Bad Investment Advice – Part II

This is a continuation of the story I shared with you in “Bad Investment Advice.” If you do not have time to read the entire article, in short, a brother of a friend of mine went into TD looking to start up an RRSP, armed with some great recommendations for a balanced, well-diversififed set of index mutual funds in equities and stocks. Instead, thanks to the “advice” of one of their investment “advisors,” he came out with a 100% equity portfolio in Canadian equities because “it has done so well in the last few years.”

I wrote about that story on January 25th. The story continues. Just yesterday before the RRSP contribution deadline for deductions made for the 2005 tax year, my friend’s brother went in to add to his RRSP. Here’s what happened:

[he] went in to the bank to contribute some last minute money to his RRSP’s, and the tried to get him to transfer his mutual funds to a GIC paying 2.5% per annum! A 23 year old kid with 45+ years of investing on the horizon, and she recommends a GIC paying 2.5%!? I’m going in there with him this Saturday.

Unbelievable.

Should You Borrow To Invest in Your RRSP?

Many Canadians wonder whether or not they should borrow money to help them maximize their RRSP contributions. Never was this idea touted more than in 2002 onward when interest rates were very low. There is no reason why it is not a good idea now, and interest rates are still historically low. This article, “Should clients borrow to catch up on RRSPs this year?” discusses why it can be a good idea.

Even though many experts discourage the use of long-term RRSP loans, most people would actually benefit from them, claims Talbot Stevens, a London-based financial educator, author, and industry consultant.

“If you just look at the math, RRSP catch-up loans always make sense when investment returns match or exceed the cost of borrowing,” explains Stevens. “If you can borrow at 6% interest and get returns of 6% or higher, you will come out ahead by borrowing to catch up on RRSPs, even if it takes 10 years or more to repay the remaining balance of the loan.

He does not go into detail here but the math is fairly simple. If the return in your RRSP matched the interest on the loan, the amount the RRSP increased by in the first year would match the amount you owed in interest on the loan. Once you take into account the tax refund that will be generated due to the RRSP deduction (at your marginal tax rate multipled by the amount of the deduction) you can see that you will wind up ahead. But I am neglecting something. We will be taxed on the RRSP’s returns later, when we withdraw it. This will reduce our effective return inside the RRSP. Not only that but we will be taxed on the contributions we made as well. The math does get a bit complicated, and it is always made even more difficult by the fact that it is impossible to predict future returns on an investment inside an RRSP. As the author of the quoted article says, however, behavioural factors are often overlooked when considering the advantages and disadvantages of borrowing to invest in your RRSP:

Stevens also likes the investment discipline afforded by long term RRSP loans. “When you also account for the behavioural reality that most investors spend their RRSP refunds, the scales tip heavily in favour of long-term RRSP loans, even when returns are half of the cost of borrowing,” says Stevens.

“For most investors, the catch-up RRSP strategy generally produces a larger retirement fund because the loan locks in a higher level of commitment. Once started, the loan becomes a forced savings plan, like a mortgage, where we don’t have a choice but to continue the payments.”

At first I did not understand what “the behavioural reality that most investors spend their RRSP refunds” had to do with the scales tipping “heavily in favour of long-term RRSP loans.” I think what he means is that if you have a long-term RRSP loan, you will be less-inclined to spend (in other words, waste) your RRSP refund. Instead you will be more likely to put it down towards the loan in an effort to lower interest payments and/or get rid of the debt sooner. Of couse it is better to contribute to your RRSP with cold-hard cash, but if you cannot maximize your contributions with cash, there does not seem to be anything fundamentally wrong with getting an RRSP “catch-up” loan.

Of course most of the arguments for and against borrowing to invest in your RRSP also apply to the pay down your debt vs. contribute to your RRSP argument.

