Articles

TriDelta Q3 Report – Are the markets in better shape than you thought?

0 Comments

Overview

It is amazing how the day to day can seem very volatile, but when you step back far enough, returns have been fairly steady.  Q3 was one of those quarters.  July was good, August was bad, and September was good.  When you add it all up, the quarter was not great, but decent.

The TSX was up 2.5%, the S&P500 in Canadian dollars was up 1.5% and the MSCI world index was up 2.1%.  This was a rare quarter where Canada outperformed on the strength of Utilities, Consumer Staples and Financials.

The TriDelta Pension fund had a strong quarter, up 4.5%, while the Growth fund was still solid with a 2.3% gain.

The Canadian Bond Index was up 1.2% while preferred shares were up 0.5% on the strength of a rebound in September (after more weakness in July and August).

Despite these numbers, the recession chatter is as strong as ever.

Should we be worried?

How is TriDelta responding?

Where do we see things today and what are we doing about it?

We do not believe that a bear market is imminent.

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.

Today, we see none of the four circumstances in place.

Current growth rates in the U.S. are 2.0%, while Canada is at 1.6%.  These are not booming growth rates, but solidly better than a recession.

Oil prices did see a big drop from October 2018 to December 2018 and rebound, but it was well under 100%.  2019 has actually had more stable oil prices than we have seen in general.  As you can see below, there has been small positive trend for the past 3.5 years.

We are actually seeing Fed loosening of policy as the Fed Funds rate has been lowered twice this year.  As per the chart below, after four years of slowly raising rates, the tide has turned the other direction in 2019.

Valuations on the S&P500 are currently just slightly above their 25 year average based on a forward price/earnings basis, and in a reasonable space on a 12 month trailing basis.

When we take these factors along with our belief that Donald Trump will ease up on China trade demands and tariffs if stock markets are falling, we do not believe in an imminent bear market.

Despite this relative optimism, we do recognize some real risks that include:

  • Slowing growth
  • Few obvious catalysts for near-term market growth
  • Fear that the Fed won’t lower rates as fast as the market expects
  • Brexit dangers
  • Trump….just saying
  • Middle east hotspots in Syria, Iraq, Turkey.

When we net things out our view is slightly positive.  We did have a fairly defensive stance in the third quarter with both higher cash (10%) and a market hedge position in our funds (4%).  We are now slowly lowering our cash weighting, but will likely keep the small hedge in place for now.

Stocks

We are spending a little cash by adding to Emerging Market exposure.  We simply believe that Emerging Markets are undervalued and will benefit more than the rest of the world if the U.S. and China trade improves.  Year to date, Emerging Markets are up only 2.0% while the S&P500 in CDN dollars is up 18.8%, and we believe that gap should narrow.

We are also moving a little more towards Financials and Consumer Staples and a little away from Consumer Discretionary.

Interest Rates

U.S. – The Federal Reserve looks likely to lower rates another quarter percent in late October.  There may be a tougher case to be made for another cut in December as there are currently some Fed Governors clearly against further cuts.  Having said that, the market is still expecting further cuts after October.

Canada – The Bank of Canada is really standing alone as the only major economy that is not planning to lower interest rates any time soon.  Their view is that growth is reasonable and employment is strong while their biggest concern is consumer indebtedness.

Preferred Shares

We see more value in Preferred Shares than many Bonds at this point, in particular perpetual or straight preferred shares that have dividend yields in the 5% to 5.5% range.  While rate reset Preferred Shares provide the most value, and did see a big improvement in September, we still see more volatility on this side of the market.

Alternative Investments

We will soon be sharing information on a new offering from TriDelta that will represent some of our best thinking on the income focused Alternative Investment space along with better liquidity, better pricing, and full flexibility to be held in registered and non-registered accounts.  Stay tuned.

Canadian Dollar

We believe that there could be some strength in the Canadian dollar over the next year as U.S. interest rates fall below Canadian levels.  The very different view on interest rates between the two countries should provide a solid support for the Canadian dollar.  In fact, we have now put in place a 25% hedge on US$ in our funds when we often have no hedge in place.

