Wednesday, June 30, 2010

Tackling the Taxman

From first-hand experience, I can tell you that dealing with the Canada Revenue Agency (CRA) can be bewildering. I would have to say that just about all the CRA people I have spoken to seem motivated to help me, but they all seem to disagree with each other. In his book Tackling the Taxman, Alex Doulis gives a host of examples where CRA employees don’t seem as willing to be helpful as I’ve found them to be.

This book may actually be mistitled because most of the CRA people I’ve spoken to are women. However, given the tone of this book, my guess is that these women don’t mind being left out of the accusations.

It’s clear that Doulis knows a great deal about income taxes and the dispute process between CRA and taxpayers. The parts of the book that explain these matters are very useful. However, the bulk of the book is a collection of stories of serious misdeeds by CRA employees. These stories are entertaining, but they don’t have quite enough detail for the reader to figure out exactly where the truth lies. Have a read and decide for yourself.

One important point Doulis makes is the distinction between an audit and an investigation. If you are being audited by CRA, you are required to turn over information related to your income and deductions. This information is not supposed to be used to lay charges against you. If you are being investigated, then you aren’t required to be as forthcoming with answers to investigators’ questions.

For those who move around from country to country, it can be difficult to determine which country should collect income taxes. An important difference between the US and Canada is that the US “bases taxes on citizenship”, and “Canada bases tax liability on residency.”

Doulis claims that “tax collection is a business” and that tax collectors don’t like to spend time on a particular case unless the amount of tax recovered is likely to be above a threshold amount. Once a CRA employee invests time in you, he or she is then motivated to find some reason to demand more taxes. Doulis says that for this reason, you should try to end an audit as quickly as possible.

Some CRA misdeeds: “It doesn’t seem to matter that CRA has been told not to use audits to seek third-party information, pursue high-profile Canadians, or have investigators masquerade as auditors; it is continuing as you read this.”

The book finishes with a strong pitch for a flat tax. One thing that I’ve figured out about the various people who advocate a flat tax system is that they all seem to mean something different by “flat tax”.

Most people would prefer not to get into a dispute with CRA, but if you do, you’ll want to understand some of the things this book explains about the dispute process.

Big Cajun Man also reviewed Tackling the Taxman.

Tuesday, June 29, 2010

RRSP vs. CPP

A reader, Andi, is concerned about the value CPP gives for the money contributed. Andi sent a detailed analysis comparing RRSPs to CPP that can be summarized as follows:
If I could take all the CPP payments I’ve made and will make and instead invest them in my RRSP, the investment returns in the RRSP would make me far more money than I’ll ever get from CPP benefits.
Assuming Andi is one of the few who has the discipline to stick with a reasonable portfolio through thick and thin, the conclusion that the RRSP approach would beat CPP is very likely true. The problem for government is that the majority of investors will make an anaemic return on their money due to paying huge fees on mutual funds, failed market timing attempts, and so on.

Even worse, many people would simply dip into their RRSPs either out of true need or simply a desire for more consumption. Eliminating CPP would leave governments with a big problem. We can’t have huge numbers of older citizens no longer able to work lying around in the streets starving. So, the government would not have any CPP income and would still have to bail out some fraction of retirees with some sort of minimal payments.

The next suggestion is to allow people to opt out of CPP. The problem here is that it won’t be just those who can manage their money well who will opt out; many of those who opt out will end up needing help in old age. The opt-out strategy wouldn’t solve the government’s problem at all.

Some commentators suggest that people should take personal responsibility and accept the consequences of their actions. This sounds good until you think of the reality of an explosion of elderly beggars clogging our streets.

It is doubtful that CPP will ever be scrapped or made optional unless it is replaced with some other similar mandatory scheme. If anything, CPP is likely to expand over time.

Monday, June 28, 2010

CPI-Indexed Life Annuities

Update: Annuity payment rates for one insurer are at the end of this post.

The Canada Pension Plan (CPP) is essentially a CPI-indexed life annuity. Your CPP benefits are determined based on your contributions during your working life, and once payments start they rise with the consumer price index (CPI) each year. CPP payments may not be large, but their purchasing power remains constant for the rest of your life. This brings considerable peace of mind.

For people who have built their own savings over the years without the benefit of an employer defined-benefit pension plan, it’s natural to consider turning a large lump sum of savings into a CPP-like CPI-indexed life annuity. This would eliminate having to worry about investing and would eliminate concerns about outliving your money or losing ground to inflation.

I wouldn’t want to tie up all my savings in an annuity, but I can see the appeal of allocating a portion to an annuity so that the combination of CPP and annuity payments would guarantee a “necessities” level of income for the rest of my life.

The last time I wrote on this subject I couldn’t find a life annuity in Canada whose payments were indexed to inflation. However, in Jonathan Chevreau’s recent Financial Post article, he explains that “most Canadian insurance companies don't sell true inflation-indexed annuities”. The implication is that some insurance companies do sell inflation-indexed annuities.

I tried harder to find a seller in Canada and finally found Standard Life Canada’s annuity page. Among the many choices is a fully CPI-indexed life annuity. The next questions are

1. What does “fully indexed” mean? Is there some sort of cap on inflation adjustments?

2. What monthly payments can one get for a given lump sum?

Unfortunately, Standard Life Canada does not sell directly to the public. They only sell through licensed advisors. Are there any licensed advisors in the house willing to find out what “fully indexed” means and whether payment increases are capped? As for the payment levels, I think quotes for the following three situations would be instructive:

– 3 cases: Single life annuity (woman or man) or joint life annuity
– Age 71 (when RRSPs have to be rolled into RRIFs)
– $100,000 in an RRSP
– Fully CPI-indexed
– No guarantee period or other options

According to Chevreau’s article, advisors prefer to sell different products that generate higher fees, but perhaps we will get lucky and an advisor will dig up some useful information on these CPI-indexed annuities.

