Don’t bet RRSP on bad advice

Recently I received an e-mail that made my blood boil. The writer had been consulting a financial advisor and received some advice which he questioned. Here’s what he wrote:

“A financial advisor is encouraging me to start to close down my RRSP (I am 55), pay the 50 per cent tax, and then reinvest the balance in Mineral Fields, with its supposedly super flow-through shares.

His argument is that, given the tax break of investing in Mineral Fields, I will, in effect, be getting my money out of my RRSP and only pay the equivalent of about 25 per cent tax. I have always been conservative in my RRSP. Any thoughts?” – G.D.

Frankly, it is hard to image any financial advisor recommending such a course of action to a client. Given the context, it appears to be irresponsible.

Let’s dissect this recommendation and look at what it involves. For starters, the client is obviously a cautious investor. He doesn’t tell us how much money he has accumulated in his RRSP but if he is going to be hit with a 50 per cent tax rate on withdrawal it is probably substantial. He describes himself as conservative, which suggests that the portfolio is likely invested a balanced mix of fixed-income securities (e.g. GICs and bonds) and low-risk stocks (e.g. banks and utilities), or mutual funds.

Within the RRSP, a portfolio like this could be expected to grow tax-sheltered at a rate of 8 per cent a year until G.D. retires. If that is scheduled for age 65, a portfolio worth $100,000 today will grow to $216,000 over the next decade, assuming no additional contributions.

This money will presumably be withdrawn from the RRSP/RRIF over time at a much lower tax rate than 50 per cent. I’ll use a 30 per cent rate for this calculation which means that, in after-tax terms, the RRSP would be worth about $151,000 at 65.

He is now being told to cash in the portfolio, pay $50,000 to the government in tax, and invest the remaining $50,000 in flow-though shares. He’ll receive a tax break for the shares, which will reduce his net tax cost to $25,000. So he has $75,000 to invest, of which $50,000 will already be in the flow-though shares.

Income won’t be tax-free
He can still end up with an after-tax portfolio of comparable value at age 65 with an 8 per cent return – but only if all the income earned within the portfolio is tax-free. Of course, it won’t be.

Consider the flow-through shares, which represent two-thirds of the assets. Flow-through shares are notoriously risky. They are designed to pump venture capital money into smaller mining or energy companies, which is why the government allows a tax break for them. Sometimes they make a profit, often they do not.

Flow-through shares are normally priced at a premium because of the tax advantages that accompany them. Right now, with mining and energy stocks probably near a cyclical peak, they will be especially expensive. This increases the risk factor considerably.

But suppose G.D. gets lucky and this particular issue scores some gains thanks to the good management of the sponsoring company. The tax deduction he received early on would result in a reduction of the adjusted cost base of the shares for capital gains purposes, in some cases to zero. This means that some or all of the profits would be taxed at the capital gains rate once the shares are sold.

As for the remaining $25,000 in his portfolio, any income earned on that would also be subject to taxation. He could reduce the tax liability by focusing on dividend-paying stocks, REITs, etc. but he could not eliminate it entirely. For someone with taxable income of $65,000, the effective rate charged on dividends is from 20 per cent to 30 per cent, depending on where you live.

Bad odds – poor advice
The bottom line is that our conservative member is being advised to bet his RRSP on the success of a flow-through share issue. I don’t like the odds.

I would hate to think that the financial advisor is making this recommendation because of the generous commission that he can earn from the flow-through shares. I would prefer to believe that he is simply overworked and did not take the time needed to revisit the client’s investment profile and carefully consider his objectives. Perhaps the advisor had just returned from a road show at which the advantages of the share issue and the track record of the company made a big impression on him.

But however generous we might be in ascribing motive, the fact remains that the advice is totally inappropriate in this case. I can only hope this is an isolated incident.

Most financial advisors have the best interests of their customers at heart. They understand that when investors do well and are comfortable with their portfolios, it translates into a long-term relationship, more business, and personal recommendations. But, as in any profession, there are a few exceptions. Their actions can be enough to taint the reputation of the entire business. That’s why tough standards and strong enforcement are needed.

People’s financial futures are at stake.