TriDelta Private Funds

We paid another distribution in the first week of October.  Over 17% of the remaining value of the TriDelta Private Fund 2 (High Income Balanced Fund) was distributed out as cash.  Over 4% of the remaining value of the TriDelta Private Fund 1 (Fixed Income Fund) was distributed out as cash.  We expect to pay further distributions next quarter as more of the underlying investments mature or are sold.     

TriDelta Ranked one of the Top 10 Wealth Management Firms in Toronto by AdvisoryHQ

Here is what California-based Advisory HQ had to say about our firm:

“TriDelta’s holistic financial services approach ensures clients get personalized help from experts in a variety of financial specialty sectors. This provides additional value and ensures a client’s financial strategy is fully integrated.

With a deep bench of professionals, a wealth of financial education resources, and a talented team, TriDelta Financial earns 5-stars as one of the best financial advisors in Toronto….”

Summary

As we head into the final quarter of the year, 2019 continues to feel like a recovery year from the weaknesses of the second half of 2018.  Despite the fear that seems ever present, we do not see a particularly weak investing environment.  In the short term, anything can happen, but our slightly cautious approach should weather such storms and allow us to take advantage of opportunities.

At TriDelta we will continue to focus on being nimble in the short term, being a leader in the Alternative Income space, and helping clients plan for the long term.

Here is to a beautiful fall for everyone.

TriDelta Investment Management Committee

Cameron Winser

VP, Equities

Ted Rechtshaffen

President and CEO

Paul Simon

VP and Head of Fixed Income

Lorne Zeiler

VP, Portfolio Manager and
Wealth Advisor

FINANCIAL FACELIFT: Can Chelsea and Chad ‘make it all work’ with a second baby on the way and a possible career change?

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 October 4, 2019

Chelsea and Chad are earning big and saving mightily, but with a second baby on the way, Chelsea is mulling a possible career change that would cut her income substantially. They are both 34 with a toddler, a mortgage-heavy house in Toronto, and two rental condos.

Chelsea earns $250,000 a year in sales, Chad $115,000 a year in technology. Their condos – their principal residences before they got together – are both generating positive cash flow. With the “main breadwinner” taking a year off and big mortgage payments, they are wondering how to “make it all work.”

They ask whether they should continue paying down their home mortgage aggressively, and whether they should borrow against their rental units to invest. “There is a lot of money coming in and out of our accounts monthly, with property tax, condo fees, and so on,” Chelsea writes in an e-mail. They wonder whether they are managing it optimally.

“We just keep saving but with no clear goal in mind or understanding if our planning is sound,” she adds. They have a “strong desire to maintain a safety net,” and to have a “sound strategy for retirement.”

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

What the expert says

Mr. Ardrey started by running the numbers Chad and Chelsea provided for their income, savings and expenses. To his surprise, his software showed the couple had a $45,000 a year surplus – even after accounting for savings and tax refunds from RRSP contributions. “I believe this is significant leakage in their spending that they have not recorded,” he says.

“Because most people know what they earn and what they save, I can only assume this is being spent,” the planner says. He has included an additional $45,000 worth of expenses in their plan to account for the discrepancy. This takes their adjusted spending to $205,000 a year, including mortgage prepayments.

“This is the primary issue that Chelsea and Chad need to address before any others,” Mr. Ardrey says. “A material change in expenses will affect all financial projections and analysis, including making sure they have sufficient life and disability insurance,” he adds. “I recommend that they go through a detailed budgeting process as soon as possible.”

Both Chelsea and Chad have defined contribution pension plans or group registered retirement savings plans at work to which both they and their employers contribute. As well, they both make maximum contributions to their tax-free savings accounts.

In addition to the registered savings, they make an extra payment of about $12,000 each quarter ($48,000 a year) on their mortgage, and tuck away $2,000 a month ($24,000 a year) in a non-registered savings account. In the past, they have used this money for RRSP top-ups, TFSA contributions and mortgage payments. More recently, they have been setting it aside to help offset the drop in income during Chelsea’s mat leave. Chelsea will get 60 per cent of her salary for the first 16 weeks and employment insurance benefits thereafter.

Their rental properties bring in an additional $19,800 a year for Chelsea and $14,820 for Chad after expenses, but before taxes.