Bad Investment Advice

Interesting story came my way today. A good friend of mine (the person who bought me the Intelligent Investor last year), and a loyal reader of my blog, got his brother to go out and put some money into RRSPs for the first time. Most likely he has a little bit of cash saved up from working and is saving it up for rainy day. My friend wrote up a suggested portfolio for his brother that went something like this:

  • TD Canadian index fund (40%)
  • TD US index fund (20%)
  • TD international index fund (20%)
  • Some TD bond fund (20%)

I’d say this was an excellent suggestion for a starting portfolio. It has a low overall MER and is diversified in terms of equities and bonds, but also diversified across several markets, By keeping the allocation rebalanced and by supplementing it with monthly contributions, you could expect to hold onto this portfolio for a long time and you might just beat a large fraction of the managed mutual funds out there.

But I am getting ahead of myself here. My friend’s brother may have walked into the bank with this suggested portfolio (typed up and printed I might add), but he didn’t walk out with anything resembling it.

The person at TD Canada Trust suggested instead that he invest in a 100% Canadian equity mutual fund because it has done so well in the last few years. My friend’s brother of course went along with it (I would too if I was in his shoes). After all, from the age of 17 to 20 my paltry savings were all invested in AIC Advantage Fund, a Canadian equity fund. Why? Because it had done so well in the previous years. This is probably one of the most common traps people fall into: chasing good performance.

There are so many reasons why the portfolio the TD person suggested (or lack thereof) is just wrong. The fact that this person at the TD Canada Trust branch would ignore the excellent suggestion the client came in with is not too surprising I guess, but it still makes me puke.

RRSP Snowball Effect?

In this article by Dereck Slattery he offers a few RRSP tips. His 2 tips basically boil down to 1) don’t contribute at the last minute, instead take some time and make a “good” investment and 2) apply your refund to your RRSPs for the following year.

He goes on and on about this second point as if it’s some magical thing and there are so many assumptions built into his advice. Here’s the entire section:

Make it a habit to re-invest your tax refund back into your RRSP over and above what you put into the RRSP on a regular basis.

The benefit of this is as follows. Let’s assume that you invest $200 per month into your RRSP and normally you receive $1,000 in refund when you file your taxes. If this year you were to re-invest your refund into your RRSP when you receive it, you will have contributed $3,400 to your RRSP for next year.

All things being equal, in a 40 per cent tax bracket, your refund should increase to about $1,400 next year.

You can see where I am going with this – you contribute the same amount out of your pocket each year, your refund grows each year because you have put your refund into the RRSP each year and the snowball effect begins.

Bit by bit, your total amount invested into the RRSP each year climbs and your refund gets a bit higher each year, adding greatly to the value of the RRSP as each year passes.

First of all, this is hardly a “snowball effect.” Using the numbers above, you normally get a refund of $1000 and after contributing that amount into your RRSP, your refund the following year is $1360 (he approximated it by $1400). If you contribute that $1360 refund into your RRSP, your refund the following year will be $1504. Contribute and deduct the $1504, and you’ll receive a $1562 refund. Contribute and deduct the $1562 and you’ll receive $1585. Actually if you keep doing this forever you’ll increase your refund to $1600 and it won’t increase anymore. Hardly what I would call a “snowball.” So by following his little technique we have increased our refund to $1600 from what would normally be a refund of $1400. He puts way too much emphasis on this “snowball effect” and misses the real point that he should be trying to get across, which is: contribute as much as possible to your RRSP. If your refund helps you to do this, then that’s great.

For those people who already maximize their RRSP contribution room with their monthly contributions, the “snowball effect” won’t apply to them anyways. You won’t be able to use your RRSP refund for your RRPSs because you are already maxing-out your RRSP room with your monthly contributions.

Pay Down That Debt With Your Tax Refund

Now that we are all done school, we are now at the point where we need to think about paying down our debt. With on the order of six figures of student loan debt, it’s hard to feel like we’re making any progress towards paying it down. Although we have not been forced into an amortization plan yet by the bank, we have been paying the interest and some principal every month. This will ensure that the principal is at least going down a little. If we only paid the interest every month, the principal would never decrease (although it would decrease in real dollars due to inflation).