Update: I received the following quotes for a $100,000 lump sum from Standard Life (accurate on 2010 July 7):


71-year old male: $522 per month
71-year old female: $470 per month
71-year old couple: $468 per month (40% reduction on first death)
71-year old couple: $388 per month (no reduction on first death)

The time to break even on these payments is 16, 18, 18, and 21.5 years, respectively.  The CPI increase is exactly equal to the officially-reported CPI increase except that any CPI decrease would not lead to a decrease in payments, but would be used to offset future CPI increases.

Friday, June 25, 2010

Short Takes: Pleasure from Following the Crowd, Blocking a Mutual Fund Report, and more

1. Jason Zweig at the Wall Street Journal reports on research into why it feels good to follow the crowd. Unfortunately, following the investing crowd is a formula for losing money.

2. Jonathan Chevreau reports that the Investment Funds Institute of Canada tried to block a Morningstar report on fund stewardship.

3. Scott Adams explains how “withdumb” leads to poor investing decisions.

4. Preet explains that the cost of the fake lake is barely a drop in the bucket of the total cost of the G8 and G20 summits.

5. Thicken My Wallet explains some of the legal defences investment advisors can use when facing accusations of misconduct.

6. Larry MacDonald isn’t taken by the “sell in May and go away” investment strategy.

7. Canadian Capitalist looks at the financial side of buying vs. renting a hot water heater.

8. With the earthquake in the nation’s capital, Big Cajun Man takes a look at earthquake insurance.

9. Gail Vaz-Oxlade explains how credit card companies calculate interest.

10. Frugal Trader got quite a response to the question of whether it makes sense to increase the Canada Pension Plan.

11. Canadian Mortgage Trends reports on the disagreement between Canada’s Privacy Commissioner and the Canadian Association of Accredited Mortgage Professionals over whether Social Insurance Numbers should go on mortgage applications.

12. Financial Highway explains some of the pitfalls of using debit cards.

Thursday, June 24, 2010

New Marketing Strategy from RBC

I’m getting used to the periodic phone calls from the Royal Bank to discuss the products I have with them. However, their latest contact by snail mail adds a new twist.

The RBC phone calls I get seem aimed at getting me to use more RBC products and always end with a pitch for a credit card. These calls are awkward because I don’t want to say too much until I’m sure that I’m really talking to a Royal Bank representative, and the person at the other end is trying to pretend to be interested in helping me save money, but is really interested in selling more products. The calls end when I’m sure that there was no important reason for the call.

My latest contact from RBC is a letter with the following printed in large bold letters at the top:

“Meet with your RBC Advisor before August 10, 2010 to review your ... . Please book your appointment today.”

The body of the letter repeats the deadline and adds even more of a sense of urgency. I wouldn’t blame people for reading this letter and thinking that they should call the phone number listed to see what is wrong. The deadline is the part that really sells the feeling of urgency.

I’m going to assume that this is just an attempt to get me in to meet face-to-face with someone who will try to sell me more products. It’s either that or I’m going to pass up my last chance to stop my financial world from crumbling down.

Wednesday, June 23, 2010

Chuck it All and Buy GICs?

It's possible to make a reasonable argument that the average investor would be better off investing in GICs than stocks and bonds. Unfortunately, David Trahair fails to make this argument well in his book Enough Bull: How to Retire Well Without the Stock Market, Mutual Funds, or Even an Investment Advisor. So, I'll try to make it for him.

The main argument in favour of investing in stocks is their higher expected returns (called the risk premium) than guaranteed investments like GICs. However, the typical Canadian investor working with a financial advisor is invested in balanced mutual funds (half stocks and half bonds) and pays yearly fees in the 2%-3% range. To these fees we can sometimes add front-end loads and deferred sales charges. On top of that we can add the losses that come from panicking and selling at the wrong times.

Taken together, these costs eat up the risk premium. This type of investor very likely is better off with bank GICs as long as they are held in tax-advantaged accounts and the investor learns to negotiate for the best possible GIC interest rates.

Where this argument falls down is that there is another approach to investing that doesn't involve giving away your risk premium to financial “helpers”. It is called indexing. Just take your retirement savings and buy a mix of low-cost index funds. Returns will be more volatile than GIC returns, but they are very likely to be higher over the long run as long as you don't panic and sell your index funds when they are cheapest.

So, Trahair is right to compare GICs favourably to high-cost mutual fund investing, but wrong to suggest that GICs beat the simple indexing approach. The main failing of his argument is that he ignores the dividends that stocks pay. This is like saying I'm a better basketball player than Kobe Bryant if he doesn’t use his hands.

For the rest of this review, I’ll look at a few specific parts of the book.

It's different this time

Right in the first paragraph, Trahair makes the oft-repeated mistake of thinking that things are different this time: “The old rules regarding personal finance are now history, as in obsolete”, due to the 2008 stock market drop. Long-time investors know that recent history is not a good guide to the future.

Inflation

When it comes to answering criticisms of the 100% GIC approach, Trahair calls discussions of inflation a “red-herring”. It's true that inflation affects all investments, but we should be looking at real returns (returns after taking into account inflation). When Trahair implores you to “sleep at night knowing your investments will NEVER decline”, he is ignoring the fact that GIC investments can decline in terms of real purchasing power if inflation exceeds the GIC return.