Chelsea and Chad have a $719,000 mortgage on their principal residence and a $42,000 mortgage on one of the rentals.

It is unfortunate that Chelsea and Chad have so little debt against their rental properties and so much against their principal residence, because the rental mortgage interest is tax deductible, but interest on their principal residence mortgage is not.

Although a common thought would be to leverage the equity in the rentals to pay off the principal residence, the Canada Revenue Agency has recently disallowed a similar strategy. For interest to be tax deductible, the use of the borrowed money must be to produce income, the CRA says. The intention of the transaction and the assets pledged for security are both immaterial in this determination. The agency is reviewing tax deductibility on a case by case basis.

Chad and Chelsea ask whether they should use their surplus cash flow to pay off the mortgage or invest. They might be better off financially investing, Mr. Ardrey says. That’s because the after-tax cost of the mortgage interest is low: 2.54 per cent based on the current mortgage rate on their principal residence.

“To break even on investing instead of making extra mortgage payments, assuming a 50 per cent tax bracket and earning interest income, they would need to earn 5.1 per cent on their investments,” he says. This would be even more appealing if they engaged in tax-efficient investment planning and had more of their returns coming from dividends and capital gains, Mr. Ardrey says.

For their children’s education, the annual RESP savings of $2,500 for each child will fall short of the future costs by about 50 per cent, the planner says. The current average cost of postsecondary education is $20,000 a year. Historically, these costs have outpaced inflation, so he assumes the education costs rise at the rate of inflation plus two percentage points. If Chad and Chelsea want to fully fund their children’s education costs, they will be in a position to do so at the time simply by redirecting the surpluses from their non-registered investing to the education expenses, he says.

Next, Mr. Ardrey looked at how Chelsea’s lower income would affect the family finances. If Chelsea changes careers, earning $125,000 a year, they will not be able to make extra payments to their mortgage for the time being. As well, they would not be able to add to their non-registered savings. They would have to reduce their spending by a significant amount: $20,000 a year after-tax, to $137,000 a year. That’s a reduction of the $48,000 for the extra mortgage payments and $20,000 of actual spending. This would continue until their first child is 12, in 2029. If they are both working full-time with good income, they will likely have to have some form of before and after school care, the planner says. By the time the older one is 12, most agree that they can be responsible enough to babysit.

The reduced savings would affect their retirement, but they would still be able to retire comfortably, Mr. Ardrey says.

Finally, Chad and Chelsea would benefit from having a full financial plan prepared, Mr. Ardrey says. “A comprehensive financial plan will create a road map for them to follow.” In their case, it is not the retirement that is unclear, it is the next 10 years, he adds. “Having a plan will help them make the right financial decisions for both today and tomorrow.”

Client situation

The person: Chad and Chelsea, both 34, and their children.

The problem: How to prepare themselves financially for the career change Chelsea is considering. Should they keep paying down the mortgage, or should they borrow to invest?

The plan: Draw up a budget that tracks their actual spending to determine where the leakage is. If Chelsea changes jobs, be prepared to cut spending and halt the mortgage prepayments for a few years.

The payoff: A clear road map across the next decade or so when their cash needs will be greatest to open roads later on.

Monthly net income: $22,900

Assets: Bank accounts $100,000; her TFSA $69,000; his TFSA $71,000; her RRSP (including group RRSP) $233,000; his RRSP $83,000; his DC pension plan $8,000; RESP $9,500; principal residence $1-million; her rental condo $700,000; his rental condo $350,000. Total: $2.6-million.

Monthly outlays: Mortgage $3,820; property tax $695; home insurance $160; utilities $160; maintenance, garden $75; extra mortgage payments $4,000; transportation $455; groceries $350; child care $1,300; clothing $200; gifts $50; vacation, travel $1,000; dining, drinks, entertainment $380; grooming $75; subscriptions, other personal $60; drugstore $10; life insurance $275; disability insurance $225; phones, TV, internet $70; RRSPs $3,500; RESP $210; TFSAs $835. Total: $17,905. Surplus: $4,995.

