A few suggestions on how to invest a $300,000 inheritance

Last week’s post contained a real life Canadian couple’s financial dilemma on how to invest a surprised inheritance. I asked writers and readers of financial blogs to email me their suggestions. This couple is in their mid-fifties and are hoping to retire in 8 to 10 years. They are debt free, have poor paying jobs and only managed to save $55,000 for retirement. Unfortunately, my bullet point list of Canadian tax info wasn’t very clear.

Additional clarification of  the Canadian Tax system

Canadians have three choices for saving for retirement if they don’t have a company pension.

Registered Retirement Saving Plan (RRSP)

  • Contributions are limited to 18% of working income (max. $25,370 investment income not included)
  • Tax deductible, refund based on your tax rate (lowest 20%, highest is 53%)
  • Tax free compounding, withdrawals are 100% taxable at your personal tax rate (lowest 20%, highest is 53%)
  • Government requires you to make withdrawals at age 72
  • Not usually recommended for low income families

Tax free Savings Account (TFSA began in 2009), geared to low income families

  • Personal contributions are limited to $5,500 per year, not tax deductible
  • Unused contributions are carried forward indefinitely
  • Tax free compounding, withdrawals are not taxable
  • No restrictions on withdrawals, money can be taken out and put back in the following year.

Taxable investment account

  • Interest income, foreign interest and foreign dividends are 100% taxable at your current tax rate (lowest 20%, highest is 53%) Plus there is 15% foreign tax withheld. If personal your tax rate 30%, foreign dividends of $100 minus  $30 personal tax – $15 of foreign tax = $65
  • Canadian Dividends have an eligible tax credit that increases the after tax yield. In theory, a Canadian could earn $40,000 in dividends tax free if they had no other income.
  • Capital gains has the lowest tax rate because only 50% of the gain is included in income, so only $50 of a $100 gain would be included. High income earners (53% tax bracket) would only pay 26.5%  in income tax.

I only received two suggestions and didn’t receive any input from any Canadian bloggers or readers.  So, I asked a financial planner who works at one of my local bank branches to weight in.

From the United States, Bear with the Bull offered the following:

I am not sure I am most qualified to be a financial adviser and I really do not know Canadian tax laws. I would think they might want a mix of income, bond, possibly cash, and growth stocks.  For my 401, I have about a 60/40 split of stocks and income/bond allocation. So if they are looking for more cash / income, maybe they would be more comfortable with something more 40/60 instead. 

They probably would look to a portion to be cash or bond fund that could be used to maximize yearly retirement contributions and or have readily available should they need it.  Since the Canadian real-estate market is seemingly doing well, how about investing in some Canadian REITs?  It would have a short term growth opportunity and dividends as well.  ETF’s also seem to be the latest investing vehicle and generally have lower fees than mutual funds.

  • The 40% equities ($120,000) 50% Canada 40% U.S 10% Emerging markets
  • The 60% fix income ($180,000) Perhaps a 1/3 split.  $60,000 Bonds, $60,000 Reits, $60,000 Cash

Realize that this response and $5.00 will get you a good cup of Starbucks so take it for what it is worth.

From Belgian, Amber Tree Leaves offered the following:

Here is a potential solution, as I am not sure to fully understand the Canadian system, I will skip that part.

General comment: As they have not yet accumulated a lot of assets, it might be tough to retire in the next 8-10 years. It is reasonable to expect a severe correction in that period. As it seems that they have little investing experience, it might be better to go for an approach that generates cash from dividend stocks. The assumption here is that it generates higher yields than ETFs. 

  • allocation: 70 % stock and 20 % bonds and 10 % gold.
  • The 70% equities 20% in Canadian dividend stocks, 50% world wide in dividend paying stocks

The gold is there as a hedge against the really bad times. It should be managed in a way that it needs to be sold and converted into stock/bonds when the price rises a lot. Timing this is hard, it is not the goal to get the absolute top.

Bank Financial Planner

First of all, I believe that money has different weights or “gravity” depending on how you acquire it.  Inheritance money seems to have the most weight as often people feel they “owe” a higher degree of care of duty to it and are less likely to deal with it the way they would a lottery win or an insurance settlement.

