Canadian Capitalist

It is a good practice to order your credit report periodically and check for any inaccuracies. I tend to do it once every two years even if I have no intention of applying for a loan of any sort. There are three major credit bureaus in Canada, but I only bother with the first two:

• Equifax: Equifax offers online access to the credit report and credit score but I simply requested the free credit report by mail. You can request your free credit history report by filling out this form and mailing in two copies of personal identification.
• TransUnion: Like Equifax, you can pay to check your credit report and score online but I prefer to request the free copy by mail.
• Experian or Northern Credit Bureau: The NCB website (Who did they hire to design their web pages? A fourth grader?) states that you can order a credit report by filling out and mailing in a Declaration Form and Identity Form. The address can be found on this page.

I found my Equifax credit report interesting because the company listed as my current employer is one I worked for five years and two jobs back. I also found a number of department store credit cards that I haven’t used in years and should really close these dormant accounts.

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The siren song is irresistible: “Make your mortgage tax deductible” or “Want to beat the tax man?” — is that a trick question? Who doesn’t? This is also accompanied by a warning — “Don’t try this at home. This stuff is so complicated that you need our help to do it”.

While there is no question that the tax issues involved in implementing the Smith Manoeuvre are complicated and potentially require the services of a tax accountant to make sure that everything is set up right, it is worth asking if the warning isn’t a little self serving. If a homeowner simply builds equity in their home, no trailer fees or sales commissions are generated for the advisor. But, the home owner implementing the manoeuvre with actively managed funds, while compensating her advisor handsomely, faces long odds of making any profit.

How so? There is a striking consensus among pundits that future equity returns are going to be rather modest and real returns from stocks can be expected to be in the neighbourhood of 4% to 5%. We’ll split the difference and say that the risk premium — i.e. the extra return obtained when you invest in stocks instead of T-bills — is 4.5%. Let’s further assume that the real return on risk-free assets such as T-bills is going to be 0% (a very conservative assumption but we’ll give the Manoeuvre all the benefit it can get).

From the 4.5% excess return that stocks can be expected to provide, we’ll have to deduct the costs of the SM. First, there is the line of credit provided by our friendly bank at a 1.75% premium over the risk-free rate. That leaves us with a 2.5% premium of implementing the SM, which may not be too bad if a homeowner can handle the risk and negative behaviours that come with leveraged investing, especially when the portfolio grows to a significant size.

But, sadly, there is more. The average mutual fund in Canada has a MER of 2.5%. It is a good bet that the average mutual fund will produce, well, average gross returns. Net out the MER and the intrepid investor implementing the Smith Manoeuvre using an average mutual fund sold through an advisor will be left with a return of — drum roll, please — 0%.

It’s true that we haven’t accounted for the tax arbitrage between the deduction from income of interest paid and the capital gains tax rate on investment income. However, consider that (a) part of the investment income comes from dividends, which is taxed on an ongoing basis (b) mutual funds generate turnover that results in a tax bill and (c) capital gains tax is levied on the nominal, not real, gains. Does the tiny return justify the extra risk assumed in implementing the Smith Manoeuvre? I’d argue that there are less risky, old-fashioned alternatives such as simply paying down the mortgage.

So, who benefits from the Smith Manoeuvre? The bank made money on the loan. The advisor made money on commissions and trailers. The homeowner? Well, I suppose, as the old saw goes, two out of three ain’t so bad.

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It’s an annual tradition for me to write about the Tax Freedom Day (June 25th in 2005, June 23rd in 2006 and June 18th in 2007) and rant about our high taxes. The Fraser Institute estimates that, in 2008, Tax Freedom Day fell on June 14th. The Institue’s report is a useful reminder of the sheer number and amount of taxes we pay and demand that all levels of government are careful with the public purse.

Some of the big ticket taxes we pay are obvious — federal and provincial Income tax, sales taxes like GST, PST or HST, EI premiums, CPP contributions, provincial health premiums and municipal property taxes — fall into the category. Less obvious is the “hidden” taxes — employer contributions to EI and CPP, liquor tax (which is the main reason why alcohol is much cheaper in the U.S.), tobacco tax, amusement tax, fuel tax, gasoline tax, land transfer tax, motor vehicle license tax, import duties, corporate taxes (which are ultimately borne by its owners) etc. Add it all up and the Fraser Institute reckons that an average Canadian family making $90,678 ends up paying $40,667 or close to 45% of their income in taxes. So much for a “temporary measure” introduced to fund the expenses of the First World War.

