sells his condo and buys a larger one in 2025, he will no longer be able to tuck away $10,200 a year in his savings account, the planner says. The condo purchase price, adjusted for inflation, is assumed to be $911,000. Not only will he have transaction costs, Philip will have to pay off his existing mortgage. Mr. Ardrey’s forecast assumes Philip takes on a new mortgage of $590,000 at 4 per cent interest, amortized over 25 years. His payments will rise to $3,092 a month from $1,705 now. Unless he makes extra payments, he will still have a mortgage balance of about $344,465 outstanding when he retires from work in 18 years. To pay off the mortgage before then, he would have to make extra payments of $8,800 a year, putting a strain on his finances, the planner says.

At age 58, Philip will be eligible for an unreduced pension of $73,000 a year, plus a bridge benefit of $15,250 a year to age 65. “Both are indexed to inflation, which is assumed to be 2 per cent,” Mr. Ardrey says. By then, Philip’s spending target will have risen in line with inflation.

Philip’s spending goal is over and above any mortgage payments he might still be making, the planner notes. “Based on these assumptions, Philip would fall short of his goal,” Mr. Ardrey says. By the time Philip turned 65, he would be running budget shortfalls of about $45,000 a year in future dollars, the planner says. This would fall after his mortgage was paid off – assuming he could hang in that long – but he would still be in the red by about $20,000 a year.

“He would need to reduce his retirement spending by $1,000 per month or work another six years until age 64,” the planner says. By working longer, his pension would be larger and the number of years he would be retired smaller.

What if Philip stays put and doesn’t buy the more expensive place?

Suppose, instead, he moves his savings ($59,000) to a tax-free savings account, tops it up to the maximum ($63,500) and contributes $6,000 to it each year? With savings of $10,200 a year, that would leave him with $4,200 to put into a non-registered investment account. Both the TFSA and the non-registered account would be invested in a balanced portfolio of stocks and bonds. The assumed rate of return would be 5 per cent, Mr. Ardrey says.

These small changes could be enough to enable Philip to achieve his goal of retiring at 58 and spending $70,000 a year, the planner says. “The big differences would be the better rate of return than he is getting in his savings account, the continued ability to save each year that he is working and a smaller mortgage, hence smaller mortgage payments, in retirement.”

Philip has been using his savings account as an emergency fund, Mr. Ardrey says. “Instead of holding large amounts of cash, I’d suggest he use a secured line of credit against his home.”

Client situation

The person: Philip, 40.

The problem: Can he afford to buy a bigger place and still retire early with $70,000 a year?

The plan: Work longer, invest the cash stash and consider putting off the condo upgrade entirely.

The payoff: Recognizing that he can’t achieve all of his goals at once and may have to make some choices.

Monthly net income: $7,940

Assets: Savings account $59,000; chequing account $5,000; RRSP and AVC (additional voluntary contributions) $63,000; estimated present value of DB pension $376,800; residence $610,000. Total: $1.1-million

Monthly outlays: Mortgage $1,705; condo fee $455; property tax $200; home insurance $30; hydro $35; car insurance $250; fuel, maintenance, parking $355; groceries $250; clothing $55; vacation, travel $200; dining, drinks, entertainment $950; personal care $35; club memberships $35; other personal $25; health care $20; disability insurance $200; phones, TV, internet $125; RRSP $255; pension plan $1,015; spending that is unaccounted for $895. Total: $7,090. Surplus $850 to savings

Liabilities: Mortgage $345,000

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
↓