Liabilities: Residence mortgage $719,000 at 2.54 per cent; rental mortgage $42,000 at 3.15 per cent. Total: $761,000.

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

Making the most of an RESP

0 Comments

With kids heading back to school, education planning and registered education savings plans (RESPs) are at the forefront of discussions that financial advisers are having with many investors – whether these clients have children in a postsecondary institution or saving for them to go into one in the future.

The RESP is an enticing vehicle for investors because the federal government provides a 20-per-cent matching grant through the Canada Education Savings Grant (CESG), which is subject to both an annual maximum of $500 and a lifetime maximum of $7,200. The unused CESG accumulates each year a child is alive, even if no RESP is open. And if no contribution was made in a year of the child’s life, a double contribution can be made to reach back for a year of the grant. There are no annual limits on contributions, but there is a lifetime limit of $50,000.

When investors contribute toward a child’s RESP, conventional wisdom tells us that they should take advantage of the free money in the 20-per-cent CESG. But is that always the right decision? Let’s consider three scenarios for contributing to the RESP, assuming a 5-per-cent annual rate of return:

Scenario 1: The investor contributes $2,500 a year, beginning when the child is first born, to the maximum of $50,000. The RESP receives $7,200 from the CESG and produces total income and growth of $43,654. The total value of the RESP when the child is 19 years old is $100,854.

Scenario 2: The investor contributes $50,000 into the child’s RESP in the first year of the child’s life. The RESP receives only $500 in CESG, but produces income and growth of $83,492 for a total RESP value of $133,992 when the child is 19 years of age.

Scenario 3: The investor contributes $16,500 into the child’s RESP in the first year, then contributes $2,500 a year thereafter until reaching the lifetime limit of $50,000. The RESP receives the full CESG of $7,200 and produces income and growth of $62,386. The total value of the RESP when the child is 19 is $121,486.

What this shows is that front-loading RESP contributions is more valuable than receiving the government grant. Of course, for many people, putting $50,000 into an RESP in the first year of a child’s life is unfeasible, but the more that could be invested at once earlier on, the better.

If the RESP is maximized and additional educational savings are desired, two other methods can be used to save for a child’s education. First, if the child is 18 years of age or older, she will have contribution room in her tax-free savings account (TFSA). Thus, contributions could be made to the child’s TFSA to supplement the RESP. Second, if the child is under the age of 18, an informal trust could be used to save for her education. (A note on taxes: If the contributions to the informal trust come from the parents, then income from the account will attribute to the parents for tax purposes, but capital gains will not.)

When it’s time for the child to draw down on the RESP, the account is divided into three sections: contributions, CESG, and income and growth. The contributions could be withdrawn tax-free; but the the CESG and the income and growth must be withdrawn as an Educational Assistance Payment (EAP), which is taxable to the child.

There are no restrictions on withdrawing the contributions once the child is attending a postsecondary institution. The EAP does have some additional rules. The main ones are that the child must provide proof of attending a qualifying institution and that the withdrawal is limited to $5,000 in the first 13 weeks when the child begins postsecondary education.

Those restrictions aside, it’s best to maximize the EAP withdrawals over the contributions wherever possible. Any remaining grant is repaid to the government and any remaining income or growth is taxable to the subscriber (parent) as an Accumulated Income Payment (AIP).

The AIP not only has the detraction of being taxed at the subscriber’s marginal tax rate, but also carries a 20-per-cent tax penalty on top of that. The 20-per-cent tax penalty is taken off the top and then the remaining 80 per cent is included as income to the subscriber. The only ways to avoid this tax penalty and retain the value of the assets in the RESP are for the investor to transfer up to $50,000 of these assets to his or her registered retirement savings plan, if he or she has the contribution room, or to another child under a family RESP plan.

Having these EAP payments taxed in the child’s hands is the most advantageous. Even if the child is working while she’s in school and has income in excess of the basic personal amount, her education credits will be enough to offset any taxes owing from the RESP, in most cases.

As much as it’s advantageous to maximize the EAP, in the case of a family RESP, the subscriber must ensure he or she doesn’t exceed $7,200 of CESG withdrawal per child. Each child is permitted only $7,200 of CESG as a maximum. Thus, if more than that amount is withdrawn from the CESG for the older child, the government will demand repayment and take the overpaid grant funds back from the RESP. That, in effect, means those assets are lost to the younger child.