Obviously, the first thing I would need to do is get a better understanding of their situation and their time horizon and risk tolerances.  Let’s assume they are comfortable with a balanced approach. I would recommend 60% equity/40% fixed income.  ($180,000 in equity and $120,000 in fixed income.)

I would recommend they start by contributing fully to TFSAs, which would account for $102,000 between the two of them.  In the TFSA, I would use a ladder of market linked GICs to give them diversification, security of capital and the potential for higher returns than offered by traditional GICs.  This allows them their only chance to earn interest without paying tax on every penny of it.  It also means there are no fees to pay on almost one third of their investments. 

For the non-registered account, I would recommend a core holding of a growth ETF portfolio ($100,000 with additional positions in our Canadian ($30,000), US ($15,000 and International ETF funds $25,000), with a portion in our US Dollar ETF $15,000) for additional diversification on currency. 

After the initial investment occurred, I would want to have an annual strategy to move the maximum TFSA contribution for each of the clients.  This would involve selling a position of the non-registered investments (unless there are additional savings available) and reinvesting in the same fund inside the TFSA to maintain the balance in the overall account.   This would allow the gradual transition into the TFSA accounts, helping with taxes and probate fees down the road.  A portion of capital gains (or losses) would be triggered each year, smoothing the tax impact on the clients.

I am not sure if this inheritance is big enough to bail out this couple’s retirement plan. A key element is understanding after tax returns when investing.

 

 

 

Tips on rebalancing your retirement portfolio

rebalance-moneyunder30

Many investors are in for a rude awakening when they open their year-end retirement plan statements. The bond portion will probably show negative returns. It could even wipeout a good portion of their positive returns from owning equities.

Now, the most common method used in rebalancing your established asset allocation mix would be to reduce the holdings that are up in value (sell stocks) and buy assets that have fallen in price (buy bonds). This practice may have worked very well in the past but interest rates are going up forcing bond prices down.

The chart below compares the S&P 500 with the IShares 20 plus year Treasury bond ETF

tlt

“The decades-long bull market in U.S. Treasuries has finally drawn to a close following Donald Trump’s surprise presidential election victory, according to mutual-fund manager Bill Miller.”

“Miller isn’t the first to call time on the bond bull market. Economist Henry Kaufman, the original “Dr. Doom” who is credited with calling the last bond bear market in the 1970s, told the Financial Times this week that the current bull run is at an end.”

In the past, when the Federal Reserve decided it was time to unwind its easy monetary policies, it would raise the federal funds rate fairly quickly. The Fed believes a neutral stance on monetary policy is reached somewhere above the 4% level. The current Federal Reserve is moving slower than normal. Based on an average of three rate hikes per year, it will take the Fed a little over 4 years to normalize interest rates.

Tip # 1

Short-term, reduce or eliminate investing in target date mutual funds since they automatically rebalance from equities to bonds. Plus they increase your bond exposure the closer you are to retirement.

Tip # 2

During a period of rising interest rates, the prudent strategy is to reduce the duration of your bond portfolio. That could mean using a short-term bond ETF or a ladder of GICs both of which would allow you to benefit from an increase in rates.

Tip # 3

If you’re comfortable with a little credit risk, use short-term investment-grade corporate bonds to get a little more yield.

Tip # 4

Cash is by far the safest asset class. Move some of your equity allocation and some of your fixed income allocation to cash. I have my doubts that President Elect Trump can get congress to pass all his stimulus agenda and even economists are unsure if these policies will actual increase economic growth.

Corrections in the bond market are not as uncommon as you think. Most have been short in duration. See the chart below:

lt-treas-losses

Keep in mind that in the past, rate hikes were implemented  at a much faster pace than what the current Fed has purposed. Losses in the bond market could continue for longer than expected.

The Trump Rally: Buy on rumor, Sell on news?

trump-stocks526

Never in a million years did I think that Trump would not only win the election but that the stock market would rally afterwards. It proves once again how difficult it is to time the stock market.

Trump’s promise of a big stimulus package, tax cuts and less regulation has boosted the dollar and triggered a selloff in the bond market. The “Trump trade” has become the reflation trade with investors buying cyclical stocks and selling bonds. Financials have benefited as well as industrials.