We could pay more in principal every month to our loan, and this is not a bad idea. Every dollar paid to the principal is sort of like a dollar contributed into a fixed-income investment which pays interest at the same interest rate as the loan. So paying down principal is like a fixed-income investment. Instead of increasing the principal we pay down every month, we have chosen to maximize our RRSPs first and foremost, which is something I discussed in a previous article. Under the assumption that over the long term our RRSP will achieve a rate of return roughly similar to the loan interest rate, this is a great idea because the return of the RRSP will match the return of the loan (again, treat the loan as a fixed-income investment) but we will also get a bonus: a tax rebate will be generated from the RRSP deductions (because income contributed into an RRSP is tax-deferred).

Since we have made our RRSPs our #1 priority (for the reason mentioned above and described here), we maximized our RRSP contribution room last year and will again maximize our RRSP contribution room this year, at the expense of less principal applied to the loan monthly. In April 2006, we plan to receive a hefty tax refund generated from our RRSP contributions. Since we have already maximized our RRSPs, we do not need to use contribute the tax refund into our RRSPs. Instead we are planning on applying the entire amount against the student loan. This is only possible because we already have an automated savings plan for vacations and other short-term goals, and therefore we do not need the tax refund for any other purpose.

It turns out my parents also used this technique for many years while paying down their mortgage on their home and on a second rental home, allowing them to pay it down faster and become debt-free sooner.

Tory Government Would Allow Deferral of Capital Gains Taxes

Today, the Tories announced that they would allow deferral of capital gains taxes. They would

. . . eliminate the capital gains tax for individuals who reinvest profits earned from selling real estate or financial investments within six months

This would be quite a significant change from the way things work right now. These days, if you sell a stock or mutual fund, for example, and buy a new one with your cash, you have to pay taxes on your capital gain when you sold the investment. This proposed policy would effectively allow Canadians to transfer money from one investing into another (with up to 6 months between selling and buying) without paying taxes (hmm, sounds like an RRSP!). You will, however, pay taxes when you eventually sell your investment, when you retire, for example, and cash out:

But he pointed out that the move only defers the payment of capital gains tax. Those taxes will still be paid at the point when the assets are sold without being reinvested. “At some point people need to check out – they need to take out those investments and live off them,” Williamson said. “There’s nothing here that will help individuals who are checking out.”

So it is acting as a tax deferral mechanism just like RRSPs. And some final words from the Canadian Taxpayer’s Federation:

John Williamson, federal director of the Canadian Taxpayers Federation, called the Conservative measure a positive move that would create new pools of capital for businesses. Investors would be able to better manage their portfolios because it will be possible to sell a stock and re-invest without paying capital gains tax, he said. “This is very good, and significant.”

This does not mean that you should vote for the Conservative party. You should of course, look at ALL the issues. This tax cut will have consequences, such as lost revenue for the government which will have to be made up somehow, either through higher taxes somewhere else, decreased spending, or decreased surplus/increased deficit.

TD Gets Out of ETF Market

As reported by the Canadian Capitalist, TD ETFs are history. The TD announcement says that “the decision to terminate the Funds is based on a lack of investor interest in the Funds and low trading volumes since their creation.” The TD ETFs (TAG and TAV especially) offered some real choice for semi-passive index investors in Canada. TAV (TD Select Canadian Value Index Fund) tracked the Dow Jones Canada TopCap Value Index and TAG (TD Select Canadian Grows Index Fund) tracked the Dow Jones Canada TopCap Growth Index.

