Henry Lum Associates Articles

Living large during recession

2009-12-29T17:42:00.001-05:00

It has been more than a year since the collapse of Lehman Brothers that triggered a widespread domino effect that lead to a deep recession. While the market has turned around quite remarkably in the past 6 months, many people have since realized the importance of prudent investing and money management. In the previous newsletter I have written about some money management tips to control or curb spending. This time I am going to share a few ways to live large without spending or spending very little.

Do you like to buy books, magazines, or movies regularly? Buying books from online stores such as Amazon is convenient since you don’t need to leave the comfort of your home and they are delivered to your home. However, have you considered going to a local library to find what you needed? The local library provides online access for you to find and reserve your favourite books or movies. If you don’t mind waiting, then once the item becomes available, the library will kindly remind you and have it ready for you to pick up.
As the old cliché says: someone’s junk can be another’s treasure. It’s true! If you have the patience to go through garage sales on weekends or classified ads, you may indeed find some real treasure. Internet has made this activity even more convenient with classified websites. Definitely try your local Craigslist to find what you want for free or next to free. If you feel generous or don’t feel like selling things, try out the grassroots efforts from Freecycle by giving away your stuff for free. Freecycle allows you to give or take things with one catch – it has to be absolutely free and no trading. I was surprised how much my infant child benefited from this by finding some useful baby items that can be quite expensive from a retail store. At the same time my wife and I happily freecycled piles of items sitting in our basement to another people who found them useful.
If you or your kids are an avid gamer or a movie lover, have you considered trading them since the useful life of these items tend to be fairly short? Second-hand game industry has already become a billion-dollar industry, and major retailers or discounters have already caught on to this bandwagon by offering in-store credits for anything in the store. If you have piles of older titles that may not be accepted by the major retailers, you can also consider online communities that trade games or movies; as long as you can find a taker then a trade can happen.

If you have your own ideas, feel free to drop me a line and share your money-saving tips.

Registered Disability Savings Plan

2009-12-29T17:40:00.002-05:00

The Registered Disability Savings Plan (RDSP) was introduced in the 2007 federal budget designed to meet the need to assist families to provide a long-term savings plan for relatives with disabilities. This is a federal regulated plan and is the first of its kind in the world to address the issue of providing financial security to individuals with disabilities. This plan is modeled after the Registered Education Savings Plan (RESP) to provide tax-free growth within the plan. Obviously, RDSP did not get the same spotlight treatment compared to the TFSA since the disabled population in Canada who qualify for RDSP only makes up a small percentage compared to the population who are qualified for the TFSA. Since RDSP came into effect late last year, RDSP is currently only offered by the big banks.

An individual who is qualified as a beneficiary of an RDSP if he/she:

is a Canadian resident under the age of 60;
has a valid social insurance number (SIN);
is eligible to claim the disability tax credit (DTC).

The disabled individual can be the account owner, but can also allow anyone to contribute to the plan given permission by the account owner. If the beneficiary is a minor, the legal guardian/parent or a qualified individual may become the account owner.

The main benefit provided by the RDSP is the ability to shelter gains within the plan tax-free. Contributions made to the RDSP is not tax deductible, while withdrawals are not considered as taxable income either. Similar to the TFSA, when the withdrawal is not considered as taxable income, other income-tested benefits such as Old Age Security or GST credit will not be affected. Contributions can be made until the age of 60 and while there is no annual contribution limit, there is a lifetime maximum contribution of $200,000.

The federal government also provides matching grants called Canada Disability Savings Grant (CDSG). The matching grant ranges from 300% to 100% of the contributions made, depending on the beneficiary's family income. The grant can be paid to the beneficiary's account up to the year the beneficiary turns 49 years old. Here is how the matching grant works:

For family income lower than $77,655, the first $500 contribution is subject to 300% grant, and the next $1000 contribution is subject to 200% grant. The income test is indexed to inflation.
For family income higher than $77,655, the first $1000 contribution is subject to 100% grant.

The beneficiary can receive up to $70,000 in CDSG in the lifetime.

For lower income families, the government also provides a Canada Disability Savings Bond (CDSB) regardless of the amount contributed. The beneficiary can receive up to $20,000 in CDSB in the lifetime. Here is how the CDSB works:

For family income lower than $21,817, the grant is $1,000.
For family income between $21,817 to $37,832, the grant is pro-rated. The income test is indexed to inflation.

Note that when withdrawing from the plan, CDSG and CDSB plus the investment growth from the grants are considered taxable income. Only RDSP contributions plus its investment growth can be withdrawn tax-free.

Once the beneficiary reaches age 60, the beneficiary can start to receive payments in the form of lifetime disability assistance payments (LDAP). The LDAP payments has an annual maximum withdrawal limit based on the age of the beneficiary and the life expectancy of the beneficiary. The beneficiary may also request for disability assistance payments (DAP) from the plan before the age of 60 but with similar withdrawal limits.

In general, the federal government provides generous grants and bonds through the use of RDSP. Most provincial governments have also allowed assets held within RDSP to be excluded from income and asset tests for qualifying various government benefits. This gives other family members to freely contribute into RDSP to support their loved ones without the fear of clawbacks or disqualifying from other important disability benefits.

Harmonized Sales Tax Revisited

2009-12-29T17:37:00.001-05:00

As I have written about this topic in my previous issue of the newsletter, Harmonized Sales Tax (HST) has become increasingly a hot topic of discussion. I want to specifically bring up one issue with the HST that affects you directly with your investment savings. Whenever you invest in an investment fund such as a mutual fund or segregated fund, the investment fund is paying management fee. At present, the management fee is subject to the GST at 5%. With the introduction of the HST, the management fee will be subject to the HST, which the combined rate will be 5% + 8% = 13%.

The obvious problem with HST is that broadening the sales tax will mean all Canadians will be paying more for any goods and services they consume. Based on the figure provided by the Investment Funds Institute of Canada, Canadians paid $355 million in GST on mutual funds they held in RRSP accounts alone. With the addition of the HST, Canadians will be paying 160% more in taxes held within RRSP accounts. Mutual fund being the popular choice for many Canadians as an investment vehicle for retirement savings, an additional tax will mean a slight reduction in future retirement income for Canadians. To put things into perspective, with an average management fee of 2.5% for mutual funds, HST is only adding 0.2% of cost to the entire investment amount. For example, an account with $10,000 invested in mutual funds will incur about an additional $20 in taxes.

While additional cost is something unpleasant for investors, there are two additional concerns that are unique to the investment fund industry when HST is introduced next year:

Who really pays the HST?

Ontario and British Columbia are the 2 provinces introducing the HST. Normally this means the tax is paid when you consume goods or services within these two provinces, however, Canadians outside of Ontario and British Columbia may be subject to the HST due to the pooled structure of mutual funds. An individual investor can live in any province and have access to the same mutual fund. It is unclear whether an individual investor living outside of Ontario/BC will also be paying the HST because the investors share the management fee paid by the fund. It may prove to be very difficult, if not impossible, to calculate the appropriate level of tax to each individual investor living in different provinces.

Discrimination on tax levied on funds

Other financial products such as Guaranteed Investment Certificates (GIC) and non-fund products receive a more preferential treatment on sales tax than investment funds. Sales tax applies to all goods, services, and labour used to supply an investment fund, while taxes only apply to goods and some services for non-fund financial products. The difference amounts to about from a range of one forth to one fifth of the taxes paid compared to investment funds. With the introduction of HST, the difference of taxes between the types of financial products will get amplified. At a time where investors are free to choose their investment vehicle, it does not make sense for investors to get penalized based on the choice of investment vehicle.
Also, some pension plans such as defined benefit or defined contribution plans pay little or no GST. With the number of pension plans shrinking over the years, Canadians must rely on individual savings plans such as RRSP and RRIF to fund their retirement years.

Conclusion

The mutual fund industry is seeking the government to make changes to bring fairness on how the GST and HST are applied to the funds. To maintain fairness between different types of investment vehicles, investors should not be penalized for choosing investments funds as compared to other non-fund financial products. At the time of writing, the provincial government has extended the HST exclusion list for food under $4, but no changes are planned for mutual funds.