The markets have rallied assuming that Donald Trump is pro-growth. However, he was also the same guy who talked about tariffs and tearing up trade deals, things that are anti-growth. The stock market is currently ignoring the negative side of Trump’s campaign promises.

Now, I’m not convinced it’s a one-way street. Under the surface, the trend has certainly changed. Whatever you thought about stocks before the election, you have to like them a little more and whatever you thought about bonds, you have to like them a little less.

Could this be the start of the “Great Rotation’” out of bonds into stocks?

Almost $2 trillion has been wiped off the value of global bonds since Trump was elected as the next U.S. president, sparking a reassessment of growth and inflation views.

JP Morgan notes that over the past week, a record inflow into U.S. equity exchange traded funds (ETFs) was accompanied by a record outflow from bond ETFs.

Within equity markets,  a sharp rotation out of so-called “bond proxies”, dividend-paying sectors such as utilities, telecoms and healthcare which were favored by investors for their yield and a move into more cyclical sectors such as banks, industrials and some commodities-related sectors is already underway.

Before you jump on the bandwagon, there’s a flood of economic data in the week ahead

  1. update to third-quarter GDP on Tuesday
  2. OPEC meets on Wednesday and it will decide whether to curb output
  3. Thursday is ISM manufacturing data and November auto sales
  4. jobs report on Friday expected to show 175,000 nonfarm payrolls

Now, the bond market has already priced in expectations that the Fed is on track to raise interest rates Dec. 14 by a quarter point. Next week’s economic data will be evaluated to determine future rate hikes for 2017. If inflation expectations are overhauled than so are perceptions about the rate outlook. Money markets are starting to price in one or more Federal Reserve rate hikes for next year.

Good economic numbers could cause a further selloff in the bond market next week which would be positive for U.S. stock markets. Plus many active fund managers have underperformed their benchmarks, there could be some performance chasing until year end.

Unfortunately, President Elect Trump is unpredictable and somewhat scary. If he shuts the borders because the anti-trade Trump comes out, we’ll have a recession and the market will go down. If that side stays quiet and he manages to convince congress to cuts taxes, it could be up a lot.

My gut tells me that we could be in over bought territory and that we could see some market consolidation. My fear is that Janet Yellen could spark a stock market selloff like she did in December 2015 when she indicated the possibility of 4 rate hikes for 2016 which didn’t materialize.

Are you buying into the Trump rally or are you a seller?

 

 

 

Is it time to look at alternative investments?

'I have mostly conservative investments in my retirement portfolio, plus a few riskier, short-term performers tossed in as a hedge against inflation.'

Hedged funds are usually reserved for institutional investors and for the very wealthy. Alternative strategies are now available to ordinary investors. These funds must adhere to a higher level of transparency and liquidity than hedge funds or limited partnerships.

Ever since the crisis of 2008–2009, financial advisors and their clients have looked for ways to shield portfolios from potentially devastating losses. Many set their sights on liquid alternatives funds, an emerging investing category that’s sold as both mutual funds and exchange-traded funds.

In 2008, just $44 billion was invested in alternatives through mutual funds and ETFs, according to research firm Morningstar. At the end of 2015, however, assets had exploded to $300 billion, with close to 600 funds.

There are a large selection of alternative strategies available. When the market faltered in 2008, managed futures and interest–rate swaps funds were up in value while stock holdings were down. Other categories include strategies, such as market neutral, commodities, multi-asset, multi-currency and long/short equity.

Some advisors use liquid alternative funds as a way to deal with the current low-interest-rate environment. Bonds are dead money right now and stocks themselves aren’t cheap. Advisors are essentially eliminating bonds and replacing them with something that will serve the same purpose, but also offer some potential return. A very popular choice to protect your equity exposure is a long/short strategy. These fund managers buy stocks that they expect will rise in value (long), while shorting those they expect will fall.

Most advisors use alternative funds as ballast during falling markets because they invest in non-traditional assets that aren’t correlated with stocks or bonds. Investment experts recommend a meaningful allocation of 15 percent to 20 percent; otherwise, the impact won’t be felt. Trying to predict when markets are likely to fall and inserting an alternative fund is very hard to do.