To support the idea that today's very low GIC returns may rise in the future, Trahair points to the past: “Do you know what annual interest rate a GIC was paying in 1980? It was 12.36%.” Well, inflation was 10% in 1980. Many investors who had to pay income taxes on GIC interest lost purchasing power. What matters is the difference between GIC returns and inflation.

Dividends

Trahair compares historical GIC returns to historical increases in the S&P TSX Composite Index of Canadian stocks, but the problem is that this index does not include the dividends from the companies making up the index. This error alone casts doubt on the author’s competence to advise people about investing.

Personal Investing Experience

The book contains a detailed account of the author's own experience investing in equities, which was dominated by Labour-Sponsored Investment Funds (LSIFs). LSIFs are known to be very risky. Governments have had to entice investors with tax breaks to generate interest in LSIFs. Investing in low-cost equity index funds is a very different game.

Advice on Stocks

Due to the stock market performance of 2008, Trahair says “Here's my advice: get out of equities altogether if you can.” Since the end of 2008, the S&P TSX Composite Index of Canadian stocks has gone up about 37% (including dividends). Nice call.

Conclusion

Trahair has a point that the typical mutual fund investor could do better. However, better means a low-cost indexing approach rather than hiding from the world with 100% of long-term savings in GICs.

Other reviews of this book:

Canadian Capitalist
Balance Junkie
Canadian Dream: Free at 45

Tuesday, June 22, 2010

Costly Liars at the Front Door

The Ontario Energy Board is seeking a $495,000 penalty against Summitt Energy for unfair practices in their business of trying to sign people up for 5-year fixed price contracts for gas and electricity. Ellen Roseman reported on this and the detailed allegations can be found here.

Here is my favourite allegation:

“AB attended at the residence of T.V. in Pickering, Ontario. He did not identify himself as being a sales agent from Summitt but rather stated he was a representative of Veridian, the local utility in Pickering. AB told T.V. that he had just changed the meter outside her home and she needed to sign a document to prove that he had attended at the residence. He did not explain that the document was for a five year fixed price contract with Summitt for the supply of natural gas and electricity.”

I don’t think most of us are prepared for brazen lying of the type alleged here. I expect people to shade the truth a little, but just don’t expect something like this while speaking face-to-face with someone who seems friendly enough.

The lesson is that we should read documents carefully before signing them regardless of what we’re told they contain. This is doubly true when the document is presented by a stranger at your door.

The sad truth is that if Summitt’s current practices are still profitable after taking into account this fine, then they have no reason to change anything. Businesses seek profit within the rules imposed on them. Businesses aren’t people. They aren’t friendly or considerate or evil. They are just machines that seek profit. We need laws that make unsavoury practices unprofitable. Hopefully the Ontario Energy Board’s actions are a step in the right direction.

Monday, June 21, 2010

Reducing the Cost of Air Conditioning

The best ideas for protecting the environment are the ones that save money as well. It’s hard to get people to spend more money for the good of the environment, but it can be easy to get them to save some money if it’s painless.

Currently, the typical air conditioning system in most homes cools the entire house to a temperature set by a thermostat. In some cases, this chosen temperature varies throughout the day. However, this system is inefficient in two ways:

1. At night, most people set the thermostat lower for sleeping, but they really only need the bedrooms cooler, not the rest of the house. My air conditioner often works in the evening for several hours cooling the whole house down by two degrees. Some automated venting could concentrate the cool air in just the bedrooms to greatly reduce power consumption and save money.

2. Humidity is a big factor in the perception of temperature. But, thermostats only let users select a temperature. There are times when 26 degrees feels too cool and other times when 22 degrees feels too warm because of humidity differences. Another possible factor in the perception of inside temperature is the outside temperature. It seems foolish to sit in an air-conditioned house feeling cold sometimes because the thermostat can’t be set to match the way people perceive temperature. At a minimum, thermostats need to take into account humidity.

Solving these problems could cut down significantly on power usage and make us more comfortable in our homes at the same time. Automated venting would involve some cost, but adding a humidity sensor to thermostats can’t be too costly. Government support for solutions like this might get more support from homeowners than some current efforts to drive adoption of thermostats that allow the government to turn off your air conditioning remotely when they judge it necessary.

Friday, June 18, 2010

Short Takes: TFSA Fiasco, Grow-Op Mortgage, and more

1. Over 70,000 Canadians were hit with taxes for over-contributing to their TFSAs. Here is a selection of articles on the subject:

Canadian Tax Resource: Letter To Jim Flaherty on TFSA Over-contribution Penalties
Canadian Capitalist: Apply for waiver of TFSA over-contribution penalties
Rob Carrick: Taxman may forgive TFSA rule breakers
Ellen Roseman: Lisa’s story: Charged $1,240 for TFSA over-contribution
Michael James on Money: TFSA over-Contribution Tax can Apply to an Empty Account

2. Royal Bank and BMO lent money to a grow-op. Oops.

3. Thicken My Wallet has some sound advice for the self-employed with 10 things he wishes someone had told him when he started a business.

4. Larry MacDonald reports on the problem at the US Securities and Exchange Commission (SEC) where employment is a revolving door of employees who jump to the industry the SEC is supposed to regulate.

5. Preet interviewed Mark T. Williams, author of Uncontrolled Risk.

6. Big Cajun Man makes the case for paying yourself first using an automatic bill payment system.

7. Frugal Trader updates the state of his Smith Manoeuvre Portfolio and includes a disclaimer that should scare most investors away from trying this manoeuvre.

8. Mr. Cheap argues the merits of “under promise and over deliver”. Makes sense to me.

Thursday, June 17, 2010

Taxing the Rich

A reader of this blog, Chris, posed the following thoughtful question:

What do you think the implications would be if Canada were to implement more tax brackets? For example, if federal tax tiers were added at $200k and $300k with a federal rate of say 33% and 37% respectively?