Passive Investments

2009-07-15T13:51:00.002-04:00

The capital market is a fascinating place that allows investors to make money by investing in equities, and the market itself has created an entire industry of professionals to analyze the capital market. For investors like us who would like to invest in equities, we can rely on professional money managers who manages mutual funds. There are 2 main philosophies among the investment products: active and passive. In this article I will express my opinion on which type of investment style works in the best for most retail investors.

Active investment believes in the selection and timing of stocks to generate investment return in excess of the market return. Most mutual funds hire professional managers that have the experience, expertise, and access to information to make informed stock selection. They strive to create value for investors which is to generate investment return.

Passive investment, on the other hand, takes an entirely different approach than active investments. Passive investors accept the fact that it is very difficult to beat market return, and would be happy to receive the market return. Therefore, there is no need to spend time on stock selection and just "buy the entire market". Investment products such as index funds that mirror the performance of popular benchmarks (S&P 500, S&P/TSX) are great examples of passive investments.

Before I go into explaining which my preferred investment style is, it is important to remember that selecting the right asset mix, or asset allocation, has a much higher impact than selecting the investment style. It is a common misconception that finding a good mutual fund to invest in equities can help a low-risk taker to avoid risk. This is not true - remember that a mutual fund that invests in equities is designed to provide market return. Whenever we participate in equities, we are also taking the market risk. We have all learned that equities alone, no matter how diversified, does not protect us from a widespread market downturn like last year, so in order to take less risk, we need to rely on a different asset class. The 2 main asset classes fixed income and equities behave very differently, and using a mix of both will have a much higher impact to reduce the fluctuation of investment returns than just choosing the right equities mutual fund. While selecting the asset allocation is a personal choice, the resulting portfolio is always based on investor objectives and risk tolerance.

Once the investor has determined his/her asset allocation with the advisor, we can go back to the question of active or passive investments. My vote goes to passive investments for 2 main reasons:

All the investors in the entire world make up the market, so investor returns will either be average, below average, or above average. This will also mean the performance of investment funds will also be average, below average, or above average. While we all want to achieve above average return, there is inherently no way to predict which investment manager will be producing above average return. Even if a manager has produced better than average return in the past history, it is still not a reliable indicator that the manager can continue to outperform the market. In order to reduce the risk of picking the wrong investment manager and underperform the market, I believe in taking the average return using passive investments and eliminate an extra variable of picking managers.
If we take fees into account, the cost of active management will further erode the probability of picking a manager that outperforms the market average. With passive management, the fee is minimal which has been one of the features for passive investments.

There have been long standard debates between active and passive investments, and there will continue to be long debates about them. What's great about passive investments is that it has encouraged a breed of investment products such as index funds and ETFs that greatly reduces fees and creates stiff competition in terms of bringing down the management fee for investment funds in Canada. This spells great news for investors who get the cost savings in terms of lower management fees.

Money Management Tips

2009-07-15T13:49:00.001-04:00

With the recession hitting hard upon us, many are looking for ways to save money and keep enough for a rainy day. While we are all balancing our check books, I would like to offer a few money management tips that help us keep our finances in order.

A healthy cash flow is essential to good money management, and a way to maintain good cash flow is by segregation. By allocating the cash flow for specific purposes, this technique will ensure that we don't get to spend everything we get from every single paycheck. When we receive employment income and investment income, we first direct the inflow to a collection account. From this point, we segregate the collection account into 4 main flows.

Investment Account - The savings can reside in an RRSP account or a non-registered investment account. The money saved will be used to fund your financial planning objectives such as retirement planning. Whatever portion of your income you plan to save, transfer the amount frequently and I generally recommend that you transfer on the days that you get your paychecks (ie. bi-weekly, monthly, etc.)

Intermediate Savings - There are certain expenses that do not fall into a monthly pattern such as property taxes, car maintenance, etc. and as such there will be some significant timing differences between your paycheck and your expenses. Transfer a fixed amount from each paycheck for this separate account so that you can later use for these types of expenses. TFSA is great for this purpose because you can avoid paying interest income on the interest you earned while parking the cash.

Checking Account - Create a checking account and transfer a fixed amount monthly from the collection account. This is the money you can used to meet your living and lifestyle expenses. This is all the money you get for the month and you should NEVER live beyond your means by using credit cards. Credit card is meant to be a convenience tool and not as an extension to your checking account, so use the checking account to pay off the credit card balance every month. I would further categorize the expenses into 2 subtypes, and I choose to use separate checking accounts so that I don't mix up the expenses.

Living Expenses - Living expenses are expenses that are recurring in nature and usually run at a fixed amount. Items such as mortgage payments, insurance premiums, car payments, utility bills are examples of living expenses. Sum up the monthly living expenses and direct your cash flow to this account. You may use a separate checking account for this, but make sure this account is only used to pay bills that you have listed as living expenses.

Lifestyle Expenses - Create a separate account for all other lifestyle expenses. This includes everything from grocery, dining, cell phone usage, clothing, and entertainment. Also, only use this account to pay off your credit card bills every month and never carry a balance on your credit card.

Emergency Fund - If you have surplus left from your collection account, direct the remaining balance to an emergency fund where the fund is used for only unexpected expenses. There are different opinions on the amount of emergency fund, and it normally works out to be 3 to 6 months of living expenses. Be sure to review the emergency fund at least semi-annually to make sure there is a healthy amount that you are comfortable with. If you think there is too much emergency funding, direct excess to your RRSP or investment account. If you think there is too little funding, reduce your lifestyle expense to keep up this account.

By streamlining your accounts and budgeting properly, you can rest assure that what you have in your lifestyle expense account can be yours to spend, with the confidence that the rest of the living expenses and other savings are taken care of.

Harmonized Sales Tax

2009-07-15T13:46:00.003-04:00

In the most recent Ontario budget, Ontario will be introducing Harmonized Sales Tax, which combines the current Provincial Sales Tax with the GST. Starting July 1, 2010, the combined rate will be 13% which consists of 5% GST and 8% PST. The current PST has a limited scope of tangible properties that can be taxed, and the intention is to adopt the same scope as the GST with a much broader base. This is also intended to simplify the administration of the sales tax. Limited detail has been released by the budget so far, and we will certainly hear more about this topic as we approach next year.

How does it affect the consumers?

There will be many more items that will be taxed by the HST. Items such as gasoline and heating fuels were normally taxed by the GST and not the PST, will no longer be exempt from the HST. Example of items that are no longer exempt include:

Gasoline, Heating, Electricity
Tabacco
Personal services such as haircuts, gym membership fees, taxi fares
Professional services such as lawyers, accountants, and real estate agent commissions
Newspapers and magazines

HST will also be applied to the sale of new homes. While no sales tax will be applied to resale homes, however, there will be taxes on the transaction fees. Ontario government will also be introducing a new housing rebate for new homes to reduce the effect of the HST for homes less than $500,000. The effect of the provincial housing rebate will effectively eliminate the provincial portion of the tax burden for homes up to $400,000.

Exemptions

Items that were exempt from the GST will remain exempt from the HST. This includes:

Basic groceries
Rent and condo fees
Medical services, prescription drugs and medical devices
Education and childcare services
Children's clothing, footwear, car seats, diapers, and feminine hygiene products

In order to soften the blow of paying 8% more for a cup of coffee, the government will be reducing personal income tax by 1% at the lowest tax bracket and also a transitional benefit called the Sales Tax Transition Benefit. Families who earn less than $160,000 annually will receive up to $1,000 in the next 3 years.

Budget 2009 Highlights

2009-02-18T10:31:00.001-05:00

On January 27, the government has unveiled the 2009 budget which include a wide range of stimulus and tax relief and the budget has been passed on February 3. The following will highlight the tax relief measures listed in the budget.