With no foreign limits in RRSPs anymore, it is easy for Canadians to get any US and international ETFs they like. Barclays iUnits, however, is the only provider of ETFs for the domestic market. The selection is mostly limited to the S&P TSX 60 Uncapped Index (XIU) and the S&P TSX Composite Capped Index (XIC), a Canadian Mid-cap Index (XMD), and now, a Canadian Dividend Index Fund (XDV). From this article in the National Post,

Advisors who specialize in creating ETF portfolios don’t view TD’s departure as a serious setback for investors. The TD ETFs “never took off and they never really put much marketing effort into it anyway,” says Fred Kirby, president of Armstrong, B.C.-based Dimensional Fund Advisors. In his permanent portfolios Kirby is substituting BGI’s new iUnits Dividend Index fund (XDV/TSX) for the TD Canadian Value ETF (TAV/TSX).

I was thinking about buying TAV myself, but may have to look at XDV a little more closely as well as a way to invest stocks with higher dividend-yields and slightly lower P/E ratios compared to XIC. I still wish there was more choice in the Canadian ETF and index market and if I had a bit more money I would forget ETFs altogether and just make my own index (0% MER), starting with equal amounts of the top 10 holdings of the large-cap Canadian indexes.

Thinking of Delaying that RRSP Deduction?

I’ve often heard the suggestion that if you are expecting to get a raise in the near future, make your RRSP contributions now, but wait until you are in that higher tax bracket to make that RRSP deduction. You’ll find this advice in many sources.

Is hoarding the generated deductions until you can make the most use of them, ie. when you are in the highest tax bracket a beneficial strategy? Let’s analyze the two cases:

  1. If I use the RRSP tax deduction now, I can take the tax refund I receive in April and invest it now, rather than later.
    Let’s say my marginal tax rate is T1. So making an RRSP deduction of R now will generate an RT1 tax credit in April. Let’s say that I am planning on getting a raise, or changing to a new, higher-paying career n years from now. Let’s assume I can reinvest my tax rebate and earn an annual rate of return of i. So in n years, my tax rebate will have grown to R(T1)(1+i)n.
  2. If I instead use the RRSP tax deduction later, when I am in a higher tax bracket of T2, I will get a larger tax refund, but I will have lost out on any earnings my money might have made in 1). My tax refund will be RT2.

So, it makes sense to take that RRSP deduction if T1(1+i)n > T2. It doesn’t look so complicated after all. Let’s plug in some numbers. Let’s say that you’re currently in a 31% tax bracket, and are expecting to move into the 38% tax bracket in the future. Let’s also assume that i=7%. Solving for n, we get n > 3. So if you are expecting a raise more than 3 years in the future, it makes sense to make that RRSP deduction now. And a smaller change from the 31% tax bracket to the 34% tax bracket yields n > 1.4. You can also fix your time n and solve for the new tax bracket T2.

Since raises are hard to predict with certainty, delaying RRSP deductions will most likely only make sense for people who are moving up several tax brackets (ie. those going to school earning summer/co-op income while making RRSP contributions and transitioning to full-time careers). Although even in this case, because it is not possible to predict the future, I would take the tax rebate now rather than later.

It is important to realize the difference between contributions and deductions. There is no reason why you shouldn’t make those contributions as soon as possible. I’ve heard people telling me before, to not put money into RRSPs until you are older and “until you have taxable income are able to make use of them.” This is utter nonsense and comes from the confusion between contributions and deductions. Most working adults make their contributions and deduct the full amount on their next tax return, so contributions, to them, are one and the same. But in general, they aren’t.

Make your contributions as early as you want (as soon as you have the room) so it can grow inside the RRSP without having to pay tax on any dividends or capital gains you might generate when you buy & sell. Use your deductions later on, as soon as you have taxable income, or later, if you plan on getting a raise (check to see if it’s worthwhile using the formula above).

Doom and Gloom

There is an interesting chart here, “Asset Class Performance” (got the link from here) showing the performance of various asset classes since 2000 and giving several predictions. One comment said: “I believe all will fall, while bonds will soar. special thanks to debt deflation depression.” The poster leaves no website to track him down unfortunately.

While digging around in Google for the term “debt deflation depression,” I found found this article: “Will the Latest Oil Price Shock Lead to a U.S. and Global Recession?