The RESP is a great savings tool. Understanding its intricacies will help to maximize its value. On the flip side, failure to do so could be a costly mistake for investors and their children.

Reprinted from the Globe and Mail, August 28, 2019.

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

Why Canada should eliminate minimum RRIF withdrawals entirely

0 Comments

An industry colleague and I were talking the other day about registered retirement income funds (I know, we aren’t the most exciting people) and he suggested the government should just remove RRIF minimum withdrawals entirely. The comment was like a lightning bolt to me. It is such a straightforward thought and, in my mind, makes a lot of sense.

What fascinates me is that seniors would love to see this change, because it would likely lower their tax bill in the short term. Our firm will quite often tell people to draw more down than the minimum, and we like to take a lifetime approach to taxes. Either way, let’s look at this idea from both the government and individual’s perspectives to see if it is something that could really work.

In 2015, the federal budget lowered the amount that had to be withdrawn from a RRIF each year starting after you turn 71. This was a pretty major change, lowering the minimum withdrawal at age 71 to 5.28 per cent from 7.38 per cent. The change was viewed as a big win by seniors’ advocacy groups, and likely resulted in a meaningful decline in taxable income for many seniors — at least in the short term.

In 2019, the federal budget announced a new advanced life deferred annuity under certain registered plans, which is an annuity that can be purchased from within an RRSP or RRIF, and where the payments can be deferred until age 85. Again, the goal was to help seniors find another way to defer, somewhat, drawing out their RRIF assets each year.

My view is that the government should stop tiptoeing around and just eliminate the minimum withdrawal altogether.

RRIF Minimum WthdrawalOverall, I believe the federal and provincial governments would collect more in tax dollars if they allowed seniors to draw out as little or as much as they wanted each year from their RRIFs. The reason is that if someone leaves as much money as possible in their RRIF, it still ultimately gets taxed when the person dies (or when the surviving spouse dies). If there is a sizeable amount in the account upon death, the entire amount is taxed as income in the final tax return, likely at a higher tax rate.

Let’s say someone has an average taxable income of $60,000 a year in retirement including their RRIF withdrawal. Their average tax rate in Ontario would be 18.4 per cent. If they had $250,000 in a RRIF when they die and another $40,000 of income in the final year, they will have an average tax bill on that large amount of 40.5 per cent, which will include a portion of the income taxed at 53.5 per cent.

Using a different example, and using a marginal tax perspective, let’s say someone drew out $15,000 a year at a 29.65-per-cent marginal tax rate for 18 years. The total withdrawal would be $270,000 and the taxes would be $80,055. If, instead, they drew out nothing for 18 years but upon death they had $540,000 of RRIF assets (due to growth and tax sheltering), they are taxed at an average rate of 46.53 per cent (assuming no other income) and about 60 per cent of the amount would be taxed at 53.5 per cent. Using the average rate, the tax bill would be $251,262.

Looking at this from the government’s side, it benefits from a potentially much higher amount of tax collection and gets a big political win from seniors who would appreciate the freedom and flexibility on their RRIF assets. But it would be hurt by collecting a lower tax amount in the short term, until the larger tax bills start to come in over time, and it would pay out a little more Old Age Security (OAS) to those who currently might be clawed back because their income is too high.

Of interest, only about five per cent of seniors are clawed back today and only two per cent lose the entire amount, according to a report from the former Human Resources Development Canada. Some of the five per cent of people would still be clawed back even without RRIF income because their overall income is too high. This shouldn’t be much of an issue for government since it could easily adjust the income numbers for clawbacks in order to not pay out more OAS under a “Freedom of RRIF Withdrawal” scenario.

On the other side, a typical Canadian senior would benefit from the flexibility to manage RRIF withdrawals as they see fit and in a way that may minimize their year-to-year tax bills, the ability to have more tax-sheltered earnings and their funds can grow faster without the near-term tax bills, the possibility of collecting more OAS and feeling more in control over their own money.