Personal tax relief highlights

The basic personal amount will be increased to $10,320 in 2009 from $9,600 in 2008;
The first personal income tax bracket at 15% will be increased to $40,726 in 2009 from $37,885 in 2008;
The second personal income tax bracket at 22% will be increased to $81,452 in 2009 from $75,769 in 2008;
Increases the Age Credit amount by $1,000 to $6,408 for seniors, which provides an additional $150 of tax credit annually. The clawback threshold remains unchanged at $32,321;
Increases the refundable tax credit provided by the Working Income Tax Benefit for low-income Canadians. The benefit starts at 25 cents per dollar of earned income in excess of $3,000 (compared to 20 cents per dollar). The benefit maximizes at $925 at $6,700 of earned income (compared to $522). Once the earned income is excess of $10,500, the benefits reduces 15 cents per each additional dollar earned, until the earned income reaches $16,667;
An introduction of a time-limited Home Renovation Tax Credit that is valid from January 27, 2009 to February 1, 2010. Individuals will be able to claim a 15-per-cent non-refundable tax credit for eligible expenditures made in respect of eligible dwellings. The tax credit will apply to expenditures in excess of $1,000, but not more than $10,000, resulting in a maximum credit of $1,350 ($9,000 x 15%);
Increasing the amount allowed to be withdrawn from Home Buyer's Plan from $20,000 to $25,000;
A proposal to introduce a new First-time Home Buyer's tax credit. This is a non-refundable tax credit of $5,000 for qualified first-time home buyers.

Income Products

2009-02-18T10:26:00.003-05:00

When we retire and require a steady income stream, we may look towards investments to generate income. Traditionally, the main income vehicles are GICs, fixed income investments, and annuities. In the recent years the insurance and investment industries have come up with many products that generate income, and in some case even income guarantees. In this article, we will look at the different types of income generating vehicles and the purpose of each type of product.

Annuities

Annuities are offered by insurance companies and the purpose of an annuity is to generate a guaranteed stream of income. When used in combination of government benefits and defined benefit pensions, the retiree can receive a stable source of guaranteed income.
To find an annuity that is suitable, the retiree should know the answer to these questions:

When do benefits begin?
How long the benefits should be paid? Do you need benefits for yourself only or for yourself and your spouse?
Can withdrawals be made?
Do you need inflation protection?

The answer to these questions can quickly help you pick the right features for the annuity. The following list some of the main features of an annuity:
A term annuity provides income for a specific period of time, while a life annuity provides income for life. There are many variants of term and life annuities, and the most common ones are explained here:

Term certain annuity - provides guaranteed income for a specific period of time or ending at a specific age;
Life straight annuity - provides guaranteed income for life and the benefit stops with the death of the annuitant;
Life annuity with period certain - a life annuity that guarantees a minimum number of payments;
Joint and last survivor annuities - provides guaranteed income for both 2 lives.

Indexing - the amount of payments increase every year to keep up with inflation.

Immediate/Deferred annuity - The annuity can begin providing payments immediately, called immediate annuity, or deferred until a later date, called deferred annuity.

Some annuities can also be made available as commutable, where the annuity can be cancelled before the maturity date and the balance of the account could be converted to a lump-sum payment.

Taxation of annuities

Annuities are available in a non-registered plan or in a registered plan such as RRIF. All income generated by a registered plan is taxable while only the interest portion of payments from a non-registered plan is taxable. There are 2 variants of annuities in a non-registered plan that affects on the taxation of interest:

Non-prescribed annuity - Similar to paying off a mortgage, although the monthly payments are fixed, the payments in the early years are mostly interest while the payments in later years are mostly capital. A non-prescribed annuity works the same way where early payments have a higher portion in interest. As the capital portion increase over time, the amount of taxes will gradually decrease over the duration of the annuity.
Prescribed annuity - An additional benefit of an immediate annuity is that it is available as prescribed annuity for a non-registered plan. A prescribed annuity can evenly spread out the amount of capital and interest paid for each payment, giving the taxpayer a precise amount of taxable income to be paid each year. The annuities are designed such that the total amount of interest paid is the same for both prescribed and non-prescribed annuities over the same duration of the annuity.

Mutual Funds

Without going into details about the investment choices, a portfolio of mutual funds can generate interest income from fixed-income investments and dividends from dividend-paying common stocks. Unlike annuities and GICs, most mutual funds do not provide guarantees on principles or income stream, however, the investor enjoys flexible control on the investments and can take investment risks in exchange for long term growth potential. In order to customize the income stream for the investor, mutual fund companies provide 2 types of services to generate income called SWPs and T-SWPs.

Systematic withdrawal plans (SWPs)

This plan allows the investor to redeem mutual fund units on a regular basis and treat as an income stream. The investor also has the flexibility to customize the period and amount of redemption anytime. It is important to note that the investor may run into the risk of exhausting the capital prematurely when all the units are redeemed, and there is no guarantee on the income stream nor the principle.

T-SWP mutual funds

In the recent years, many mutual fund providers started to offer a product variant called T-SWP or T-Series. T-SWP is a simplification and improvement on systematic withdrawal plans for non-registered investments; that is, it provides a tax-efficient cash flow specified by the mutual fund. Since systematic withdrawals are redemption of mutual units, they are considered as taxable events and the investor may be taxed on capital gains on each withdrawal. T-SWPs, on the other hand, are specifically designed to defer taxable gains while producing cash flow. The cash distribution mainly consists of interest income, dividends, and return of capital in excess of the interest income and dividends. The purpose of providing a return of capital is to defer the taxable event and hence no capital gains tax will be paid until the mutual fund units are actually redeemed or the return of capital becomes in excess of the cost of investments. On the flip side, when the mutual fund units are finally redeemed, the amount of taxable capital gain will normally be larger than SWPs.

The amount of monthly cash distribution provided by a T-SWP is set as a policy in the fund, usually calculated as an annual percentage of the unit price. The percentage varies greatly among different products, usually anywhere from 4% to 12%. The monthly cash distribution is usually re-calculated annually to make sure the cash distribution is maintained at the percentage of the market value. If the mutual fund performs well for the year and the unit price is higher than the previous year, then the cash distribution may be increased. On the other hand, if the unit price is lower than the previous year then the cash distribution may decreased. Note that there is no guarantee on the amount of cash distribution and the investor runs into a risk of a significant reduction of cash flow if the market performs poorly. Given a poor market return in the past year, investors who currently hold T-Series mutual funds should see a decrease in monthly cash distribution.

Guaranteed minimum withdrawal benefits (GMWB)

This product type offered by insurance companies is relatively new in Canada. It is designed as a variable annuity with guaranteed income and has been marketed in the US for years. In order to understand GMWB, one needs to understand the benefits of segregated funds as well. Segregated funds are variable annuity contracts that allow the investor to choose the underlying investment and most segregated funds use mutual funds as the underlying investments. There are 2 added benefits to segregated funds:

Maturity guarantee - the investor is guaranteed a minimum amount at maturity regardless of market value of the account. The maturity can be 10 years or at age 100. The guarantee is provided as a percentage, from 75% to 100% of the net deposit to the account. The benefit is paid out only when the market value of the account is lower than the guaranteed value at maturity, where the difference is considered as the benefit.
Death benefit - similar to the maturity guarantee, this benefit is paid at death and the guarantee may have a different guarantee percentage than the maturity guarantee.

The guaranteed minimum withdrawal benefit guarantees a minimum benefit regardless of the market value for 20 years. The annual guaranteed benefit is 5% of the Guaranteed Withdrawal Balance (GWB), which equals to the net deposit to the account, less withdrawals in excess of the guaranteed benefit. GWMB comes with 2 important features:

Reset feature - The reset feature happens every 3 years. If the market value of the account at the reset date is greater than the GWB, then the GWB is reset to the higher value. This in turn increases the amount of annual guaranteed benefit as well.
Bonus feature - The bonus feature applies to deferred withdrawals only. For every year that the investor does not take the cash benefit, the GWB is increased by 5% every year thus increasing the annual guaranteed benefit.

GMWB on the market today is also known to guarantee benefits for life. This is called the Lifetime Withdrawal Benefit. The GWB is set at age 65 or at the time of deposit, whichever comes later. The reset and bonus features also apply to lifetime withdrawal benefit.

To explain all the benefits of GMWB, let's use an example to illustrate the benefits. Assuming the investor deposited $100,000 at age 65, the GWB is $100,000. If the investor were to start receiving annual benefits, he will be guaranteed 5% annually, or $5,000 for life. If the investor were to invest $100,000 earlier at age 55 and did not withdraw until age 65, the bonus feature would increase the GWB by $5,000 annually for 10 years. By the age of 65, the GWB becomes $150,000 and the annual guaranteed withdrawal becomes $7,500 at age 65.

As with all guarantees, the guarantees provided for segregated funds as well as guaranteed minimum withdrawal benefits come at a cost. The more aggressive the investment mandate is, the higher the cost of the guarantees. The management fee plus the cost of guarantees can cost more than 3.5% annually. Lately, there have been concerns and criticisms for insurance companies insuring the risks of GMWB with the recent poor market performance, stating that they may have under-priced the cost of the guarantees. Therefore, investors and advisors need to carefully weigh the cost and benefits of guarantees.

