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The Smith Manoeuvre Debate

January 28, 2007

265 comments

About one year back, I did a review of The Smith Manoeuvre (SM) book and noted that the book should have talked about the pitfalls involved with the strategy. Many financial planners have left comments disagreeing with my review (though I reviewed the book, not the strategy) and I challenged one planner to show me how a client implementing the SM will come out ahead in the worst-case scenario (this particular planner uses segregated funds, so he tells me the worst case scenario is 0% returns).

The planner’s client (let’s call him Joe) owns a house appraised at $350K and has a $260K mortgage on it. His monthly mortgage payment is $1,520. To implement the SM, the planner takes out a secured investment loan of $55K and invests the proceeds (less expenses) in segregated funds. To service the investment loan, Joe pays an interest of $275 per month.

To make an apples-to-apples comparison, I am going to assume that Joe can make an extra payment of $275 towards his mortgage principal. If Joe can find an extra $275 savings for the SM, he can find a similar amount for a mortgage pre-payment.

After five years, let’s assume that Joe’s home is still worth $350K (the home’s value doesn’t affect the outcome). If he had opted for an accelerated mortgage pay down, he would have a mortgage balance of $211K and he has a net worth of $139K. If Joe had implemented the SM instead, after five years, he would own the $350K home, an investment portfolio of $99K and a loan of $321K, leaving him with a net worth of $128K.

What about after 10 years? With mortgage pre-payments, Joe’s net worth would be (Home:$350K – Mortgage:$149K) $201K. The SM would leave him with (Home:$350K + Investments: $160K – Loan:$321K) $189K. Even after 15 years, Joe would be better off with a mortgage pre-payment (net worth of $280K) than the SM (net worth of $270K).

Now, surely over 20 years Joe would have come out ahead, right? Not really. With pre-payment Joe now owns his home free and clear. The SM also results in a mortgage-free home, but Joe now has a portfolio of $346K and an investment loan of $321K and a net worth of $375K. But, the key difference is that Joe hasn’t made a mortgage payment for 17 months, which if he had saved would have added an extra $31K to his net worth.

The point of this exercise is not to show that the SM doesn’t work but that it entails taking a small risk, not any risk at all as many planners claim. You should also note that this particular SM example involves a higher leverage and would become risky if a severe real estate downturn should occur. Also, while segregated funds may give you peace of mind, it also comes with a higher price tag. If you are earning 8% in the markets and giving up 3% in expenses, you would probably just break even with the SM. I’ll close with a comment made by David Trahair, author of Smoke and Mirrors, in a recent Toronto Star column: “It’s a high-risk strategy because you’re betting the farm that some investment adviser can do better than you can. You have a guaranteed return from getting rid of the mortgage.”

RESP Basics

November 9, 2006

205 comments

Reader Alex left the following comment on how to get started with a RESP for his soon-to-arrive baby:

Do you have any RESP accounts that you recommend? Most I’ve seen charge an administration fee, and I’d like to avoid that.

I have set up a RESP for my boys with TD eFunds, which doesn’t charge an administration fee and offers some of the lowest-cost index mutual funds in Canada. There is a bit of a process involved in setting up the account initially but once it is taken care of, you can contribute every year with the click of a button. Three-to-four weeks after the contribution is made the Canada Education Savings Grant (CESG) is automatically deposited into the account.

I park the initial contribution and the CESG in a money market fund, which I then liquidate and buy four funds according to my asset allocation target (TD Canadian Bond Index eFund: 20%, TD Canadian Index eFund: 20%, TD US Index eFund: 35%, TD International Index eFund: 25%). The portfolio is rebalanced roughly once a year when new contributions are made. This simple portfolio has performed reasonably well gaining about 4.3% over the past nine months.

There are other options available for RESPs that are not very attractive in my opinion. Group RESP plans like the Canadian Scholarship Trust are inflexible, expensive (the heavy promotions to new parents comes out of the pockets of existing plan members) and are invested in low-growth fixed income assets. I also avoided a self-directed RESP because they typically charge an annual administration fee if a minimum balance is not maintained.

Related Post – RESP: Getting Started