Some things to think about

By Ian Davidson
Illustration: Cathy Pentland

When it comes to our finances, some strategic issues just don’t get highlighted enough

It is not uncommon to turn on the news or pick up your newspaper and find a business story heading the lineup or the front page. Even 10 years ago, such press would have been infrequent and a business TV show would have seemed preposterous. But even with the prevalence of business reporting, it’s still not easy to get a story out. The press is filled with the latest scandals, the quick and easy hits, while the issues that aren’t hot or topical don’t get printed or discussed. And then there are those that can’t be discussed enough, such as financial planning trends that don’t make the news.

Financial independence
The purpose of financial planning is to achieve financial dignity, which is defined as the ability to retire when you want, where you want and how you want. TD Waterhouse Canada Inc.’s recent survey determined that almost half of those surveyed did not realize how much money they need to achieve financial independence. One-third said they planned to continue working either part time or full time past the usual retirement age. Statistics Canada numbers show that labour force participation of those 55 and up is increasing.

But there are two questions people ask: who will they work for and how much capital will they need to retire? If you are older than 55, it is not easy to find jobs, and it’s even more difficult at 60. Determining the amount of capital required for financial independence is the most basic of financial planning analysis. Imagine you are an auditor with a gross income of $80,000 and want to retire at age 65 with a retirement income of $50,000 after tax. You will need more than $1 million to do this; you will need approximately $1.2 million. Imagine your annual gross income is $250,000 and you want to preserve your lifestyle with a retirement income of $125,000 after tax at age 65. To do so, you will need capital of $2.6 million.

Only 450,000 Canadians have more than $1 million of invested assets. The $5-million club has just 54,000 members. And 72% of millionaires are 50 and older. Contrast these numbers to holdings of the average member of one of Canada’s largest public sector pension plans. In the public sector, invested capital per person is about $500,000. Compare this with the average RRSP size of $50,000.

Canadians are going to have a difficult time retiring and should be the peg of every article you read about financial planning. Working until you die has not been considered a good retirement strategy, nor has expecting that the labour force will need a significant number of older employees.

RRSPs and financial independence
RRSPs were started in 1957 when the government recognized that 90% of Canadians needed government assistance to retire, but it seems that Canadians are still not saving enough. After all, more than 90% of Canadians qualify for old age security. Here are some numbers for RRSP contributions:

• Annual RRSP contributions are about $35 billion. Offsetting these contributions have been withdrawals, which have risen a comparable amount to contributions in the past decade. RRSPs are used to smooth over income fluctuations during nonretirement years.
• The current pool of RRSPs is $600 billion, expected to grow to $1.2 trillion in 10 years. Unused contribution room is currently $400 billion.
• Registered pension plans have $630 billion of assets; and 100% of public employees are in defined-benefit pension plans; while 40% of private-sector employees are in pension plans. The majority of these are in defined contribution.
• Taken together, RRSPs and RPPs make up one-quarter of Canadians’ wealth.
• The average RRSP is now $50,000 and one-third of eligible Canadians contribute to RRSPs.
• Of the dollar value of RRSP contributions, 80% comes from those earning more than $40,000.
• Men contribute more than women, and more often.
• Canadians 35 and younger contribute only 17% of the dollar value.
• The number of Canadians who maximize their contributions is several hundred thousand.

To reiterate trend No. 1: we have a financial independence problem in Canada. Canadians are not saving enough.

Why Canadians don’t save
The overriding issue is that the middle class carries the freight in an economy where only 10% of Canadians make more than $80,000. Housing and post-secondary school costs have risen. Tax credits are not tax deductions and the tax act is not generous in its allowance for the hallmark expenses of the middle class: healthcare, the post-secondary education of children, support of spouses, children and even parents. 

The single most basic financial planning strategy is more meaningful than ever before: pay yourself first. As a CA, you are probably in the private sector. It is useful to examine the pay stub of a public-sector worker to see why he or she can retire. The source deductions for pensions are mandatory and large. There is no equivalent in the private sector.

Pay yourself first is dull and overlooked but necessary if you want to improve your financial well-being.