Summary

In this article, we have briefly walked through the main features of each types of income vehicles. Each type of product has its own strengths and weaknesses, and there is no single product that will work for all types of investors. Depending on your financial situation and risk tolerance, maximize the benefits of each vehicle to your advantage to meet your financial needs.

Charity Donation Alert

2008-10-09T23:42:00.004-04:00

The Canada Revenue Agency (CRA) has issued a few alerts in the past about some tax shelter arrangements with charity donations. This article will provide some examples about why some of these tax shelter schemes do not work and what individuals can do to identify them.

In general, an individual who donates an amount to a registered charity is eligible to receive both federal and provincial tax credits. For the first $200 of the donation made in the calendar year, the individual will receive 15% federal tax credit on the amount given plus a 6.05% of provincial tax credit, assuming the province is Ontario. For the any amount beyond the first $200, the individual will receive 29% federal tax credit plus 11.16% provincial tax credit. The individual is allowed claim donation up to 75% of the net income for the calendar year and can carry forward any unclaimed balance forward for 5 years. Unlike a tax deduction such as RRSP contribution, a non-refundable tax credit does not reduce your net income but directly reduce the amount of tax. The good part of this tax credit is that the tax credit rate is fixed for all levels of income instead of a declining rate like tax deduction. The rate of donation tax credit beyond the first $200 of donation is equivalent to the highest marginal tax rate at both federal and provincial level, making donation an attractive way to reduce taxes, especially for individuals at lower tax brackets. Also, instead of claiming the first $200 tax credit at a lower bracket for both couples, the tax credit can be transferred and claimed by one spouse.

In addition to the cash donations, the 2006 federal budget has completely eliminated the capital gains tax when the taxpayer donates eligible securities to a registered charity. Eligible securities include listed shares, mutual funds, and segregated funds. This allows philanthropic investors to do some tax planning by donating securities instead of cash to get charitable tax credit.
If you see some tax shelter promotions that are promising donation tax receipts that are beyond your actual cash donations, beware of these schemes as the CRA has been actively auditing these charities and may reassess your actual donation down to zero. Here are some statistics reported by the CRA:

As of July 2007, the CRA has reassessed over 26,000 taxpayers who participated in these schemes, and denied about $1.4 billion in donations claimed.
Audits of another 20,000 taxpayers involving $550 million in donation claims are just about complete.
Audits on other arrangements involving over 50,000 taxpayers are about to begin.

Here are some of the problematic donation schemes:

Art “Flipping” scheme – the promoter provides an individual an opportunity to purchase some art at relatively low price and arrange for donation to a registered charity. The promoter also arranges an appraiser to provide an appraisal value of the art donated to the charity. The appraised value ends up being significantly higher than the price the individual paid for, resulting in a donation tax receipt that is higher than the actual cost. The end result would provide a tax credit higher than the actual price the individual paid for the art, providing an immediate and zero-risk return from the “investment”. This scheme does not always refer to art objects, but the principle of “buy-low, donate-high” can apply to any property.

Gifting trust arrangements/Leveraged cash donations – The Income Tax Act has been amended on December 2003 to reduce any artificial advantage that is in any way related to a gift. In gifting trust arrangements, the taxpayer makes a cash donation to a charity and also becomes a beneficiary of a trust. The taxpayer receives property as a distribution from the trust and donates it to a charity. The taxpayer receives donation receipts for the total of the cash and the purported fair market value of the property. In a leveraged cash donation, the advantage is artificially created by a loan to increase the amount of cash donation plus actual cash donation, but the taxpayer is not at risk for the loan. In both of these scenarios, the donation tax receipts received becomes much bigger than the actual cash donation resulting in a tax credit larger than the cash contribution.

Scholarship donation – There have been instances where taxpayers are involved donation schemes where the beneficiaries of the scholarship donations are the children of the donors. The Supreme Court of Canada has recently ruled that the CRA will have access to the entire donor list of a charitable foundation without the need to get judicial approval (Redeemer Foundation v. Canada (National Revenue), 2008 SCC 46). This allows the CRA to assess the donors in cases where the donors are directly financing the kid’s education and the donations do not become true charitable gifts.

Conclusion

Some of these tax shelter schemes may sound reasonable or legitimate; however, the CRA may deny any charitable donations that CRA finds the taxpayer cheating the tax system. The CRA has been proactive to warn the taxpayers by issuing numerous taxpayer alerts on the above schemes. From the words of the former Revenue Minister Carol Skelton, “If it sounds too good to be true, don't fall for it. Taxpayers need to know that the Canada Revenue Agency (CRA) is auditing all tax shelter gifting arrangements". If in doubt, always seek for independent professional tax advice from someone who is not tied to the promoter.

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. However, please call Henry Lum to discuss your particular circumstances.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus be-fore investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated.

3 Cardinal Rules of Investing

2008-10-09T23:34:00.005-04:00

With the recent market downturn (or meltdown depending on how you interpret it), many people are left wondering about what has happened to their retirement portfolio. All sorts of questions are raised and I am sure we have seen or read enough news and articles about the current conditions. There are also many articles written to provide their advices on what to do and how to invest in a bear market. I am going to do the same thing in this article and will take a step back and go back to the basic principles of investing: 1) Diversify; 2) Diversify; and 3) Diversify. Although the repetition sounds familiar, but this verb essentially summarizes the fundamental rules for families who need to build an investment portfolio in order to sleep well at night. Let’s look at the rules:

#1 - Diversify over time

The stock market has provided a significant investment return premium over guaranteed investments such as T-bills. Over the past 50 years, the S&P500 index has generated over 11% annualized return while one-month treasury bills has generated around 5% annualized return. For this reason, there is a significant incentive to invest in the market. We definitely understand that the stock market can be volatile at times and we cannot predict what the price would be the next month, or even the next day. In order to reduce the risk, diversifying over time is the most important factor in reducing the risk of investing.

As an individual investor, your investment time horizon is the essential to determine your risk tolerance in investing the market. Understanding the time horizon can help the investor to select an amount of exposure in the market that is in line with the risk tolerance. This is also the crucial part of asset allocation to determine the fixed income and equities portion of the portfolio. With a longer time horizon, we can expect lower fluctuation from the average return, and the investor may consider allocating a bigger portion of the investment portfolio to the stock market than an investor with much shorter time period.

#2 - Diversify the holdings

While it is extremely rewarding to invest in a few hot stocks and make some big gains from a few good picks, the main problem with a few good picks is that there are many types of risks that come with concentration. The stock price may react significantly due to poor earnings, fraud, or lawsuits. A company may fail entirely or get acquired at rock-bottom prices. An entire industry may even be at risk; despite the perceived strength in the financial sector for years, we have seen in the recent turmoil that even banks are not immune this type of risk. Concentration risk can be easily mitigated by holding a diversified portfolio of holdings that invests in the broad market such an index fund or mutual fund.

Another argument against concentration is that the market is sufficiently efficient that the current stock price correctly reflects the current fair value. The efficiency is caused by the fact that there are enough people in the stock market that compete with each other and that competition drives the price to become a fair value. The exercise of trying to find mispricing of individual stocks that provides return in excess of the market return may prove to be a costly exercise in the long run as compared to just holding on to a simple index fund. In other words, even with the most skillful investor, it becomes very difficult to “beat the market” in the long run. If you already follow the rule #1 of diversifying over time, then the cost of not beating the market in the long run can be a costly exercise.

#3 - Diversify the asset allocation

So far with the above 2 rules we have been using the word market referring to the US stock market or the S&P500 index. The S&P500 index represents 500 large companies in the US and it is considered as one of the most important asset class in an investment portfolio. The third rule of diversification is to further diversify the portfolio with global reach that diversify against risks that are systematic to countries. By following all 3 rules, the investor can further diversify against country risks.

As an illustration, if we compare the main indices (S&P/TSX index, S&P 500 index, MSCI EAFE index) from 1970 to June 2008 with a portfolio with the 3 indices weighted equally and rebalance annually; the whole portfolio actually provide slightly higher annualized return and with slightly less risk, measured by annualized standard deviation.


