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A Tax Free Savings Account Doesn’t Have to be a Savings Account

It’s time to contribute to your tax free savings account (TFSA). The limit for 2017 is $5,500 plus any left over contribution room from prior years plus any withdrawals you made in prior years.

A lot of people don’t realize it, but a TFSA can be invested in the same things an RRSP can be invested in. And, if you have your funds in a TFSA for the long haul, they should be invested the same way as your RRSP. A lot of people think that the TFSA money has to be in a savings account and so they have up to $50,000+ sitting there earning a fraction of a percent in interest each year. And the banks like their clients to think that. It’s a good deal – for the banks, that is. This is one really good example of how a fee-only financial advisor can help. The bank will be looking after your best interest, they will be looking after their own. The fee only financial advisor’s best interest is to give the best possible advice in the client’s best interest.

Of course, TFSAs can be used for many things and weren’t really intended for retirement purposes. If you’re planning on accessing the funds in the short term, keep it liquid (but you can probably still do better than a savings account). But if you’re keeping the funds in your TFSA for the long term, invest the funds for the long term.

CRM2 is Coming

Many “advisors” are in a state of panic because “CRM2” will be here in January.

What is CRM2? you might well ask.  It is the second step of the implementation of changes to the securities regulations in Canada.  This will require the disclosure of the dollar amount of commissions and fees paid to the dealer firm.  The amount paid will appear for the first time on a lot of statements in January for the 2016 calendar year.  Many individual investors will be shocked at how much they are paying for the “advice” they are getting.  The amount shown will not include the actual investment management fee paid to the mutual fund investment company.  Many people will see the number and say “no wonder I can’t beat the market”.

For example, if you have an equity fund, the management expense ratio (aka MER) might be as high as 2.5%.  Of this, your dealer firm may be getting half.  So, if your fund is worth $400,000, you will be paying $10,000 per year, $5,000 of which is paid to the dealer firm who, in turn, pays the person or team with whom you deal directly.  This $5,000 will now show up on your statement.  The other $5,000 that is paid to the investment manager (e.g., Trimark) will still not be disclosed.

Many advisors provide comprehensive financial planning as part of their service. And, really, they should.  Your investments are just one part of your financial future.  Even for these advisors, some clients may still feel they aren’t getting much bang for the buck, especially for the larger investment amounts because the fees will still seem pretty large.  In these situations,

Unfortunately, there are also many “advisors” who give little, if any, advice.  They basically sell the mutual funds (or whatever), collect the ongoing fees and provide little service. For these salespeople, CRM2 will be a problem.

Of course, this is always a problem with commission based sales.  The seller is paid to make sales, not provide service, so some will do just that, sell as much of the highest commission product possible and move on to the next buyer.  I do realize that many commission based sellers do provide service but often the service is just used as another sales opportunity.

This where fee only financial advisors (also known as fee for service financial advisors) come in.  They will provide a comprehensive financial plan and help you choose a financial advisor or help ensure your investments are in line with your goals and objectives and your risk/reward preferences.  They will spell out the services and costs ahead of time and they will work in your best interest because you are the one paying them.

I have always wondered why the MERs have managed to stay so high, with trillion dollar funds still charging in excess of 2%. It will be interesting to see how this all plays out.

Coming Soon – More Information for Investors

Client Relationship Model – Phase 2 (CRM2)

The Canadian Securities Administrators (“CSA”) implemented changes to securities legislation in2013 to provide investors with more and clearer information about the performance of their investments and the fees they are paying. At the heart of CRM2 is the objective to give investors the information they need to understand how their investments are growing and what they are paying for the services related to managing their account.

The first two phases have been implemented and the third is effective July 15, 2016. This is the one that scares most dealers in the mutual fund world because most investors who purchase retail mutual funds have no idea how much they are paying in fees. The changes are going to apply to all retail investments you purchase through a bank or a mutual fund company. Retail segregated funds available through insurance companies are exempt (for now).

All fees charged to your account by the dealer’s firm will be expressed in dollars (not percentages) – whether those charges were visible to you or not. By the end of 2016, investor statements will go through some transformations as consumer-friendly reporting of performance and costs, expressed in dollar terms, becomes mandatory.

Even though the requirement is effective July 15 of this year, the mutual fund dealers have one year to implement it, so don’t expect changes to occur overnight. However, since most mutual fund dealers operate on a calendar year basis, most investors will see the information in all likelihood starting early in 2017 for the year ending December 31, 2016.

Some of the dealers are saying this is no big deal. The clients already know how much they are paying. I have to say that most people I work with are surprised when the fees they are paying are explained to them in plain language. The management expense ratio (or MER as it’s often called), is typically described to the investor in percentage terms and it is available, but often only after a fair amount of digging. An MER of 2% or 3% doesn’t sound like much in the grand scheme of things but it certainly adds up year after year.

If you invest $10,000 per year and earn 5% without fees, you would have $132,000 at the end of 10 years.  If the MER was 2%, you would have $118,000 at the end of 10 years.  The fee in year 10 would be almost $2,400.

In any event, most investors have no idea how much they are paying for the “advice” they get from their mutual fund advisor or the person sitting across from them at the bank. Nor do they know how much the advisor gets for the various funds sold. The new law will require disclosure of the dollar amount paid to the firm. It unfortunately, still doesn’t show how much is paid to the actual advisor by the dealer. The total expenses are still not being disclosed, just the fees paid to the dealer firm. And the fees will be for each account without any breakdown by specific fund in the account. So, the client will still not know how much extra the advisor is getting for the money you may have sitting in the global equity fund versus the Canadian government bond fund, for example.