I'm not sure why the government hasn't gone in this direction because the majority of voters are not anywhere near these levels. This would help redistribute the tax burden and work down more of the country's debt.

It's always tempting to tax the rich more. This idea isn’t new. In fact, back in 1963 Quebec's top marginal tax rate was over 93%!. This rate applied to income over $400,000 (the equivalent of about $2.9 million today).

Chris's proposal is certainly a lot less punitive, but it still represents a significant tax increase for wealthier people. However, the world is a much different place than it was in 1963. The wealthy have much more freedom for where they choose to live and where they produce their income. So, even if you believe in taxing the rich more, many of them have the ability to simply leave the country if they can find a better tax deal elsewhere. I don't know whether this exodus would be large enough to make a big difference, but it is something to keep in mind.

As an example of a wealthier person who chose where to live based on tax considerations, a former colleague of mine with a large number of stock options chose to live a few years in a country that didn't tax his stock option gains. Once he satisfied the rules for having been out of Canada long enough to avoid paying Canadian taxes on the income, he came back.

Another thing to consider is that people who are able to get themselves into a position to earn large incomes also tend to have the savvy to influence the political process. So, even if taxing the rich more is the right thing for the country, the wealthy people who would be affected are likely to mount an effective opposition to this change.

Deciding exactly how much to raise taxes on the rich without causing undesirable side effects is a difficult question that I can't answer.

Wednesday, June 16, 2010

Retirement Dreams Clash with Economic Reality

Canadian Financial DIY had a thoughtful piece about pension reform and what retirees need that will resonate with many Canadians. An important consideration for any such plan is whether it is economically viable.

The plan calls for replacing 40-45% of pre-retirement income adjusted for inflation for the rest of the retiree’s life. This is a significant increase over the existing Canada Pension Plan benefits. Let's assume that this change in benefits will be achieved by expanding CPP and that it will be fully funded by sufficiently large deductions from everyone's pay cheques to pay for these retirement benefits.

I'm assuming that the 40-45% replacement figure is intended to apply to your income in the last few years of working, which is generally more than the average income over your working life (even adjusted for inflation). So, let's say that your yearly retirement benefits will be 50% of your average lifetime inflation-adjusted income.

Let's also assume that the average Canadian works for 40 years and is retired for 20 years. Then you need to save enough in two years of working to pay for one year of retirement income. This means that CPP contributions will need to be half of the retirement benefit, or 25% of income. Income taxes complicate this calculation. In reality, CPP contributions may only need to be about 20% of your gross income.

Currently, the total of the CPP contributions you and your employer make are only just under 10% of your gross income, and this is only for income below the current cap. This cap would have to rise to give any real meaning to the 50% replacement figure, and now we're talking about doubling CPP contributions for low-income Canadians and more than doubling them for middle- and higher-income Canadians.

All this may well be sensible, but it won't be cheap. The more modest CPP changes that Canadian Capitalist reported on are much more likely to be adopted.

Another thing to consider in this discussion is that if we adopt a system with higher CPP contributions and benefits, the higher benefits would only apply to people who pay the higher CPP contributions for their entire working lives. If these plans were adopted today, current retirees would get nothing extra and those close to retirement would get little extra.

Any plan that gives current retirees and those near retirement significantly higher benefits must necessarily be paid for by others. Those others are young people. I wonder how much we can tax these young people to pay for lavish retirement benefits before they revolt.

Tuesday, June 15, 2010

What Americans Need to Know about Canada

Former columnist for the Montreal Gazette, Bill Mann, has started a new Canada Watch blog at Dow Jones' MarketWatch.com site.  Take a look and see what Mann thinks Americans need to know about business in Canada.

In his first blog entry, Mann has a "did you know?" list of Canadian facts.  My favourite is "Canada has had only one bank failure in history (and none recently)."

Uncontrolled Risk

The credit crisis that exploded in 2008 affected people across the planet, but few of us understand what happened to cause it all. Risk management expert Mark T. Williams wrote the book Uncontrolled Risk that tells the story of Lehman Brothers’ fall and more generally the events leading to the credit crisis. More than just a chronology, Williams explains why events unfolded as they did and why Canada’s banking system survived largely unscathed.

Taking on too much risk in mortgage-backed securities led to the downfall of Lehman Brothers, a 158-year-old financial institution. With increased risk comes higher profit, but also greater chance of total failure. Lehman lost the gamble that in the case of imminent failure the US government would judge it to be “too big to fail”.

Here are a few parts of the book that I particularly liked:

CEOs with too much control

In the last couple of decades “shareholders became less hands-on and showed displeasure not by voting out directors but rather by selling stock. As shareholders became more removed from deciding how companies were structured and run, CEOs enjoyed more latitude in their decisions.”

“Unfortunately, some boards have developed into an extension of a CEO’s friendship network instead of an independent governing body that ensures shareholder interests are put first.”

Change that led to the crisis

When banks made decisions about granting mortgages, they used to have to live with those decisions for up to 30 years. But mortgage-back securities “allowed lenders to package and sell their loans, severing the accountability between those who created the risk and those who assumed it. Banks and other lenders could pass the risk down the line to further removed and often less-informed investors.”

Risk measurement

One measure of risk level is called value-at-risk (VaR). This measure has been criticized as a measure that is only accurate when markets are calm. David Einhorn, a short-seller of Lehman Brothers’ stock, is quoted as saying that VaR is like “an airbag that works all the time, except when you have a car accident.”