Index Name            Return    Standard Deviation
S&P TSX Index         10.52%    16.11%
S&P 500 Index         10.41%    14.69%
MSCI EAFE Index       10.94%    15.77%
Diversified Portfolio 11.01%    13.06%

Some facts

We all know that we are currently in a bear market condition. Let’s try to put things into perspective with some actual numbers. I want to acknowledge Weston Wellington from Dimensional for building the numbers in his recent web presentation. If we look at the past 50 years, the US is currently experiencing the 10th bear market, where we define a bear market is from the market peak to trough of more than 15% decline:


High        Low         Decline    Duration in months  Rank
09/10/2007  07/10/2008  -35.83%    11                  4
24/03/2000  09/10/2002  -49.20%    28                  1
16/07/1990  11/10/1990  -19.90%    3                   9
25/08/1987  04/12/1987  -33.50%    3                   5
01/04/1981  12/08/1982  -25.00%    16                  7
21/09/1976  28/02/1978  -19.30%    17                  10
11/01/1973  03/10/1974  -48.20%    23                  2
29/11/1968  26/05/1970  -36.10%    18                  3
09/02/1966  07/10/1966  -22.20%    8                   8
12/12/1961  26/06/1962  -28.00%    6                   6

The first row represents the current bear market we are currently facing. While I am not trying to downplay on the financial crisis that we are facing currently, we have seen that the market economy has demonstrated resiliency in the past and we should be confident that it is going to do so in the future.

If you are interested in watching the full presentation from Weston Wellington, please visit: http://www.dfaca.com/library/videos/different/

Conclusion

It is easy to get caught up with the current news from strong emotion words such as “unprecedented” or “crisis”, and it is very tempting to make drastic changes to the portfolio. In order for the investor to enjoy long term success, the investor must maintain discipline despite difficult times and keep the portfolio well diversified. If you don’t know how a well-diversified portfolio should look like, don’t panic, it may be a good time to work with an advisor and do a check up.

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. However, please call Henry Lum to discuss your particular circumstances.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus be-fore investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated.

Moving Expenses

2008-06-18T16:22:00.006-04:00

If you normally receive employment income, the major source of tax deduction is usually from the result of RRSP contribution. Unlike self-employed businesses where business expenses can be deducted from business income, there are not a lot of options for claiming tax deductions from employment income. Moving expenses can potentially create a significant tax deduction, and this is often overlooked as a way to offset the cost of moving. In this article we will look at the details about moving within Canada.

If you are arranging to move within Canada to start a new job or business, the moving expenses you incurred may be deductible if you move to a home that is 40km closer to the place of work. The distance is not measured as the distance of a straight line from point A to point B, but it is the shortest route of normal travel. You can only claim eligible moving expenses paid in the year against the income you earn at the new place of work in the year, and you can carry-forward and deduct unused portion from income you earn at the new place of work in the following years. If you receive reimbursement from your employer for the move, the amount of deduction is reduced accordingly.

If you are a full-time student at a post-secondary education, you can qualify for moving expenses and deduct the expense from your scholarships and grants that are required to be included in your income. The same 40-km distance requirement applies in this case as well. If you are a student moving at the end of school year for a summer job, you can claim moving expenses against the income earned at the job as well. It also means you can claim moving expense when you move back to school for the next academic year, given that you meet the distance requirement again and it is deductible against scholarships and grants only.

Which moving expenses are eligible?
Make sure you keep all records of expenses to support your claim.

Transportation and storage costs for moving household effects;
Reasonable travel cost incurred to move you and members of your household; this includes meals, accommodation, and vehicles. For meals and vehicle costs, you can track using a simplified method: in case of meals, you can claim a flat rate of $17/meal up to $51/day. For vehicle expense, you can claim 49.5 cents/km when you travel in Ontario. These figures vary from year to year and from province to province, make sure you visit http://www.cra-arc.gc.ca/travelcosts for the latest figures;
Costs up to 15 days for meals and temporary accommodation near either old or new residence for you and the members of your household;
If you rent in the old residence:

Lease cancellation costs.

If you sell the old residence:

Cost of legal fees and land transfer tax (not GST) for buying a new residence;
Cost of selling the old residence: advertising costs, legal fees, real estate commission, and mortgage penalty when mortgage is paid off;
Cost of maintaining your vacant property while selling the old residence: you can claim up to a maximum of $5000 for the cost of mortgage interest, property taxes, insurance premiums, and utility costs.

Incidental costs related to the move such as utility connection/disconnection and address changes on legal documents and driver’s licenses.

Which expenses are not eligible?

Loss from the sale of the old residence;
Cost of improving the old residence for the purpose of selling the home;
Expenses incurred in house hunting trips or job hunting;
Mail-forwarding costs;
Costs incurred in the sale of the old residence if you delayed the selling for investment purposes or market timing.

Conclusion

Moving expense can potentially create a substantial tax deduction when you need to sell your old residence; the real estate commission alone is large enough to create a substantial tax deduction. Whenever it is practical to do so, consider meeting the 40-km test so that you will be eligible for the tax deduction. Maintaining good records is important to support your claim.

Henry's Note

2008-06-18T14:49:00.004-04:00

Since the last newsletter, I have started offering tax return services for some of my clients. I have received good feedback for this service so I will extend this service for all my clients starting next year. This means that all clients who subscribe to my full service will get a full range of ongoing services from investments, financial planning, and now tax preparation. I have also received requests to write more about tax topics in the newsletters and I will definitely do so in the upcoming articles.

If you have not noticed, the website has recently been revamped to include all the existing newsletter articles. For those who love to read blogs, you can even subscribe to an Atom or RSS feed from our website www.henrylumassociates.com for all the articles. The website also included the full fee schedule from full service to individual services. I have simplified the descriptions to clarify the fee schedule so that it will be easy to read.

Tax Free Savings Account

2008-06-14T11:50:00.010-04:00

In the 2008 Conservative budget, one of the most important changes that affect Canadian families is the introduction of the Tax Free Savings Account (TFSA). This is one of the most important savings vehicles since the introduction of Registered Retirement Savings Plan (RRSP). Similarly to RRSP, all money and investment inside the TFSA grows tax free throughout its lifetime. This article will examine the features of the TFSA and explain some of the uses of this tool.

While RRSP is strictly designed to be a retirement tool, TFSA is designed to be for anything else. TFSA is designed to provide Canadians with a flexible tool to save money. You can use TFSA to save towards your next vacation, home improvement project, or as a down payment towards your next home. There are few important differences between RRSP and TFSA:

The amount of RRSP contribution can be used to reduce the income and deduct tax, while contribution to TFSA is not tax deductible;
Any amount withdrawn from the RRSP is considered taxable income, while all withdrawals from TFSA not subject to taxation;
Any amount withdrawn from the TFSA increases your contribution room by the same amount for the following year, while this is not case for RRSP;
The annual contribution room for TFSA is fixed at $5000 (adjusted to inflation), while RRSP contribution room is 18% of your income from last year (up to a certain maximum adjusted to inflation);
Unlike RRSP, there is no requirement to covert the plan into a Registered Retirement Income Fund (RRIF) at age 71 with minimum withdrawal amount.

Other features at a glance:

Canadian residents over age 18 can begin opening TFSA accounts starting in 2009;
Eligible investments are the same as RRSP;
Any unused contribution room will carry over to future years, and there is no limit on the number of years to carry forward;
If you over contribute to the account, you will be penalized on the over contribution for 1% per month;
TFSA can be used as security for loans;
Similar to RRSP, if you borrow to invest in a TFSA, the interest paid on the loan will not be tax deductible;
Upon death of the annuitant:
The fair market value of the TFSA is passed to the estate tax free, only gains after death will be taxable;
The TFSA can also be transferred to a surviving spouse’s TFSA without affecting the spouse contribution room.

Let's look the most important attribute of TFSA: the ability to grow tax free within the account. With regular savings accounts, interested earned is taxed as earned income. If we use the current interest rate of 3%, current inflation of 1.7%, and marginal tax rate of 45%, the real rate of return turns out to be -0.05%. With high-income earners, this used to be a huge disincentive to save money. If we allow money to grow tax free inside TFSA, the real return becomes 1.3% no matter which income level you are at.