They would be hurt by a likely higher lifetime tax bill if they delay too much in drawing out their RRIF until death, and possibly spending less on themselves while they can, in order to lower tax bills.

It is not often that a new rule can be implemented that would be cheered by the electorate and likely lead to higher taxes in the long run. Eliminating RRIF withdrawals minimums could be one of those rare cases.

Reproduced from the National Post newspaper article 28th August 2019.

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

FINANCIAL FACELIFT: Rosy projection for long European vacation, then retirement in B.C. hides ‘substantial risk’

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 August 2, 2019

To celebrate the sale of their house for an impressive sum, Dave and Deborah are planning a long European holiday followed by a big move: from Toronto to a popular retirement destination in British Columbia, where they plan to buy a new home.

Dave, who is 67 and self-employed, will be retiring from a successful career in communications. Deborah, who is 57, is self-employed in the human-resources field. She plans to continue working part-time after they return from overseas. Together, they have substantial savings and investments.

“Our big change is that we have just sold our house in Toronto for $1.7-million net and will be taking a year and a half to travel in Europe when the sale closes,” Deborah writes in an e-mail. “The idea is to invest the proceeds from the house sale in a self-directed [discount brokerage] account consisting entirely of dividend equities,” Deborah adds. “My husband doesn’t like bonds as an investment.”

They would live off the dividends while they are in Europe, Deborah adds, then use the lion’s share of the principal to buy a house in B.C. Dave manages their investments. “He is the first to admit he is not a professional investor and feels he’s in a bit over his head,” Deborah writes. Once they return to Canada, their retirement spending target is $90,000 a year after tax.

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

What the expert says

When their house sale closes, Dave and Deborah plan to use $53,000 of the $1.7-million proceeds to top off Dave’s tax-free savings account, Mr. Ardrey says. They plan to invest the remainder in “dividend aristocrats” and live off the dividend income while overseas. When they return to Canada at the end of 2020, they plan to buy a home for an estimated cost of $1.3-million.

Mr. Ardrey’s calculations include spending of $120,000 a year in Europe (which would not be covered entirely by the dividend income), retirement spending of $90,000 a year after tax, an inflation rate of 2 per cent a year, and that Deborah earns $20,000 a year working part-time to the age of 65. Both save the maximum to their TFSAs each year, but they no longer contribute to their registered retirement savings plans. They delay collecting Canada Pension Plan and Old Age Security benefits until the age of 70 to get the higher payments.

In addition to their house sale proceeds, the couple have $685,000 in RRSPs and $98,000 in TFSAs. Dave also has $544,000 in a corporate investment account that he can draw tax-free.

Next, Mr. Ardrey looks at the couple’s existing investments. Their current asset mix is 9-per-cent cash equivalents, 1-per-cent bonds and 90-per-cent stocks and stock funds. Of the 90 per cent in stocks, 45 per cent is in Canada, 38 per cent in the United States and 7 per cent is international. The historical rate of return is 5.4 per cent. Because they have a substantial proportion in exchange-traded funds, their investment cost is only 0.39 per cent a year, leaving them with a rate of return net of costs of 5.01 per cent.

“Based on these assumptions, Dave and Deborah will be able to meet their retirement goals,” Mr. Ardrey says. Deborah would still have total assets of $5.3-million by the time she is 90, the planner says. If they wanted to spend more and leave only their home as an estate, they could increase their spending by $24,000 a year to $114,000.

What could go wrong?

“Though this projection looks quite rosy, I would be remiss if I did not address the substantial risk in their plan,” Mr. Ardrey says. “Equity volatility.” Including the house-sale proceeds, Dave and Deborah would have 96 per cent of their assets invested in stocks during their stay in Europe.

They’d be ignoring a basic rule of investing: Don’t invest money that is needed short term in marketable securities.

“What if, during their European dream vacation, stock markets had a major decline?” the planner asks. That would affect their retirement plans dramatically. He looks at a second case where their portfolio suffers a 20-per-cent drop during that time. Rather than being able to surpass their spending target, they’d have to pare it from $90,000 a year to $84,000.