Two-faced banks

Banks that accepted government bailout money “continue to express public support for re-regulation of the financial markets while their paid lobbyists attempt to defeat or weaken any new regulation.”

The book concludes with ten recommendations along with strong praise for Canada’s banking system and its regulatory body. Overall, this book is a must-read for anyone with a strong interest in the causes behind our recent financial turmoil.

Monday, June 14, 2010

TFSA Over-Contribution Tax can Apply to an Empty Account

Canadians who contribute too much to their Tax-Free Savings Accounts (TFSAs) are subject to a 1% tax each month on the over-contribution. A quirk in the way that this tax is calculated means that it is possible to be in a state of “over-contribution” even after emptying out a TFSA.

The rules for how to calculate the TFSA over-contribution tax are explained in the form RC243-SCH-A Schedule A - Excess TFSA Amounts. How these rules can lead to getting taxed on an empty account is best explained with an example.

Sally opened a TFSA in January 2009 with the plan to invest in ABC stock. She opened an account and deposited her TFSA limit of $5000. Unfortunately, there was a misunderstanding with their bank and the account was not a trading account.

Sally withdrew the money, opened a self-directed TFSA, and deposited the $5000 not realizing that this was considered an over-contribution. The withdrawal amount of $5000 was added to her 2010 contribution room, but was not available for the rest of 2009. She could have made a proper transfer between TFSAs but didn’t realize that this would make a difference.

She went on to buy $5000 worth of ABC stock. Toward the end of January, she found out that she had made a TFSA over-contribution of $5000 and would pay a $50 tax each month. So, she sold the stock and withdrew the proceeds from her TFSA.

Unfortunately, ABC stock had lost 20% of its value before she sold it. Her withdrawal was only $4000. So, by the TFSA rules, she still had an over-contribution of $1000 as of the end of January. This was true even though the account was empty!

In addition to the $50 tax for January, Sally was hit with another $10 tax for each of the remaining 11 months of the year. At least the pain stopped in January 2010 when she got more TFSA room and the over-contribution tax stopped at a total of $160.

This type of situation seems like a logical case to waive penalties for the rest of the year, and it could be that CRA has policies to deal with empty TFSAs, but there is nothing in the information I’ve read about the 1% tax that allows for leniency when the TFSA is empty.

Friday, June 11, 2010

TFSA Over-Contributions may be Over-Penalized

Update:  I've now checked the TFSA tax calculation for 4 people and only one was incorrect according to CRA's rules.

One Canadian who goes by the handle Ref seems to have discovered a bug in CRA’s calculations of TFSA over-contribution taxes. From Ref’s calculations, it seems that CRA did not give him proper credit for removing excess TFSA contributions and continued applying the 1% tax each month even after the excess was removed. It's not clear how widespread this problem is.

The confusion many people are having with Tax-Free Savings Accounts (TFSAs) is that if you make a withdrawal, you can put the money back, but not until the next year. CRA hits you with a 1% tax each month on any excess amount in your TFSA. But, CRA is supposed to stop charging the 1% tax after the excess contribution is withdrawn according to their RC243-SCH-A form for excess TFSA amounts.

Let’s try a simple example. Sally heard great things about TFSAs and decided to open an account and make a contribution:

2009 Jan. 19: Deposit $5000

Sally has used all her available TFSA room for 2009. However, the next day she found out about a better TFSA account that pays higher interest:

2009 Jan. 20 Withdraw $5000

This gives Sally $5000 of new TFSA room, but not until 2010 when she will have this $5000 plus 2010’s allotment of $5000 for a total of $10,000 worth of room. Not realizing this, she puts the money in her new TFSA the next day:

2009 Jan. 21 Deposit $5000

Sally has now over-contributed by $5000. She will pay a 1% tax ($50) on this over-contribution for January. Sally could have avoided this problem by making an official TFSA transfer rather than a withdrawal and deposit. Sally realized her mistake:

2009 Jan. 22 Withdraw $5000

The TFSA is now empty and according to CRA’s RC243-SCH-A form for excess TFSA amounts, Sally’s tax on excess contributions should stop at $50. However, the method CRA seemed to use to calculate the extra tax for one taxpayer who uses the handle Ref would have Sally paying a total of $600 in taxes because she wouldn’t get credit for the last withdrawal for the months from February to December.

The first clue that something is amiss was the number of people complaining about over-contribution tax amounts exceeding $600, but claiming to have never had more than $5000 in their accounts. Some of these complaints can be found among the comments on this open letter to Jim Flaherty.

Ref produced a spreadsheet to exactly match CRA’s tax demand. Ref modified the numbers a little to protect his or her privacy before sending me a copy. The modified numbers lead to a tax demand of $796, but the actual tax amount owing should be only $367 according to calculation method in CRA’s own example.

Without further confirmation, we can’t be sure that CRA has made mistakes here, or how widespread the problem may be.

I’d be interested in hearing from anyone willing to share their over-contribution tax calculations to confirm whether CRA is doing them incorrectly. I don’t want to see names, SINs, or anything else personal. I’d just like to see the trail of deposits, withdrawals, and the tax calculations. If you’re willing to help, you can send me information at michael.james.money at gmail.com.

Short Takes: TFSA Over-Contributions, HST, and more

1. A great many Canadians have been caught by the TFSA contribution limit rules. If you make a withdrawal, you can put the money back, but not until the next year. If you put the money back right away or generally treat a TFSA like a regular savings account, you could be hit with steep over-contribution taxes at 1% per month. Tax Guy drafted an open letter to Jim Flaherty asking for leniency for the many caught by this rule. CRA’s description of how to calculate the over-contribution tax is fairly clear. It seems that some financial institutions protected customers from these problems and some did not.