Another important aspect of interest income is that it is treated as part of the total income, which affects other government benefits that are income-tested. This is especially important for low income pensioners when the Old Age Security (OAS) and Guaranteed Income Supplement (GIS) are income tested. If the pensioner who qualifies for GIS payment earns $1000 in interest per year and can shelter the interest income inside TFSA, the pensioner can earn an extra $500 in GIS payment per year.

Other applications of TFSA

While RRSP is designed to be a retirement vehicle, the TFSA can also be an effective retirement vehicle for low income earners. As explained in the above paragraph, withdrawals from TFSA are not counted as income and will not affect income tested government benefits such as Old Age Security or Guaranteed Income Supplement. For low income earners, it may even make more sense to invest in TFSA as a retirement tool since all withdrawals are not counted as income, thus allowing the pensioner to qualify for OAS/GIS with minimum clawback.

An interesting design of TFSA to note is that any amount you withdraw from the account will increase your contribution room by the same amount for the following year, while this is not the case for the RRSP. There is little incentive for one to withdraw from the RRSP since you will lose the contribution room as well as paying taxes on the withdrawal at your marginal rate. That means when you contribute to the RRSP you would likely commit to long term investing until retirement. The flexibility provided by the TFSA can be a double-edged sword for those who plan to use it as a retirement tool. With no tax consequences for withdrawal, there is a temptation to use the funds in the TFSA for other purposes and you can potentially lose sight of your long term goals.

If you compare between contributing to RRSP and TFSA, technically you should be getting the same amount of tax benefit from both plans. What it means is that if you were to contribute $1000 of pre-tax income to both TFSA and to RRSP, you should come up with the same amount after taxes, assuming the same rate of return. One more thing to note though, the comparison is equal only if you assume the tax rate is the same when you contribute and withdraw from the RRSP. This is usually not the case in reality and you will likely have different tax rates when you contribute to RRSP and when you withdraw from RRIF. RRSP is more advantages if the tax rate upon withdrawal is less than the tax rate upon contribution.

The TFSA also allows you to contribute into TFSA for your spouse and the generated income will not be attributed back to you. Normally, if you were to invest for your spouse, all interest or investment income earned by the spouse will be attributed back to you, meaning you will pay taxes on the interest income at your marginal tax rate. The government is making an exception to this income attribution rule so that the interest or investment income will not be taxed back to you. This is especially useful in the case when the family has a single income earner, or there is a large income discrepancy between the couple. This allows the high income earner to save for the spouse and the investment income will not be taxed back on the earner’s hand, and better yet, all investment income grows tax free within TFSA.

Conclusion

The TFSA is a versatile tool for all Canadians at any income level. While the annual contribution amount is not a significant amount, the flexibility provided by this tool is certainly a welcomed addition for all Canadian families. Using both the TFSA and RRSP, working class families now have a complete toolkit to save and invest in a tax efficient way. I hope the benefits provided by the tools create even more incentives for families to plan and save for their future.

Types of Life Insurance

2008-02-06T15:28:00.001-05:00

One of the principles in creating and preserving wealth is to manage the risk of loss of income when someone in the family dies. Until the family accumulates sufficient asset to cover for the living expenses of the family and paying down debts in case of death, it is critical for the family to understand and manage this type of risk. With life insurance policies, families can transfer the risk to insurance companies.

The first step in selecting the type of life insurance is to first identify the amount of insurance you require today. Your insurance agent will guide you to complete a financial needs analysis, but it basically boils down to 3 main categories:

Current needs - amount of debt to pay off, final expenses, living expenses required, tax liability
Current situation - amount of earned income, current assets and investments, current insurance coverage
Estate needs - this determines the amount of insurance needed during retirement

Once the amount of insurance is identified, you can choose from 3 main types of life insurance that addresses your specific needs. This article explains the types of life insurance available and the advantages of each.

Term Insurance

Term insurance is the simplest form of life insurance and it covers for a specific period of time, such as 5, 10, 15, 20 years, for a specific cost. The policy owner only pays for the pure cost of insurance and the policies do no carry cash value. What makes term insurance popular is that it is simple to understand and it is the least expensive type of life insurance available.

Many term insurance policies can be renewed at the end of the specified period with a guaranteed premium cost. Insurance premiums generally grows significantly at each renewal period since pure cost of insurance grows exponentially with age.

Many term insurance policies also come with the conversion feature that allows the owner to convert the term insurance into a whole life policy that provides permanent coverage. This provides the owner the peace of mind of permanent coverage when the future cash flow improves later on in life or when the need arises.

When choosing a term policy, it is the best to select the amount of insurance needed for the current situation for a specific period of time, such as the period of time before retirement or the period of time required to pay off a mortgage. While it is generally cheaper to purchase coverage with a shorter period of time, it is unwise to choose a shorter period than needed and then ended up needing to renew the policy at a later date. For example, while it costs slightly higher to pay for a 30-year term policy than a 10-year term policy today, it is much cheaper to maintain the 30-year policy for 30 years than renewing a 10-year policy 3 times.

Term insurance and other types of life insurance can cover a single life as well as two lives; A married couple apply for joint first-to-die coverage which is more cost effective than insuring two lives separately.

Optional Group life insurance is a usually provided by most companies and some professional associations. For employees, the death benefit usually comes in the form of a multiple of the gross salary. These insurance policies sometimes can be tailored to your own needs. The insurance premiums for group insurance may be cheaper than personal term insurance, partly because of group discount rates and partly because the age premium is averaged across the entire group. The main disadvantage of group insurance is that there is uncertainty about the continuity of the insurance coverage. The coverage can be canceled at the discretion of the company or association, and the coverage ends when one leaves the company or association. Also, premium is not guaranteed and is at the discretion of the insurance company based on historical claims.

Another variant of term insurance is mortgage life insurance. The only purpose of the insurance is to pay off the mortgage in case of death. The main difference between a mortgage life insurance and term life insurance is that the beneficiary of the mortgage life insurance is the lender.

Whole Life Insurance

Whole life insurance provides permanent coverage for the entire life of the insured. The premium is level and guaranteed for life; although the premium is higher than an equivalent term insurance, the cost of insurance is effectively amortized over the entire life. The amount of premium over the actual cost of insurance is accumulated to pay for higher cost of insurance later in life.

This type of insurance is needed for long term coverage beyond retirement. This is useful for families whose current cash flow is sufficient to cover for the higher premiums.

Whole life policies contain cash value and the policy owner can surrender the policy to access the cash surrender value. The cash surrender value will be taxed for value over the premium contributions

The policy allows for a reduced paid-up insurance when the insurance is in force for a certain period of time. In other words, the policy owner can surrender the policy and use the cash value to pay for a smaller insurance paid up for life.

A variant of whole life insurance is a Term-to-100 insurance. This type of insurance provides permanent coverage with level premium but there is no cash value in the policy.

Universal Life Insurance

Universal life insurance (UL), similar to whole life insurance, provides permanent coverage and is more flexible than whole life insurance. The coverage can be adjusted according to changes in lifestyle and other needs. The premium can be adjusted when one's cash flow changes, although a minimum and maximum annual premium apply.

Some UL policies also allows the policy owner to customize the investment choices in the cash portion of the policy. The investment within the policy grows tax-free within certain limits, thus providing the policy owner another tax-deferral tool beyond RRSP.

Similar to whole life insurance, UL is suitable for families who requires long term coverage beyond retirement.

UL is suitable for families who has surplus cash flow beyond implementing the retirement plan and can take advantage of extra tax deferral in the policy.

Choosing the right type of life insurance can be overwhelming as there are many features and options for life insurance. Knowing the amount of coverage and period of time you need can help you determine the right type of insurance. Over the course of the next few issues, I will continue to cover other types of living benefit insurance such as disability insurance, critical illness insurance, and health and dental insurance.

Henry's Note

2008-02-01T15:35:00.000-05:00

This is the first issue of newsletter since I have started Henry Lum & Associates back in November of last year, and I would like to thank my clients as well as FundEX to make the transition a smooth one. As I mention in the feature article in this issue, the main reason for me to start anew is because I believe clients are better served in the fee model where client sees and pays the fee. While the traditional commissioned model has the convenience of hiding the service fees, the complexity of the commission model lacks transparency and it is very difficult to find out the exact amount of commission paid. Increasing the transparency and reducing the conflict of interest with product selection in very important to me. Clients will also benefit from an increased selection of products and extending the range of services. I have received much feedback since I have started with the fee model; they are all valuable and I will incorporate the feedback into the business to continue to improve the level of service.