Income trusts and 2004
Income trusts have a similarly misleading nomenclature. They are high-yield equities; they are not fixed-income investments. Bay Street sold $40 billion of income trusts in 2004 and $17 billion in 2003. The record of Bay Street versus Main Street has not been encouraging. How many of these investors are the same ones who tell you their pharmacist prepares their tax return for $60? It is difficult to believe a low-risk investment will yield 8% to 10% a year over the long term.

Canadian dollar
The Canadian dollar has benefited from strong commodity prices. The main rise may be over, although the US current account deficit and budget deficit are probably the biggest two issues in the global financial scene.

If clients are going to retire in Canada, there is some argument they can have all their investments or the majority denominated in Canadian dollars. A more prudent strategy would be to have a portfolio diversified among different economies and currencies. 

Management expense ratios and indices
The predominant theme of written financial media is twofold. Are management expense ratios on mutual funds too high? And is passive investing better than active investing?

The answer to these questions is largely a matter of belief, but the outcome is most important. Your client’s $5,000 tax preparation bill may be the cheapest $5,000 the client has spent; while the $60 fee your brother-in-law paid to the pharmacist can be very expensive.

Most mutual funds have attractive five-year and 10-year returns because they are not allowed to invest more than 10% in a specific equity. Remember Nortel was 37% of the TSX in 2000 and even early 2004; it was Canada’s largest capitalization stock. If we take 1% off index returns over a long period, as a proxy for fee-based portfolios, a basket of mutual funds has beaten the index. Performance is not as important as media would have you believe. In a world of $50,000 RRSP portfolios and $400 billion of unused RRSP contribution room, your adviser is making a contribution. He or she is trying to change client behaviour. Everyone has to be paid. Until financial planning becomes a profession, the easiest way for the adviser to be compensated is by a mixture of fees and commission.

Financial planning continues to emerge
Last year, the Financial Planners Standards Council released its standards, increased its compliance function and added to its membership. It now has about 16,000 members, making it the most prominent financial planning organization in Canada. Each member must negotiate a six-hour exam. The designation of these individuals is that of the Certified Financial Planner. The standard of these individuals and their professionalism is very congruent with those of the chartered accounting profession.

Tax planning
As a CA, you understand the importance of after-tax returns. Blue-chip bank stocks have dividend yields of about 3%. Capital gains attract the lowest rate of taxes; dividends the second lowest. RRSPs provide tax deferral. This information is not well understood by the public. As the investing public looks for yields, we have seen the yield in long-term bonds decline, partly because the public is willing to pay a significant price for these bonds.

Estate planning
The biggest trend in financial planning will be estate planning because of demographics. The population is getting older. Your clients do not understand words such as “deemed disposition” or “testamentary trust.” Over the next 10 years they will.

You may know that the economists are saying there will be a $1.3-trillion transfer of wealth from seniors to their baby boom offspring. You should know that most of this is housing proceeds and that most inheritors will use that money to pay down mortgages or buy bigger houses. Debt repayment is also going to be big. You now know that the unused portion of RRSP contributions is $400 billion and is one-third of the $1.3 trillion. Let us hope that some of this amount is used to increase those $50,000 RRSPs.

Past performance is not predictive
Among the most popular investments in mutual funds these days are Canadian dividend funds, Canadian bond funds and Canadian balanced funds. Remember that past performance is not predictive. Bad performance usually proceeds good and vice versa.

Remember that performance statistics are heavily end period biased and that there is a significant survivorship bias. For example, suppose your top-rated Canadian mutual fund has had a return of 35% for the past three years. Three years is not enough to demonstrate anything. If the manager has had large positions in minerals and oil, 35% is not enough. The idea is to have managers who have consistent long-term returns.

Financial products
The number of financial institutions that provide financial products will continue to contract, as the big get bigger. Fifteen years ago, there were more than 100 life insurance companies; today there are 80% fewer. Expect banks to dominate the product landscape as they continue to increase their market share. Costs of financial products will decline.

Interest rates are low
From and economist’s perspective, interest rates are not low. Did you ever expect that inflation would moderate or that Canada would run budget surpluses? This trend may continue. If interest rates were to rise, the major contraction will be in the housing market. The word is contraction not crash. Most clients rate housing as the best investment. Over long periods, housing prices cannot rise faster than do incomes. Financial assets outperform real assets.