2. Canadian Capitalist generated some spirited discussion about how the HST will affect people.

3. Guest writer Rachelle at Money Smarts wrote a funny piece about the tenant from hell: the stripper with dirty feet.

4. Canadian Financial DIY has launched a comparison of cap-weighted vs. fundamental index portfolios. He plans to report the progress of these portfolios taking into account realistic costs such as MERs, trading commission, etc.

5. Big Cajun Man had some fun with his top 10 list of excuses for being in debt. This is definitely different from the standard lists.

6. Mark Wolfinger is running a contest to come up with a name for his style of options trading. Mark aims to use stock options for conservative investing strategies and seeks to distinguish his approach from wildly speculative and risky option trading.

7. Preet outlines the pros and cons of different financial advisor compensation options. I find Preet’s insight and willingness to share information on this topic a rare combination.

8. Are you trying to decide whether to get a 3-D television set? Larry MacDonald has some information you should consider about 3-D televisions.

9. Frugal Trader addresses how to determine if the Smith Manoeuvre is for you.

10. Who wants to just be average? Larry Swedroe explains why achieving the stock market average return is actually a well above average result.

Thursday, June 10, 2010

New Credit Card Minimum Payment Rules

In response to new government regulations on credit cards, credit card companies are changing their minimum payment rules and their interest rates. In general both are going up.

I don’t have many credit cards and only use one regularly, but my rarely-used Sears card is the first one to send me details on changes that will be effective in September. My nominal interest rate will rise from 28.8% per year to 29.9%. The actual yearly rate with monthly compounding is going from 32.9% to 34.4%. These rates are extremely high, but not too different from each other.

For balances over about $1000, the minimum payment is going from 3% of the new balance to the sum of the month’s interest plus 1% of the new balance, which works out to about 3.5% of the new balance. This is about a 17% increase in minimum payment.

The part of the new minimum payment calculation that is 1% of the new balance is actually the maximum of $10 or 1%. This may not seem like a big deal, but it significantly reduces the length of time it takes to pay off a balance assuming no new purchases and only paying the minimum. This has been a common source of criticism of credit cards, and the new minimum payment shortens the pay-off time considerably.

These changes seem quite modest. I suspect that the majority of consumers will find their interest rate and minimum payment changes fairly painless, but there are likely to be outliers who will see big changes that they have difficulty handling. Of course, it is best to pay off cards in full each month, but it seems that many can’t or won’t follow this sage advice.

Wednesday, June 9, 2010

CRA Decision Making

Organizations are collections of individuals who don't necessarily agree on all things. This is very evident at the Canada Revenue Agency (CRA). You can call multiple times with a complex tax question and get a different answer each time. The only important answer is the one that is made in actually assessing a tax return, but it seems impossible to access this answer until you actually file the return.

I am caught in a complex tax situation where the latest federal budget changed the rules so that I will owe much less money. Technically I'm supposed to pay the large sum, wait for the appropriate budget legislation to pass, and then re-file my 2009 income taxes and get the money back.

If lending a large sum of money to CRA only to get it all back again later sounds insane to you, I agree. I decided to contact CRA to see if a more reasonable approach was possible. After penetrating the first few layers of CRA phone help the pleasant senior tax person I spoke to agreed that the temporary loan made little sense.

She went away for a day or so to find out whether I could avoid paying the large sum just to get it back later. She came back and said that she had consulted with the appropriate group and that there were many people in my situation. If I filed my taxes in the way she described (which I did) my return would be set aside until the tax legislation passed at which time my return would be assessed.

Predictably, things have not played out in the way I was told they would. My return was assessed right away and the CRA machinery is demanding its money. The demand came with a leaflet explaining the steps CRA follows to get its money. This information is both illuminating and intimidating. I'm left wondering whether I can still expect that people in my position will be handled later when the tax legislation passes or whether the full force of CRA tax collection will be aimed at me in a month or two.

Eventually, I will call CRA to try to find out what is going on, but I'm not sure I will be able to rely on whatever new answer I get. If someone could have told me in April that I would have to pay the large sum of money, at least things would have been clear even if I didn't like the answer. I would have headed down to my bank to open a mortgage planning to close it a few months later (grumbling about CRA the whole time).

My complaint isn't that I don't like CRA's decision. My complaint is that I don't know what CRA's decision will be. And I know of no reliable way to find out what their decision will be. If I thought this was a case of CRA having just changed their minds, I could live with that. But my assessment showed no evidence that the extra documentation I was told to send in was ever received.

I can understand that CRA must hire a huge number of people at tax time and that CRA can't be held responsible for the many wrong answers these people give. However, when the amount of money at stake is very large, it would be nice if it were possible to get access to correct answers.

Tuesday, June 8, 2010

Test Driving DIY Investing

Many people asking me about do-it-yourself (DIY) investing. Despite their initial interest, the usual result is for these investors to take no action and continue investing in expensive mutual funds. This has caused me to rethink how best to approach the subject. I now think that investors might be best to try easing into DIY investing rather than deciding whether to make one big jump.

To illustrate how these interactions between me and a curious investor tend to go, I'll describe the case of a particular investor and acquaintance of mine who I'll call Sam. Sam said he heard that I write a Money blog and wondered if I might advise him on whether he needs to change anything about his investments.

Sam had a financial advisor who he seemed to like on a personal level but didn’t make him feel comfortable about his investments. Sam couldn't understand much of what was on his multi-page account summary other than the dollar amounts that weren't going up as fast as he hoped. Sam owned several mutual funds with impressive-sounding names and impressively high MERs.