Also, it is the time of RRSP season. You have until the end of February 2008 to contribute towards last year and maybe get a nice tax refund after filling out the tax return in 2 months. While it is nice to receive a big tax refund each year, it would be better to commit to a plan and contribute regularly, such as monthly or semi-monthly, and ask for a reduction of tax withheld. Just fill out form T1213 and send it to your tax service office to get approval; when you get the approval, show the letter to your employer and they will reduce the tax withheld from your paycheque. This action will increase your level of cash flow throughout the year while contributing to the RRSP. While you won't get the high of getting a nice tax refund, you will be less likely to overspend during Christmas and contribute less to your RRSP as you would have planned in the new year.

The (hidden) cost of financial advice

2008-01-06T15:23:00.001-05:00

I am in the business of providing financial planning and advice, therefore, it is important for my clients to clearly understand the cost associated with my services. It is a common misconception that financial advisors provide advice for free, and many people give little thoughts on the hidden cost they pay for advice. This article will explore how financial service providers are traditionally compensated for providing financial advice.

Consider this example: a client works with a mutual fund advisor to invest $50,000 in a mutual fund portfolio. With an average deferred sales charge of 5%, the commission generated is $2,500 at the time of sale. If the client were to spend the same amount of money to hire a fee advisor at a rate of $150/hour, it would roughly equal to 16.7 hours of work. At this rate, one would expect a great deal of planning to be accomplished within this amount of time.

With commissioned advisors, the client normally does not pay directly for the services, but then where does the money come from? The answer is management expenses of the underlying fund. The management expense ratio (MER) is a term used in the industry to measure the cost of investing in an investment fund. It is an expense paid within the fund to manage the fund. Since the market value of the fund reflects the value net of management expenses and commissions, the cost is often ignored by the consumers. A regular Canadian equity mutual fund often has an MER of about 2.5%, out of which about 1% is paid as commission to the advisor.

However, the amount of commission is often complicated by the use of various sales charges. In the example above, a common form of compensation to the advisor is deferred sales charge (DSC). An average DSC is 5%, so the amount of commission paid to the advisor up front is amortized over a period of time, usually 7 years. In other words, by choosing DSC, the client commits to invest with the fund company for a few years. If the investment is redeemed before the committed period, then the client will end up paying a redemption charge to compensate for the commission already paid to the advisor. Today, there are various form of deferred sales charge with different length of periods, but there is no standard among the industry. While the commission payout is spelled out in the simplified prospectus, the details can be difficult to find.

If a client uses mutual funds from a retail outlet such as banks and discount brokerage, often the client hears that the funds are no-load funds. While it is true that there is no up front commissions generated at the time of sale, yet the cost of MER is similar. The commissions part of the MER goes to the retail bank or the discount brokerage in form of trailer commission. Advisors using DSC still receive a trailer commission but the amount will be much smaller. Similar to sales charges and redemption schedule, there is no standard on the amount of trailer commission.

From what we can see from the above, the model of service looks like this:

Product -> (sold) -> Client -> (free) -> Advice

Is there a problem?

The problem with the traditional model is that while the initial advice seems free, the advice given is directly linked to the sale of a financial product. As a result, the scope of advice the clients received may be limited to or biased towards the sale of a product. In other words, the clients are likely to receive product solutions than comprehensive financial advice.

While some consumers will be satisfied to receive product solutions for their financial situations, but consumers are becoming increasingly demanding as families are facing multiple challenges such as shrinking pensions, longer life spans, and high debt rates. Families need to understand how each financial decision is going to affect their overall financial picture including taxation. Even though we have a wealth of information on the Internet, families are looking for personal advice that addresses their financial challenges. Therefore, a refined business model is needed to address this concern:

Client -> (pays) -> Advice -> (free) -> Product

The above fee model shows that the client pays a fee for the advice. The client is also paying for the process of which the advisor delivers the services. With the fee model, the client clearly understands the cost paid and the clients will have a clear understanding of the value received. This also allows the advisor to provide the financial products for free without commission attached. The advisor can also extend the range of service beyond what is limited by product sales. Note that the clients would still be paying the management fee of the investment products or transaction charges, but the advisors can provide objective recommendation when their compensation is not directly tied to the recommendation. If there are cases where the product always comes bundled with commission, most prominently in life insurance, clients should at least be made aware of the amount of the commission paid.

As long as the client clearly understands the compensation paid and the service received, the client ultimately has the choice to select which service delivers the most value to the client. In any case, the client should ask for it in writing.

What is Financial Planning?

2007-10-01T15:11:00.001-04:00

The standard definition from the Financial Planners Standards Council says: The process of creating strategies, considering all relevant aspects of a client’s financial situation, to manage one’s financial affairs to meet life goals.

In simpler point forms, one can explain Financial Planning as:

About meeting life goals;
A process not a product;
Ongoing and evolves as one’s life evolves;
Integrated with all key aspects of one’s financial situation.

There are 6 main components to a financial plan and they include: Financial Management, Asset Management, Retirement Planning, Risk Management, Tax Planning, and Estate Planning.While there is much financial information available on the Internet and consumers can learn to plan for themselves, there is a growing consumer demand for professional financial planning as families are facing multiple challenges, such as:

Shrinking pensions and benefits;
Longer life spans;
Families carrying higher debts and less savings;
Increased personal and professional responsibilities;
Sophisticated financial products.

It is important for families to have a written financial plan. A written plan provides many benefits such as:

Provide more control of your current and future financial needs;
Prepare for planned and unexpected events and stages of life;
Realize your ability to reach your goals.

Anyone can benefit from learning the basic concepts and prepare for a plan. If you feel overwhelmed or do not have the time to learn all the necessary financial knowledge, then work with a Certified Financial Planner Professional (CFP). A CFP professional have proven technical knowledge and competencies to help families to create comprehensive financial plans. For details, please check out http://www.fpsccanada.org.

Subprime Mortgage Meltdown

2007-10-01T15:07:00.002-04:00

If you have been following financial news (or any news) in the past 2 months, you would definitely hear the word subprime mortgage. The recent mortgage meltdown or crisis had lots of people asking what is going on with the financial system.

What is subprime mortgage?

Subprime mortgage is a mortgage given to a home buyer with problematic credit history or lack of income proof from the buyer. These applicants are usually turned down for conventional mortgages due to increased risk for the lenders. In the past few years, low interest rate has allowed banks and financial institutions to give away easy money to borrowers who may not be financially fit for handling such a mortgage, and charge only a little more interest than conventional mortgages. These borrowers were given these "honeymoon" rates that inevitably bounce back to higher subprime mortgage rates a few years later. Lenders and borrowers were anticipating that the US housing market will continually rise to cover for the higher risk debts. The subprime mortgage market makes up about 20% of the total mortgage market in the US. In comparison, Canada’s subprime mortgage market is only about 5% of the total mortgage market.

However, when the US housing started to fall in combination with rising interest rates, many borrowers were faced with the reality of not meeting mortgage payments. A steep rise in mortgage foreclosures has caused more than 100 lenders to be become insolvent, with bigger names such as New Century Financial Corporation and American Home Mortgage.

How did this problem spread into the rest of the financial system?

The subprime lenders were not holding onto all of the loans but instead sold them to institutional investors such as hedge funds looking to achieve higher returns. When the subprime loans start to go bad, the investors and lenders shift to demand higher interest rates or stopped lending. This begins the credit crunch and a widespread stock decline. Some funds who incurred large losses had to suspend redemption from investors due to insolvency.

Asset-backed commercial paper also became a victim of the subprime mortgage meltdown. Investors who park cash for a short period of time (due less than a year) use the money market to preserve capital and gain some return. Money market is usually supplied by governments and highly rated companies. In order to satisfy the growing appetite of the money market, financial companies such as Coventree in Canada set up trusts that issue asset-backed commercial paper that is backed by assets that includes many types of consumer debts, such as car loans, mortgages, and credit card debts. Suddenly, investors stayed away from all types of asset-backed commercial paper in fear of insolvency even if the debts are not backed by subprime mortgages. Conventree and these trusts fail to find buyers for their paper, leaving them short of money. The central banks all over the world tried to mitigate the credit crisis by injecting cash into the financial system during the month of August in order to calm the money market and allowing money to continue to flow through the financial system.