Advisors who actually provide a reasonable amount of service to their clients probably have nothing to worry about, but those advisors who sell the funds and sit back and watch the fees roll in might have some explaining to do once the fees start appears on the statement. After the initial sticker shock, some investors may decide that they can pursue a low cost route by using a fee-only advisor or by doing it themselves with ETFs.

Of course, seeing the fees come out of the account during times when the investments are dropping in value will be a major irritant for some clients. It is already happens to investors since the dealer and advisor get paid during good times and bad times – it’s just not noticeable to the investor.

The reports will provide the investor’s personal rate of return, but reporting of benchmarks will not be not required. As a result, the investor won’t know (without additional research) how well the portfolio performed relative to relevant benchmarks. This is important because if your portfolio went up by say 5%, you’re likely reasonably happy, but if the fund’s benchmark (i.e. what it’s measured against) goes up by 8%, then your portfolio didn’t do as well as it perhaps should have and you should ask questions to ensure you understand why and to ensure your investment advisor is actually providing value for the fees charged.

Obviously, the more information that is provided concerning fees and performance the better. One extra upside is that investors who may have been reluctant to call their advisor for risk of “bothering” them may now feel rightly justified in contacting the advisor with any questions they have or if they need any information.

The change in the law goes a long way towards providing information to investors so they can evaluate the service, fees and performance of their advisors but investors are not off the hook – they’ll still need to do their homework.

Never Trust a Pretty Picture

A graph a lot like this one appeared in one of our national newspapers recently in an ad for a mutual fund. At first glance, it looks like this fund has consistently outperformed the index that it’s measured against.  It has increased by a whopping 194% since early 2000 compared to what it’s measured against, which increased by a paltry 51%.

Chart 1:
Chart 1

I’m not really sure what that means.  Both went up in value over the period so capital was preserved.   Obviously, they want you to focus on the fact that they earned 194% over the roughly 16 years and the MSCI World Index only returned 51% over the same period.  It sure looks like the fund did better over the whole period.  It’s going up a lot faster since the 2008 financial crisis and down less before.  This chart is an example of one of my pet peeves. The ad said “The quality advantage: Capital preservation contributed to long-term performance.”

The type of chart they’ve used is called a linear chart.  They do not give a clear picture of long-term investment growth.  A log chart, on the other hand, shows what investors really want to know.  I know logs (logarithms) scare most people because of the trauma they endured in trying to learn about them in high school.  All you need to know is that:

  • With a linear chart (see Chart 1 above), an equal increase along the vertical axis (left side of the chart) represents an equal increase in the dollar amount. This means that the increase from 50 to 100 looks the same as the increase from 250 to 300.  They are the same amount, but not the same percentage.
  • In a log chart (see Chart 2 below), an equal increase along the vertical axis represents an equal percentage increase. What this means is that the increase from 50 to 100 is the same as the increase from 150 to 300 – they both doubled.  This is what most investors are really interested in.  An investor who earns $5,000 on his $10,000 investment will be a lot happier than the investor who earns $5,000 on his $100,000 investment over the same period of time.  I’ve recreated the chart, but this time using a log scale on the vertical axis so we can get a more accurate picture of how well this fund did in relative terms.

Chart 2

chart 2 fin

This is also an excellent example of how past performance doesn’t predict future performance.  Someone looking at the performance of the advertised fund after the first two years covered in the chart would have thought, “Holy cow, the fund earned 50% over the last few years and the index lost 50%.  I gotta get me some of that fund.”  They would have been disappointed over the next 14 years since they would be paying fees for a fund that was supposed to perform better than the index, when in reality, this wasn’t the case at all.   With the exception of the first couple of years, you can see that the blue and red lines follow each other very closely.  This means, since part way through 2002, the fund and the index it’s measured against have earned the same percentage return.  In fairness, the fund out performed big time for the first couple years, despite the tech bubble bursting at that time.  So, maybe that’s the preservation of capital they were talking about in the ad when describing the fund.  You can see that in Chart 1 above too,  if you analyze it carefully, but it’s not obvious.  You have to look closely – really closely.  For example, after the tech bubble burst in 2002, the fund being advertised and the benchmark it’s compared to have both almost exactly tripled.  If you look at the financial crisis in 2008, they both lost about 50% of their value, so capital wasn’t preserved very well that time by either the fund or the index.

Things aren’t always as they appear.  It’s important to look beyond the pretty picture to understand what it’s really telling you – or just as important, what it’s not telling you.

Saving for Surprises after Retirement

Most people don’t spend a lot of time planning for retirement.  I’ve heard it said several times (so it must be true) that the average person spends more time planning a vacation than they do planning for retirement.

Maybe it’s true, even if it’s an exaggeration, it does seem that people don’t really spend enough time planning for retirement.  Maybe they feel that they will have lots of time for planning after they retire.  Unfortunately, it doesn’t really work that way.  Often times, people retire without a plan and they end up wasting the rest of their lives, not really sure what they should be doing.

Some people look at their finances before they retire.  Many people in pension plans assume the pension plan will be sufficient.  They can be very unpleasantly surprised.

In any event, you need to know how you’re going to spend your time before you can decide how much money you will need.  And, if you’re like most people, you will realize you don’t have enough to do everything you need so you have to adjust your wish list.

In any event, one thing people forget to include in their plans is surprises.  By this, I mean foreseeable surprises.  For example, you’re going to have to replace your car every once in awhile.  Most people think of that.  However, what about the furnace in your house?  The shingles?  Appliances?  If you’re going to be retired for 15 to 20 years or more, which is the average life expectancy these days, you’re going to have to replace some or all of these things, at least once.

In addition, there are probably going to be unforeseen health related expenditures at some point during your retirement years.

So, when you’re figuring out how much money you need to retire, leave room for surprises.