Rate-proof your investments
Remember when everyone was talking about the miracle of compound interest? Invest early and invest often, retire on a pile. Not exactly a get-rich-quick scheme, but given enough time, it was pretty much guaranteed to work.
You don’t hear that old chestnut much anymore. It’s not that taking advantage of compound interest isn’t still a good idea – it is – it’s just that the conditions that made it the slam-dunk of investing strategies 20, even 10, years ago have changed dramatically, and it all has to do with interest rates.
If you’re an investor looking to maximize return, you’ve doubtless noticed that for the 10 years leading up to 2005, interest rates went down, scraping bottom in 2003-2004. Although they’ve nudged up since, few investment analysts believe they’ll return to 1980s levels when the prime rate topped 20 per cent, or even the early- to mid-1990s, when it flirted with 14 per cent.
If you’re someone whose earning days are largely behind you and you’re counting on your investments to carry you through retirement, you probably think that’s bad news. Although inflation and taxation have always taken a bigge bite out of the benefits of high interest rates than most investors realize (or most investment counsellors will admit), there’s something comforting about knowing your money is busily earning 10 per cent or more a year while you’re whiling away your hours in retirement. But don’t count on it, says Paul Bourbonniere, a Toronto-based 30-year veteran of the financial planning game.
Higher interest rates are probably not in the cards, Bourbonniere says. Better to plan on low interest rates. “If they go a little higher, consider it a bonus.”
Now it’s entirely possible that interest rates will go through the roof again, but let’s assume just for the moment that they don’t. Let’s assume that low or at least lower interest rates are here to stay for the next decade. Assuming that’s the case, how could we best go about protecting and growing our assets?
One of the first things investors should avoid doing at all costs is chasing after unrealistically high rates of returns. Many Canadians worried that their savings aren’t going to make it to the finish line are easy prey for investment schemes promising unrealistic rates of return. Consider, for example, the case of Eron Mortgage, which in the mid-1990s, offered investors in British Columbia 18 to 24 per cent interest rates at a time when GICs were paying an average of six per cent. While fleecing investors of some $240 million in what turned out to be a classic Ponzi scheme (whereby new investors’ money is used to pay off old investors until the entire house of cards comes crashing down), company officers adopted lavish lifestyles that would have made an A-list movie star blush. A study by Simon Fraser University professor Neil Boyd found the average Eron investor was 55 years old and felt they were “approaching retirement without adequate resources.” The majority invested their existing retirement funds, borrowed money or mortgaged their homes to buy in.
Even in legitimate business ventures, the rate of return is a reflection of risk. “If you want to get credit card rates of return (18 to 20 per cent a year), then you’re going to get equivalent credit card risks,” explains Bourbonniere.
Assuming you’re willing to work the hardscrabble soil for your income, one of the first things people nearing retirement should do, says Valerie Chatain-White of VCW Financial in Winnipeg, is work out a budget. Not in order to put yourself “on a leash,” she says, but to see how much you actually have to withdraw so that you don’t withdraw too much and invite unpleasant tax implications.
Typically, she says, people think they’re going to need more money than they actually do. “We see it all the time,” she says. “People triggering RRIFs and LIFs way before they need to.”
If you’re a do-it-yourselfer, there are numerous calculators on the Internet you can use to work out a budget. Type “financial calculators Canada” into your search engine and take your pick. Try a variety to find one you like.
We all tend to be obsessed by rates of return, but tax management is just as important. “It’s hard to fill the bathtub when the plug is out,” Bourbonniere observes dryly. One way to reduce tax exposure, he adds, is to ensure your stocks, bonds and cash are parked in the right stalls.
“A lot of time, folks leave their bonds and cash outside their registered plans and subject to full taxation, and they keep their dividend-paying stocks and capital gains inside registered plans, which doesn’t get them any tax advantages.”
Rule of thumb: ensure fixed income is largely sheltered, and capital gains and dividends are not sheltered but enjoy a tax break outside a registered plan. “We see the reverse all the time,” says Bourbonniere. “And it’s really easy to fix.”
Income splitting is another cosy way for couples to reduce their tax liabilities by shifting income from the higher-earning spouse to the lower. Spousal RRSPs and investment loans from one spouse to the other can also be used to balance out the income base. If you have GICs, make sure that they’re owned by the lower-tax spouse and that the equities are in the hands of the higher-tax spouse.