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. However, please call Henry Lum to discuss your particular circumstances.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus be-fore investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to main-tain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated.

Understanding Credit Life Insurance

2007-10-01T15:01:00.001-04:00

A few weeks ago, I watched the CBC Marketplace, a consumer affairs program on television. The episode, called “Left a Loan”, caught my attention quickly as the program focused on a few cases where people were denied life insurance claims. These individuals purchased cars separately from different car dealerships in Canada, each financed their purchases with car loans, and were also sold credit life insurance to protect the car loans in case of premature death. At the time of purchase no questions were asked and they simply signed the contract and paid a lump sum on the life insurance policies. Unfortunately, these individuals passed away shortly after their purchases due to various medical conditions, and the insurance companies denied all their claims due to pre-existing medical conditions. The families of the deceased cried foul but were left with car loan payments nevertheless.

The CBC correspondent interviewed a few car dealerships about the sale of credit life insurance, but the message was inconsistent. Without going further into the details about the sales practice of credit life insurance, I would like to share with you my view on this increasingly popular type of insurance product. Nowadays they are being offered by mortgage lenders, car dealerships, and credit card companies.

Credit life insurance is a type of life insurance that protects the borrower from an outstanding loan in case of premature death. When death occurs, the death benefit is paid to the lender directly to discharge the outstanding loan. Sometimes these insurance policies are sold with post-claim underwriting, which means that underwriting for insurance eligibility only happens at claim time, or at death of the applicant. The cases studied by CBC were cases where the applicants have had pre-existing medical conditions and may not qualify for life insurance; however, they were still sold credit life insurance at the car dealership and gave their family a false sense of security. In my opinion, post-claim underwriting insurance policies do not serve the consumer’s need and should not be sold to them in the first place.

It is important to always purchase life insurance with underwriting requirements up front. There is no requirement to purchase credit life insurance in order to get approval for any loan; do not be compelled to purchase a policy from a lender in order to get a better rate as well.

Traditional life insurance (term life, whole life, universal life, or group life) is either guaranteed-issued or requires medical underwriting up front. By going through medical underwriting at application time, it eliminates the risk of claim denial. If there is a pre-existing medical condition, then the insurance company may place a higher premium or reject the application. While it is not pleasant to be denied at application time, it is certainly worse to be denied at claim time.

For details about the CBC Marketplace program, please see: http://www.cbc.ca/marketplace/2007/07/credit_insurance.html

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. However, please call Henry Lum to discuss your particular circumstances.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus be-fore investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to main-tain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated.

Henry's Note

2007-10-01T04:00:00.000-04:00

I have received much positive feedback from the readers and I would like thank them all for spending the time reading the newsletter. Your feedback was valuable and encouraging. As a result, the second issue of the newsletter has already grown in size and content. I hope some of the topics are thought-provoking while providing relevant information to all of you.
There is a question that I would like share with the readers: Can you tell me more about the child tax benefits?

There are 3 types of child benefits provided by the government:

Canada Child Tax Benefit has been around for a long time. It is a non-taxable amount paid monthly to eligible families for each child under 18. The benefit is income-tested.
Universal Child Care Benefit was introduced in July 2006 and provides a monthly taxable benefit of $100 to eligible families for each child under 6. The benefit is not income-tested.
New Child Tax Credit is a new tax credit introduced this year. It is a federal tax credit of $2000 per child and not income-tested. With the current federal tax rate at 15.5%, it works out to be $310 for most families. Taxpayers will claim the New Child Tax Credit when they file the 2007 tax return.

For more information about child benefits, please refer to: http://www.cra-arc.gc.ca/E/pub/tg/t4114/t4114-07e.pdf

A Detailed Look at RESP Changes

2007-07-01T14:42:00.001-04:00

There are a number of changes to the RESP program in the 2007 budget and they are:

Eliminating yearly $4000 contribution limit, allowing the subscriber to make a large lump-sum purchase;
Increased lifetime maximum contribution limit from $42000 to $50000;
Increased annual maximum CESG per beneficiary from $400 to $500;
Increased the maximum CESG per year from $800 to $1000 for “catch-up grants”;
The maximum lifetime CESG limit remains unchanged at $7200Relaxed EAP requirements for part-time students. Previously, part-time studies requires at least 10 hours per week of study. Under the new change, part-time students requires at least 12 hours per month to be spent on the courses. They will be able to receive up to $2500 of EAP’s for each 13-week semester of part-time study.

The changes open up some interesting options for families who can afford a larger lump-sum payment. Note that if you contribute above the CESG grant level for the year ($1000 if you have unused room), the extra contribution will not be subject to grant. However, the benefit of forgoing the CESG in early years may outweigh the CESG because income generated within RESP is tax deferred. We will look at two scenarios to explain the potential benefit of forgoing some of the CESG.

Scenario 1

A family who just started an RESP plan for a new-born child has some cash available. They made a lump sum maximum contribution of $50,000 and expect to stay in the plan for 17 years until withdrawal. Their first contribution is subject to only $500 CESG and no more grant is received in later years.

Assuming 8% rate of return, the value of the plan will be about $186,851 after 17 years.

If the family decides to take maximum CESG available while maximizing their $50,000 lifetime RESP limit, they will contribute $3500 for 14 years and $1000 in the 15th year. They will receive $500 CESG for the first 14 years and $200 in the 15th years, thus maximizing lifetime CESG of $7200.

Assuming the same rate of return, the value of this plan will be about $123,414 after 17 years.

Scenario 2

A family who has been maximizing CESG each year for their son who is currently age 10 has two options available. The current value in the plan is $30000. They currently have enough cash to make a lump sum contribution to maximize their RESP limit forgoing future CESG, or they can also spread out remaining lifetime contribution over 7 years so they can maximize the CESG.

Assuming 6% rate of return, the value of the plan will be $90,218 when the child turns 18 with the lump sum method.

If the family takes the maximum CESG benefit, the RESP will be valued at $84,979 when the child turns 18, assuming the same rate of return.

Conclusion

I welcome the changes in RESP, especially lifting the maximum yearly contribution limit. This allows families to have more flexibility in RESP contributions and maximize the advantage of tax-deferral. The yearly CESG upgrade is nice addition for those who wish to make the most out of CESG.

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice includ-ing, without limitation, investment, financial, legal, ac-counting or tax advice. However, please call Henry Lum to discuss your particular circumstances.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus be-fore investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corpora-tion or by any other government deposit insurer. There can be no assurances that the fund will be able to main-tain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated.

Budget 2007

2007-07-01T14:05:00.001-04:00

On June 22, 2007, the budget bill C-52 has received Royal Assent. The bill includes many of the proposals in the 2007 budget.

Relevant items that are now law are as follows:

Increased lifetime contribution limit for RESPs and eliminated annual contribution limit; relaxed EAP eligibility requirements for part-time students;
New non-refundable child tax credit; $2000 claim per child under age 18 and this credit is available at all income levels. The tax credit translates into $310 per year at 15.5% federal tax rate;
Increased age limit for RRSP contributions to age 71;
Pension income-splitting for seniors effective in 2007;
Increased age credit;
Increased spousal tax credit to match with the personal amount. Previously, spousal tax credit is less than the personal amount and it was commonly known as the marriage penalty for a single-earner family;
Tax on income trusts;

There are certain proposals in the 2007 budget that were NOT included in this budget bill. They are expected to be included in a subsequent bill and will become law subject to the passing of the bill. Some of the relevant items are:

Working income tax benefit for low-income working Canadians;
New Registered Disability Savings Plan;
Increase in lifetime capital gains exemption (from $500,000 to $750,000) for qualified small business cooperation;
Eliminating capital gains tax on gifts of publicly-listed securities to private foundations;
Exemption of federal tax for elementary and secondary school scholarships.

Tax Rate for 2007

Combined federal & provincial tax rates including surtaxes for Ontario only:
first $35,488 21.55%
$35,488 -> $37,178 24.65%
$37,178 -> $62,485 31.15%
$62,485 -> $70,976 32.98%
$70,976 -> $73,625 35.39%
$73,625 -> $74,357 39.41%
$74,357 -> $120,887 43.41%
$120,887 and above 46.41%