Interesting article with some interesting comments as well. The comment that Google picked up was this prediction:

I don’t understand how you can face two decades of real wages lagging productivity world wide, and still not be 100% convinced that a major depression is guaranteed in the coming years. The only way for consumers to absorb higher oil prices would be to take on more debt. As long as debt can be piled on, growth can go on, but there is no doubt that debt growth is the one and only fuel of the present growth.

Take away the US and european overindebted consumers, meaning, take away housing boom asset wealth induced spending… And the world falls into 30’s like debt deflation depression.

And if there’s one way out, I’d like to see it. Apart from aggressive monetising of public deficit, and aggressive policies in favor of higher wages (and I see none of them coming in the coming years), I can’t think of any.

So ?
So is there a question ?
Of course higher oil prices and lower house prices, will force the world into depression. Higher oil prices may indeed speed up the top of the debt-housing boom.

Talk about doom & gloom. Also no website provided for that comment either. No one really knows exactly what will happen in the next few years, but I have certainly seen a lot of doom & gloom predictions popping up lately regarding the stock market, real estate, and the US economy. I try not to let any predictions I read dictate my behaviour. I am invested for the long term and realize that market fluctuations are a fact of life. I am prepared to stay invested no matter happens and to invest consistently in my RRSPs year after year (especially when markets are down).

Paying Down Student Loans vs. Contributing to an RRSP

There are many people, me being one of them, who ask themselves “should I put money into my RRSP or pay down my debts?” For very high interest debt, such as credit cards and bank overdraft, this type of debt should always be paid down before anything else. For other debt such as student loans, bank loans, and mortgages, the answer is less obvious.

I have come up with a good, simple example, to answer the above question. Imagine you had at least $1000 room in your RRSP and you owed $10,000 at 7% as of January 2006. In January 2006, you have a choice of either putting your next paycheque (of $1000) towards an RRSP invested in a balanced portfolio of bonds and equities, or towards the $10000 loan. You can do nothing else with your loan or your RRSP until January of the following year.

  • Case 1: If, in January 2006, you put $1000 towards the $10,000 loan, you would be left with $9,000. Over the next year, you would be charged $630 in interest, a savings of $70 over what you would have paid had the loan principal still been $10,000. Your net worth based on the RRSP and the loan would be -$9,000 – $630 = -$9,630 at the end of the year.
  • Case 2: If, in January 2006, you put $1000 into the RRSP invested in a balanced portfolio of bonds and equities. To be conservative, we will assume that it will appreciate by 7%, however, it doesn’t really matter so much as we will not be realizing any value on this portfolio for years to come (until we retire, presumably). After one year, the RRSP portfolio will have appreciated by $70. In April 2005, you will receive a tax refund. Assuming a marginal tax rate of a modest 18%, you will receive $180 in refunded taxes in April. You can then apply this to your loan in April or put it in your RRSP. Let’s keep the calculation simple and just hold it as cash until the end of the year (not a smart thing to do in practice, as technically you owe that $180, more or less, to the government later on). During the year, our loan accumulates $700 in interest. At the end of the year our net worth will be -$10,000 – $700 + $1000 + $70 + $180 = -$9,450.

In Case 2, we are $180 richer than in Case 1. This came directly from the RRSP tax credit as the amount that the RRSP holdings grew by was exactly compensated by the extra amount we owed on the loan. This demonstrates the power of RRSPs. The $1000 + $180 is now pre-tax dollars. The government has refunded us the $180 in taxes on that $1000. The $180 is not free money, as we now owe the government some taxes when we take our money out of the RRSP when we retire. It is our hope, however, the when we retire we will be in a lower tax bracket and the $180 in taxes will actually be less (let’s say $150). So really we are $30 ahead, not $180, but still, thanks to tax deferral (deferring taxes on income until we retire), we are ahead.

One strategy is to contribute monthly to your maximum allowable limit, then to apply the tax credit in April to your loans. The tax deducted from your paychecks acts as a forced savings device for an annual loan principal payment.