Trusts can be set up that allow income splitting not just between spouses but among other family members, including children and grandchildren. However, trusts are expensive to set up and run.
Lower-income Canadians can even get in on the income-splitting action with their CPP retirement benefit, paid out at age 60 at the earliest or age 70 at the latest. Let’s say Bob has $800 a month in CPP and Carol has $400 coming in. Bob can permanently assign half of his to Carol, and she can do the same for him. Now they’re both earning only $600 a month each, which will probably reduce Bob’s taxes more than it increases Carol’s. Not exactly high rolling, but a penny saved is a penny Ottawa can’t spend on fact-finding junkets to Paris.
Now while there are many Canadians who have reason to fear for the long-term sustainability of their assets, many more will outlive them. So, if you have a pile invested in Canada Savings Bonds and GICs, remember that the government is going to get its tax before your heirs get their inheritance. This doesn’t mean you have to give it to the kids now. Rather, you can invest in insurance contracts. Available from most majority insurance companies in Canada, these flexible-premium policies allow you to earn interest and then pass on the proceeds to your heirs as an insurance settlement, which, in most cases, is non-taxable.
There are a few tax management strategies to consider. Let’s take a look at some good investment vehicles.
These days, Valerie Chatain-White is advising her clients to consider investing in “corporate class” investments, which, according to the Investors Group, represent unique tax-advantaged mutual fund structures that allow you to rebalance your investments in a non-registered portfolio without triggering capital gains and incurring an immediate tax liability as a result of the switch. The beauty of them is that you don’t pay tax until you actually withdraw the money.
Chatain-White explains. “Say I have $100,000 in capital. If all I need from it in a year is $10,000, I only pay capital gains on that. If I own it jointly with a spouse, I can split the tax with them, and some of these funds have posted very high returns. In my own case, I had $8,000 that turned into $12,000, and only about $100 of it had to be included in taxable income. That’s pretty sweet.” What’s particularly sweet is that it allowed Chatain-White to focus less on the rate of return on investment and more on how much of the capital could be preserved.
And instead of trying to find a way to invest RRIF income as it becomes available, older Canadians concerned that they’re going to outlive their savings should seriously consider life annuities. They are the only creatures guaranteed to last as long as we do, and having a little fixed income is a great idea if you don’t have a pension plan.
“They don’t pay as much as they used to,” says Bourbonniere, “but every portfolio should have some fixed income. Make the annuity that part of it and get your growth elsewhere.”
Older Canadians with health issues should consider “impaired annuities.” These insurance products allow those with physical impairments to get paid out over a shorter period of time, which means you get bigger cheques as you go, albeit over a shorter period of time.
Entering retirement with a lot of debt? A number of Canadian financial institutions offer consolidation loans at prime to those who have material assets but low cash reserves. Look past the Big Banks; reasonably priced money is available from less traditional sources such as ING Direct and Manulife Bank, often at rates that undercut the big banks by as much as one per cent or more, but just about any bank will provide you with a consolidation loan at a price that makes credit card rates look like usury.
Protecting and growing your assets isn’t all about finding the highest rate of return for your investments. It’s just as much about controlling outflow and having a realistic understanding of what your expenditure needs really are. If you do see an investment you like the look of, find out what the tax implications are before you buy. If it generates a lot of tax activity, then the higher interest rate may not be worth the risk.
And finally, if you get to be within four years of retirement and you have $100,000 or less in an RRSP and little or nothing invested elsewhere, start cashing it out, pay the tax and invest in something like the corporate class vehicles mentioned above. Research indicates that going into retirement with that much in an RRSP is just enough to keep you from ever being eligible for the Guaranteed Income Supplement, and if you really do outlive your savings, you’re going to need it.
Why they’ll stay low
Why won’t interest rates rise to double-digit numbers anytime soon? In order to have runaway inflation, you have to have spiralling wages, and that’s not happening. Globalization is helping; wage increases in the developed world are being kept down by the outsourcing of jobs to countries such as India.
Investment Planning Counsel is the CARP-recommended Canadian wealth management company.