The good news is that our total tax burden has decreased in the past few years due to the cuts in the GST and lower income taxes at the federal level and in some provinces. On the not-so-good-news front, the municipal taxes are going up sharply in many Ontario cities.

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1. The biggest news this week is the Bank of Canada’s surprising decision to stand pat on interest rates. Actually, surprising is a bit of an understatement. The markets were shocked and bond yields rallied sharply. Though consumers will pay the same interest on variable-rate mortgages and personal loans that are tied to the prime rate, the rising yields in the bond markets means that we’ll be paying higher rates on fixed-rate mortgages in the near future.
2. The surprising thing about a hedge fund manager taking up Warren Buffett on his bet that a collection of hedge funds will not outperform the S&P 500 over the next 10 years is that only one has taken up on Mr. Buffett’s wager. It is touching to see the confidence that hedge fund managers have in their profession.
3. Many thanks to Pete for the link to a New York Times article on how American society has polarized into the investor class (who save and invest) and the lottery class (who resort to payday lending, credit cards and lottery tickets). An article titled A Nation in Debt summarizing the report referenced in the column can be found here.
4. Claymore Investments’ “top model summer ETF competition” might be the perfect place to indulge your gambling instincts. You can use your “investing” skills to design a winning portfolio constructed out of Claymore ETFs.
5. The Dividend Guy discovers the joys of rebalancing.
6. Preet on the economics of his annual pilgrimage to the Canadian Grand Prix in Montreal.
7. Canadian Mortgage Trends conducted a two-part interview (Part 1 and Part 2) with Moshe Milevsky on fixed and variable rate mortgages.
8. Canadian Investor on the investing surprises and ideas from how the Canada Pension Plan invests our (and our employer’s) contributions.
9. Growth in Value shares his five basics for financial success.
10. Million Dollar Journey finds out if hybrids are worth it.

[Update: I forgot to wish all the Dads out there a happy Father's Day! Have a great weekend everyone!]

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Purpose of Portfolio
The purpose of the portfolio is to provide steady growth of capital until retirement and an inflation-adjusted, after-tax income of $50,000 every year in retirement.

Return Expectations
We expect pre-tax, inflation-adjusted returns of 1% from cash, 2% from bonds and 4% from stocks and REITs. We expect a dividend yield of 2% from stocks that will at least keep up with inflation.

Time Horizon
Our target retirement date is 2030. We expect to have an estimated nest egg of $2,000,000 in today’s dollars that will supply an annual pre-tax income of $60,000 at a 3% withdrawal rate.

Asset Allocation
Cash – 5%, Bonds – 15%, Real Return Bonds – 5%, REITs – 5%, Canadian Equities – 20%, US Equities – 22.5%, EAFE Equities – 22.5%, Emerging Markets – 5%.

Rebalancing
The investment portfolio will be rebalanced to the target asset allocation when new money is added. The portfolio’s asset allocation will be checked once every year on June 1st and if necessary, we will rebalance back to the target by selling whatever has gone up and buying whatever has gone down.

Investment Vehicles
Cash will be held in high-interest savings accounts, cashable GICs, money-market funds or T-bills. Bond positions may include: Government of Canada bonds, GICs or XSB. REITs and Canadian Equities may include stocks, XIC, index mutual funds or actively-managed mutual funds. US equities, EAFE equities and Emerging markets are captured through ETFs or index mutual funds. No individual stock position is allowed to exceed 10% of the overall portfolio. The portfolio will avoid: investing in options, futures or any other derivatives, shorting, leveraging, individual positions in foreign stocks, speculative stocks such as junior exploration companies, biotech discovery companies etc.

Benchmarks and Review
As the portfolio is mostly indexed, the only review and evaluation required is for the Canadian Equities and REITs portion of the portfolio. The benchmark for Canadian Equities is the TSX Composite Index and XRE for REITs.

Note: This simplified IPS is for illustration purposes only. Customize based on your goals and needs. The actual dollar amounts and specific dates are for illustration only. Your comments are welcome.

Download in Microsoft Word format.