I looked up Sam's mutual funds for him to show him how they were split between stocks and bonds, and how much he paid yearly in MER fees to own these funds. Then I showed him how he could replace these mutual funds with index ETFs or index mutual funds that have the same mix of investments but are much cheaper to own.

Sam pondered all this information and asked a few more questions about the mechanics of opening a discount brokerage account and making trades. Then he froze and chose to do nothing. My efforts did little other than leave Sam with vague guilt that he should do something, but he was afraid to do anything. I'd like to think that he decided that his financial advisor was doing a great job and that Sam should stick with him, but that was definitely not the case.

I think what froze Sam was too many new things at once. He was uncertain about whether he had the temperament to handle DIY investing, he didn't know how to open the new accounts he would need, and he didn't know for certain whether low-cost funds really were likely to outperform his active mutual funds over the long run.

Instead of trying to decide whether to make all the changes at once, Sam would likely have been better off easing in slowly. He could have opened a single account with a discount broker and put a modest sum into it while continuing to hold his mutual fund portfolio with his advisor. Then he could have purchased a single ETF with the money and watched it for a few months (or longer).

Having become comfortable with some aspects of DIY investing, Sam would then have been in a much better position to decide whether to expand his DIY side or shut it down. So this will become my new mantra with people who ask me about their investments. I still prefer to explain things rather than tell people what to do, but I will suggest sticking just a toe into DIY investing first rather than trying to decide between doing nothing or plunging in all at once.

Monday, June 7, 2010

Scary ETF Stories

The market volatility on May 6th illustrated that wild gyrations in the stock market can affect exchange-traded funds (ETFs) as well as individual stocks. In particular, ETFs can trade at prices that differ from the value of their underlying holdings when markets get crazy enough.

Canadian Capitalist's latest roundup of interesting investing articles pointed to a Wall Street Journal piece that explained clearly what happened on May 6th. It went on to give 5 rules for trading ETFs and suggested that investors stick to mutual funds if they don't understand the technical details. I think there is some middle ground. Long term investors in broad index ETFs can protect themselves without gluing their noses to computer screens monitoring ETF data.

If you're an ETF day trader who jumps in and out of ETFs multiple times per day, or you like to place stop-loss orders on your ETFs, then I can't help you other than to suggest reconsidering your investing approach.

The first thing to observe is that if you own ETFs and their prices jump around wildly for a while and then return to their former levels, you can't be hurt unless you make trades. You may lose an opportunity to exploit the mistakes of others, but you won't lose if you don't play. So, there is no need to watch out for extreme volatility unless you have money to place in the market or want to take money out.

One investor was quoted as saying "I'll go back to mutual funds. I don't have time to sit around and watch the market all day." There is no reason for long-term investors to sit around watching the market all day.

Long-term investors can still be hurt if one of their rare trading days happens to fall on a day when market prices are fluctuating wildly. On these days investors can follow the advice in the Wall Street Journal article:

– Check the INAV to make sure that the ETF is trading near the value of the assets it holds.
– Check that the bid-ask spread is not unusually high.
– Place a limit order.

So, for example, if a broad index ETF has bid-ask prices of $17.49 - $17.51, an investor might place a limit buy order for $17.60 or a limit sell order for $17.40. This order will normally be filled at close to the bid or ask quote, but is guaranteed not to be filled at a price worse than the chosen limit price. The idea here is that you're looking to get the prevailing market price unless it happens to move against you sharply just after you place your order.

All this may sound like work, but if you only trade a handful of times per year, the work is far from onerous. The main risk comes from getting spooked by market volatility and trading at a bad time.

Friday, June 4, 2010

Short Takes: Corporate Bonds, Fiduciary Duty, and more

1. Larry Swedroe explains why you might not want to own corporate junk bonds. They tend to drop in value at the same time that stocks drop. Usually you want your bonds to provide some stability for your portfolio.

2. Jonathan Chevreau posted a reader comment making the case for why financial advisors shouldn’t have a fiduciary duty. I found this very illuminating. The attitude of the reader seems to be that only a baby should expect to have an advisor place the client’s interests above the advisor’s own interests. The relationship is a business transaction and people should expect to have advisors take advantage of them. This attitude contrasts sharply with the expectations of many clients who seek out someone they can trust.

3. Big Cajun Man had some fun announcing that Bank of Canada rates had gone up 100%!

4. Canadian Capitalist reviewed Gail Vaz-Oxlade’s book Debt-Free Forever.

5. As Preet collects more feedback on his Know Your Advisor (KYA) questionnaire, he plans to turn it into an e-book.

6. Canadian Investor looks at whether investing in Real Return Bonds is best done directly, with an ETF, or with a mutual fund.

7. Mike at Money Smarts discusses some research that suggests that if some financial advisors were made to disclose their fees, they may treat their clients worse than they do now. Even if this is true, I suspect that the benefits coming from clients knowing the fees would more than offset this potential problem.

8. Guest blogger Rachelle at Million Dollar Journey gives some tips to landlords on how to negotiate with difficult tenants.

9. Financial Highway lists the 8 warning signs that you have too much debt.

Thursday, June 3, 2010

The Downside of Garbage Bag Taxes

An often touted solution to the problem of too much garbage is charging a tax on each garbage bag picked up by local garbage services. However, according to Levitt and Dubner, authors of the book SuperFreakonomics, this hasn’t worked out very well in some amusing ways.

In addition to creating an incentive to create less garbage, it gives people other incentives:

1. Stuff bags fuller. This has become known as the “Seattle Stomp”.

2. Dump garbage in the woods. This was done in Charlottesville, Virginia.

3. Flush uneaten food down the toilet. “In Germany, trash-tax avoiders flushed so much uneaten food down the toilet that the sewers became infested with rats.”