While alternatives might fare better than a mainstream stock/bond portfolio in a downturn, they’ve got their own drawbacks. The big one is fees.

According to Morningstar, the average expense ratio of alternative funds is 1.7 percent, many times that of either equity or bond funds. “The high fees have eaten into returns, which is a concern when it’s generally a lower-return environment,” said Josh Charlson of Morningstar.

However, compared to the fees that such strategies charge in the hedge fund structure, they’re a bargain. Investors in hedge funds normally pay 2 and 20 — a 2 percent fee on assets under management, plus 20 percent of profits.

Now I believe that this low-interest rate environment may continue for another decade so investing in fix income products doesn’t make sense. Sitting on cash that yields nothing or being 100% invested in stocks is overly risky.

I recommend checking the fees that your company’s pension plan provider charges. Switching from fix income to an alternative fund may be more economical than you think.  A word of caution, before you invest in any alternative fund, make sure you understand the strategy, the risk and the fees.

What are your thoughts on alternative funds and ETFs? Are they suitable for your retirement fund?

 

Negative interest rates; do you want risk, now or later?

percentage

Today there are more than 7 trillion dollars of government bonds world-wide with yields below zero. That means investors buying bonds and holding them to maturity won’t get all their money back (scary). There is some speculation that Canada and even the U.S. may be forced to follow the rest of the world and go down the negative interest rate road.

Now, a lot has changed during the past fifteen years since I wrote my final exam to become a financial advisor. A moderate –risk retirement portfolio back then recommended holding 60% stocks and 40% bonds. A client saving for retirement, had the ability to earn money on their cash at an above 5% yield on their risk-free Treasury bond portfolio.

This opportunity no longer exists and it may take another decade or more for interest rates to get back to normal.  It seems appropriate to wonder whether the 60/40 rule remains a prudent strategy. This is a really big problem for seniors, who don’t want to outlive their retirement savings someday. Life expectancy is rising in an environment where interest rates are falling. For example, my wife and I are retired and in our early sixties. There is a 50% chance that one of us will make it into our 90’s.

The great recession of 2008-09, taught me that volatility is not the true risk for investors saving for retirement or for seniors who are retired. It only took three years for stock prices to recover from their 2009 lows. The true risks are the permanent loss of capital and the possibility of running out of money.

Advice from 85-year-old billionaire, Warren Buffett

“It is true that owning equities for a day or a week or a year is far riskier than leaving funds in cash-equivalents. For the great majority of investors, however, who can and should invest with a multi-decade horizon, price declines are unimportant. For them, a diversified equity portfolio, bought over time, will prove far less risk than dollar – based securities.”

Are you afraid to take on more equity risk?

How about a hybrid equity called convertible bonds or convertible debentures. It’s a bond that pays interest but has a stock option hidden inside. It’s the best of two worlds, you get your money back plus interest and a chance to make a capital gain. Here is an example of a Canadian convertible debenture: Artis Reit 6% series F 2020 (AX.DB.F).

It was issued on June 30, 2010 at $100 paying 6% interest and the holder can convert into common stock at $15.50 any time before June 30 2020. The common stock was trading around $11.00 when this 10 year debenture was issued. The price of the common stock hit $17.00 by April 1, 2013 which if you converted at $15.50 would have generated a capital gain plus paid interest for three years.

A word of caution, the price of convertible debentures or bonds will trade above the $100 issue price if the common stock price is trading near or above the conversion price. There is a small quantity of the Artis series F still available but the current ask is $104.28 and the common stock price is $12.70 with only 4 years left. (Not a good buy today unless you are happy with the yield to maturity)

I have to admit that my tolerance for risk is much higher than the average senior. Plus I broke some investing rules, looking after my mothers portfolio. My 84-year-old mother is quite happy today that I invested 80% of her retirement account ($76,000) back in 2001 into equities. Over the past 15 years, my mother withdrew an average of $5,500 per year and she still has $67,000 today. There is no doubt that her retirement account would have run out of money using the old 60/40 rule or her annual income would have been seriously reduced.

Ask yourself or your advisor this simple question, “When should I take some risk, now or later?”