Mr. Ardrey suggests some alternatives. The $1.3-million they’ll need to buy a new home in a year or so should be invested in guaranteed investment certificates, or GICs, where they’d be sure to get their money back. “The primary goal of these funds needs to be capital preservation,” the planner says. Dave and Deborah should keep in mind deposit insurance limits, he says. Canada Deposit Insurance Corp. insures Canadian-dollar deposits at its member institutions up to a maximum of $100,000 (principal and interest) for each account. For example, they could open an account in Dave’s name, another in Deborah’s and a joint account at each of four institutions for $100,000 each. “So they could fill their need with four institutions for most of the savings and $100,000 more at a fifth,” he adds.

“Another option would be to purchase the home in B.C. before leaving on their trip,” Mr. Ardrey says. This would remove any uncertainty about what they will have to pay.

With the remaining investments, Dave and Deborah should look at revising their strategy to reduce their stock-market risk, the planner says. They should have a balanced portfolio of large-capitalization stocks with strong dividends and a mix of corporate and government bonds of different durations. Although Dave isn’t keen on bonds, they could enhance their fixed-income returns – and reduce volatility in their portfolio – by investing a portion of their capital in carefully vetted private debt and income funds, Mr. Ardrey says.

These private funds can be bought through an investment counsellor. If they hired one and put a portion of their fixed-income assets in private debt and income funds, they would have a projected return of 6.5 per cent with 1.25 per cent a year in investment costs, for a net return of 5.25 per cent. That’s better than the 5.01-per-cent historical rate of return on their existing portfolio and it would reduce their investment risk.

Client situation

The person: Dave, 67, and Deborah, 57

The problem: How sound is their plan to invest the proceeds of their house sale in blue-chip stocks and live off the dividends for the time they are in Europe?

The plan: Invest the money needed to buy the new house in GICs, or consider buying the house in B.C. now.

The payoff: Greatly reduced investment risk

Monthly net income: $8,335

Assets: Cash $15,000; stocks $544,070; her TFSA $79,640; his TFSA $18,775; her RRSP $419,995; his RRSP $264,640, residence $1.8-million. Total: $3.1-million

Monthly outlays: Property tax $685; home insurance $195; utilities $250; maintenance, garden $125; transportation $400; groceries $290; clothing $175; gifts, charity $80; vacation, travel $200; personal care $90; dining, drinks, entertainment $255; subscriptions $35; doctors, dentists $165; drugstore $35; phones, TV, internet $280; RRSPs $1,500; TFSAs $900. Total: $5,660

Liabilities: None

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

This borrow-to-invest strategy can build you wealth with someone else’s money

0 Comments

“Borrowing to invest” can be a scary phrase. There have been many inappropriate cases where it doesn’t end well.

Yet for all of the naysayers, I am pretty sure that you are currently doing it or have done it before.

If you have ever had a mortgage or debt on a home equity line of credit, you have borrowed to invest — you were taking on extra debt to invest in a house. Houses can go up or down in value, yet you probably didn’t consider this to be similar in risk to “borrowing to invest.”

If you contribute to or receive Canada Pension Plan (CPP), then you are also, in a way, borrowing to invest. The CPP, like most large Canadian pension plans, now uses some form of leverage or borrowing to try to outperform their benchmarks.

To start off, it is important to remember that borrowing to invest adds risk. There is no getting around that. Having said that, investing in anything other than cash adds risk. Some would say that even holding cash has risk from an inflation and currency perspective.

My view on leveraged investing is that if you are going to consider it, you want to do your best to minimize the risks and try to lock in, as best as possible, a spread between your borrowing costs and your investment return. You also need to factor taxes and deductibility into the strategy.

The strategy

There is an opportunity today for certain people to profit from the gap between the lower borrowing costs for those with a home and great credit and the higher borrowing costs that others might be paying even when their loans are fairly well secured. Essentially you would be profiting from the gap between your good credit and someone else’s weaker credit.

Here is a current approach that I would support for the right individual.

Step 1: Borrow at the lowest possible rate

Today that would mean borrowing through a mortgage. You can lock in a five-year mortgage at a rate between 2.50 per cent and 3.00 per cent if you have good credit. These figures are approaching historical lows for fixed five-year rates. At such a low rate, you are meaningfully increasing the likelihood that a borrowing to invest strategy will be profitable for you.