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Talk about a pot calling the kettle black! The Federal Conservatives are running ads on radio slamming Stephane Dion’s, yet-to-be-unveiled, carbon tax calling it a “permanent new tax on everything”. Despite Mr. Dion’s claim that the proposed tax will be revenue-neutral, the Conservatives are claiming that Canadians will end up paying an extra tax on the cost of gas, electricity and everything else that we buy. They should know all about a trick like that — they did precisely the same thing with the “ecoAUTO Rebate Program”.

In Budget 2007, the Tories introduced “a broadly revenue-neutral” rebate program that offered up to $2,000 for the purchase of a new fuel-efficient automobile while at the same time imposing a “green levy” of up to $4,000 on gas-guzzling vehicles such as SUVs (but not trucks). In this year’s budget, they decided to scrap the green rebate, while keeping the green levy. It is hypocritical of the Conservatives to warn that we “better not fall for this trick”, when they themselves played a similar green trick on Canadians.

Note: Before Tory supporters pelt me with hate mail, let me state that I voted for the Conservatives in the last election and we don’t show much partisanship when heaping abuse on politicians.

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House Lust by Newsweek reporter Daniel McGinn is an eye-opening account of the obsession that many Americans have for their homes, which first led to one of the biggest boom in housing prices and later turned into a bust with far-reaching consequences. A Washington Post columnist quoted in the book probably defined the term best – “a house or an apartment becomes not just a place of shelter or an emblem of status or even a considered investment, but an obsession that haunts us no less intensely than Vladimir Nabokov’s nymphet Lolita tortured the imagination of poor, sick Humbert”.

As the author himself admits, this book is not a comprehensive analysis of the rise and fall of the housing market. Instead, it simply tells stories of (mostly well to-do) people who became fixated on their homes – constantly talking about it, checking out the prices of their friends and co-workers’ homes on Zillow or just endlessly renovating their properties. Consider the following vignettes:

1. Some homes now have master bedrooms so large that they may need an “extreme ultra king” bed that measures 12 feet wide and 10 feet long.
2. To deal with the emotional, financial and marital stress of renovating their homes, couples are engaging the services of a new breed of therapists who offer counselling at $90 per session, with a regular treatment lasting four to six sessions.
3. Investors purchasing run down rental properties (for the “cash-flow”) in far-off places like Pocatello, Idaho, sight unseen. One economist estimated that in 2005, about one in three homes was purchased as an “investment property”.

If you even have a passing interest in real estate (who doesn’t?), you might want to check out this book. Mr. McGinn’s intrepid reporting from the front lines of the real estate bubble covers people buying McMansions, lusting for newly constructed homes, undergoing renovation hell, watching or reading “real estate porn” on shows like House Hunters, looking for cash flow in odd locations, rushing to become realtors, buying one (or more) vacation properties makes for an entertaining read. The book’s website features an excerpt, articles and a quiz.

Rating: 7 out of 10.

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Exchange-Traded Funds (ETFs) are great products for investors only if: (1) they have rock-bottom fees, which means that investors keep what they don’t pay and (2) they have low turnover, which allows investors to create portfolios that are highly tax efficient. While they can nominally be called “ETF-based”, two new products fail to sport either of these advantages.

Jon Chevreau recently reported that AIM Trimark has launched ETF-based “target date” portfolios, which holds some fundamental index ETFs. A commenter posted the link to the Retirement Payout Portfolio prospectus and noted that the MER is likely to be around 2%. In addition, investors in these funds have to pay a sales load or opt for a deferred sales charge. It’s true that these funds are slightly cheaper than actively managed mutual funds that charge a MER of 2.5%. But, 2% is still too rich to pay for a smidgen of ETFs and a large dollop of mutual funds when an investor can construct a similar portfolio for 0.25% or less.

Investors can make their portfolios conservative over time simply by channelling new savings into the fixed income area. The AIM Trimark Portfolios incur unnecessary turnover by rebalancing their existing portfolio every year.

The other new “wolf in sheep’s clothing” is JovFunds tactical allocation portfolios constructed solely out of ETFs and charging a breathtaking MER of 2.25% (including a 1.25% trailer). And “tactical” is an euphemism for market timing, which even when it works (it hardly ever does), incurs devastating turnover.

Tom Bradley puts it best when he observes that “the marketing imperative of the wealth management industry is turning an effective and valuable investment product into something that makes no sense for the client”. On Bay Street, when the interest of investors clashes with the bottom line, the bottom line always wins. Why should ETFs be any different?