Step 2: Find investments that provide a high income yield and low volatility

Today, most of the investments that we find that meet these criteria would be in the private debt space. Whether it is in mortgages, business lending, factoring or other specialized debt, we have found many investments that have been paying out steady returns in the seven per cent to 10 per cent range. It doesn’t mean that there is no risk here. There are risks in all of these investments, but we believe that under most scenarios that these returns should stay stable. If someone wanted more investment diversification, other investments that we would consider might include some REITs, utilities and perpetual preferred shares that would have yields in the four per cent to 6.5 per cent range that would minimize some of the underlying volatility.

Step 3: Do the math

Let’s now look at the math if someone borrows $100,000 to invest for five years.

On a 2.75 per cent mortgage with a five-year fixed rate, each month’s payment would be $461.31. Over five years, $14,913.40 in principal and $12,765.25 in interest would have been paid, for a total of $27,678.65. At the end of 5 years, the remaining debt owing will be $85,086.60. For the purposes of this analysis, we will assume that the monthly mortgage payment will be drawn out of the investment pool, but while this is a slight drag on performance, to keep the complexity down we will assume that this draw doesn’t impact total return.

On the investment front, there isn’t the same certainty as the lending side. An example in the private debt space that we use would be the Trez Capital Yield Trust, which invests in U.S. mortgages (as they have a low correlation with Canadian Real Estate). The Canadian dollar hedged version did 9.9 per cent annually over the past five years, although we wouldn’t expect returns that high over the next five years. Outside of private debt, the TSX Capped Utilities index had a five-year annualized return of 7.79 per cent to June 30, 2019. The TSX Capped REIT index did 7.80 per cent. TSX Canadian Financial Monthly Income did 5.64 per cent. All three of these had higher returns in the prior five years from 2009 to 2014. While there are no guarantees, let’s say we had a 7.5 per cent return on these investments.

Let’s assume this individual has $100,000 of income, lives in Ontario and in one version pays 1.5 per cent in investment fees to an investment counsellor, and in another does it themselves.

On the surface, someone is earning 7.5 per cent and is paying interest of 2.75 per cent, which leaves a spread of 4.75 per cent per year for five years. Of course, it isn’t that simple.

We need to factor in taxes and fees. I will keep it simple but want to highlight a few important points.

First, interest on the mortgage is fully tax deductible because you are borrowing funds to invest in a taxable account.

Second, investment counselling fees would be fully tax deductible if the investments are being done in a taxable account.

Given the individual’s income, their marginal tax rate is 43.41 per cent.

Based on my calculations, if the investment returns were all treated as income (this is the worst-case scenario) they would earn 7.5 per cent and then be able to deduct the 2.75 per cent of interest on the mortgage and then deduct the 1.5 per cent for investment counselling fees.

If they are taxed at 43.41 per cent on the remaining 3.25 per cent, they will keep 1.84 per cent after tax. If they were comfortable doing this all themselves and paid no investment management fees they would be at 2.69 per cent. This is based on 7.5 per cent return minus 2.75 per cent interest, leaving 4.75 per cent. After 43.41 per cent tax, this would leave 2.69 per cent.

Those numbers may not seem huge, but they can add up quickly.

Over five years, on $100,000 at 1.84 per cent, that would be $9,200 in after-tax dollars with no compounding. On a pre-tax basis, you would need to earn $16,257 to get $9,200 after tax. Keep in mind that this is wealth that was created with someone else’s money.

If the same scenario used $250,000, it would be $23,000 in after-tax money or $40,643 of pre-tax income.

If the same scenario used $500,000, it would be $46,000 in after-tax money or $81,286 of pre-tax income.

Managing the investments yourself, having returns that consist in part of capital gains or Canadian dividends instead of income, and reducing your borrowing costs below 2.75 per cent can all boost the returns you can earn from this strategy.

It is important to remember that none of the returns described here can be guaranteed.

There are some risks, but if they are kept low, this strategy has the potential to be a powerful method of adding wealth using someone else’s money.

Reproduced from the National Post newspaper article 6th August 2019.

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