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1. Ellen Roseman says that dividend tax breaks make blue chips a wise buy.
2. Rob Carrick recently profiled money manager Francis Chou. Steady Hand’s Tom Bradley wrote that a contrarian bent is why Mr. Chou is a successful money manager.
3. Money magazine’s financial industry insider on what areas planner can add value and what areas they can’t.
4. The Dividend Guy picked his top three dividend investing books.
5. Preet is writing a series of posts on his breakfast with Jeremy Siegel (Part 1, Part 2 and Part 3).
6. Canadian Personal Finances finds out the real cost of that airline ticket.
7. Million Dollar Journey wrote about the basics of Fundamental Index ETFs.
8. Larry MacDonald points out the disadvantage of paying down the mortgage first and then saving for retirement.
9. Thicken My Wallet on why he became a passive investor.
10. Four Pillars on the joys of using a manual mower to mow the lawn.

Have a great weekend everyone!

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Glenn Cooke is the president of InsureCan, a life insurance brokerage that offers instant online life insurance quotes from about 25 Canadian life insurance companies. Mr. Cooke offered to write an informational and non-promotional article on life insurance in exchange for a link to his site. You can find a selection of life insurance articles on his Term Life Insurance Canada website.

Many consumers struggle with determining how much insurance they need. Even after they’ve spoken to an insurance agent or broker it may still not be clear why they’ve purchased the amount they have. Is it enough? Is it too much? Is $100,000 enough? Is $1,000,000 too much?

I prefer to use a fairly simple approach to determining the right amount of life insurance. It’s based on the underlying concept of insurance – the pooling of resources to protect against a catastrophic loss.

For most of us, we want to maintain our dependents’ standard of living should we die. And it’s that standard of living that we should focus on. Not the mortgage, not the children’s education, not buying groceries. None of those qualify as catastrophic losses. In addition, most of us want to make sure we’re not overinsured.

This begs the question – how are we maintaining our current standard of living? How is the mortgage being paid? Money for the children’s future education? Groceries? For most of us the answer is our paycheque. We maintain our standard of living from our paycheque. And it’s our paycheque we lose in the event of our death. From a strictly financial perspective, that’s all most of us are – our paycheque.

If we replace the buying power of our paycheque upon our death, I think it’s a safe assumption that our dependents can continue to maintain their current standard of living. No one will be insurance rich, but we’re not leaving them in the poor house either. They continue to pay the mortgage, save for the children’s education, and eat the same brand of peanut butter.

With an income stream over a period of time we now have a very straightforward present value calculation we can do. What is the lump sum of capital needed to reproduce an income over a period of time? That lump sum of capital we assume is the amount of life insurance we need.

Let’s look at an example. Take an income earner who is 35, making $75,000 per year. Assume 5% interest and 3% inflation. Let’s further assume that we don’t need the full 75,000 to continue the standard of living. With one income I normally use a rule of thumb of 80% replacement, with two incomes I generally assume 60% replacement. In this case lets use 60% of the $75,000.

You can use our online calculator how much life insurance do I need? to run the PV calculation. Let’s start with a 30 year timeframe for complete insurance protection (we assume a 35 year old would earn an income until age 65 or for 30 years). Using inputs of 75,000 income, 60% replacement, 5% interest, 3% inflation and 30 years, the calculator returns $1,035,687.40. Yes – a million dollars. However look at the resulting table. That million dollars produces an indexed income of $45,000 for 30 years with nothing left over. Nobody got rich here, but we didn’t leave the dependents short either. Focusing on the million dollars as a large number is an emotional decision not a financial one, and could leave your dependents short.

Since all of these calculators are at best estimates of future needs, I prefer to have use a range instead of one absolute number. The second way to look at this is to assume a replacement income just until the kids are out of the house. At that point we assume the surviving partner would be financially independent and on their own. If we rerun the same case as above but with 20 years instead of 30, we end up with $754,336.02. That amount of capital produces the $45,000 of income for 20 years with nothing left over.

So in this case we should be looking at total insurance coverage in the range of $750,000 to 1,000,000. Anything less and we would be potentially underinsured.

Feel welcome to play with the assumptions in the calculator, and post any questions you may have. If you want to extend the conversation, the same premise I’ve used above can be pointed to retirement savings planning (you lose your paycheque when you retire), and it can also be used as a basis for determiing the type of insurance one would consider for this type of need (what do your insurance needs look like in 25 years using this approach?).

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