4. Burn garbage in the back yard. A hospital in Dublin “recorded a near tripling of patients who’d set themselves on fire while burning trash.”

The authors’ main point is that people respond to incentives, but not always in the way we might expect. They study data to try to figure out people’s real behaviour. The book covers many interesting topics. A few are listed below.

When doctors are measured on their patients’ health outcomes, many doctors respond by avoiding taking on very sick patients. This helps their scores, but is bad for the patients who need a doctor the most.

In an experiment to determine how different conditions affect people’s honesty, an honour system of payment for food was set up in a break room. A sign asked for people to place the appropriate amount of money in the “honesty box.” When the price list had a picture of human eyes at the top, people were much more honest. Apparently, we don’t like to cheat when we feel watched.

Which is the more important car safety equipment: seatbelts or air bags? I’m not sure, but according to the authors, seatbelts cost $30,000 for each life saved, and air bags cost $1.8 million for each life saved.

A researcher has a plan that could possibly reverse global warming for less than the amount of money Al Gore’s foundation is spending to raise global warming awareness.

Interesting experiments to try to teach monkeys to use money seemed to lead to monkey prostitution.

I found this book fascinating. The relentless rational search for truth is refreshing. The authors don’t care what people want to be true. They want to know what is actually true. They may not always get it right, but they will change their minds if presented with real evidence.

Wednesday, June 2, 2010

Index Portfolios and Foreign Currency Exchange Costs

The premise behind the indexing approach to investing is to use a simple approach to get market average returns with a minimum of costs. This is usually done using index-based exchange traded funds (ETFs) or low-cost index mutual funds. Investors choose a mix of index funds and stick with it, possibly rebalancing periodically to maintain a preferred target percentage of assets in each fund. Once these decisions are made, the focus is on minimizing costs, including the cost of currency exchanges.

If a Canadian investor chooses to own both Canadian- and US-dollar funds, some amount of currency conversion will likely be necessary. All currency conversion involves spreads which are the difference between buy and sell prices. If you start with Canadian dollars, convert them to US dollars, and then convert back to Canadian dollars, you'll have less money than when you started.

The big question is how much less money will you have? For large dollar amounts traded in foreign exchange markets, the loss could be as little as 0.05%. However, average investors doing their conversions through a discount broker could pay much more. Over 2% is not unusual. These huge spreads are essentially an added fee rather than a genuine market-driven spread. Typically, these fees are quoted in terms of the cost of converting once in either direction. So, the 2% round-trip spread would be about 1% in each direction.

Unfortunately, discount brokers don't seem to compete on these foreign exchange fees. When customers show up at a bank branch to exchange physical currency notes, high fees to cover service costs are understandable, but there is little reason for currency conversion fees related to stock transactions to be so high other than a desire for additional profit.

If these fees were driven by a competitive market, it is hard to imagine that the added fee per currency conversion would be more than 0.1%. Discount brokers manage to trade shares for only $10 per trade. The additional costs due to the bid-ask spreads on stock prices are usually quite small. But for some reason currency conversion fees are much higher.

Let's look at an example. Suppose that an investor wants to rebalance a portfolio by selling about $10,000 worth of Canadian ETF shares to buy about $10,000 in a US ETF. Let's assume that the ETFs trade for $50 with 5-cent bid-ask spreads. So, 200 shares are involved in each trade. The total trading spread is $10, half of which ($5) is lost on each buy or sell. Add in the $10 commission and each trade costs $15. Let's assume that the foreign currency exchange fee is 1%.

The overall costs are as follows:

Sell Canadian ETF: $15
Convert proceeds to US dollars: $100
Buy US ETF shares: $15

The total cost is about $130 and is dominated by the foreign exchange cost.

Note that this problem is not solved by allowing US dollars to be held in a RRSP. This issue is similar, but not the same.

It is very easy for currency conversion costs to be lost in all the other activity in a trading account. They are buried in the quoted exchange rate. However, for some investors, the total fees they pay can be dominated by these currency conversion fees.

Tuesday, June 1, 2010

Car Warranty Shuffle

Trying to get a business to honour its warranty can be a frustrating experience. A friend of mine who I'll call Kevin encountered problems with the paint job on his car, and this has lead to a type of run-around that I hadn't seen before.

When Kevin bought his car, he paid for an extended warranty on the car's paint job. We can debate whether this type of warranty is worth buying, but in this case a serious problem did come up with the paint job on Kevin's car. It turns out that paying for the warranty worked out well in this case, or so Kevin thought.

When he took the car to the dealership where he bought it, they told Kevin that he'd have to contact the insurance company that holds the policy first to get authorization to go ahead with a repair. You might think that the dealership should handle this detail given that Kevin never dealt directly with the insurance company in the first place.

Kevin phoned the insurance company with his copy of the warranty contract in hand and was told that they had no record of his policy. They had records of the contracts numbered just before his and just after his, but not his number.

The person at the insurance company went on to say that it is common for car dealerships to just pocket the premiums and take on the risk themselves without ever sending any paperwork to the insurance company.  This is the first time I've heard of this trick, but it isn't too surprising once you think about it.  If these warranties are mostly profit, it makes sense that the dealership would want this money.

When Kevin went back to the dealership to try to straighten out this mess, they told him that they had no record of the insurance coverage on his paint job either. This leaves Kevin holding a warranty contract, but apparently unable to get anyone to honour it.

It is impossible to know whether the dealership really did just pocket Kevin's premium, but it would be interesting to know whether this really is a common practice. Consumers might think twice about buying extended warranties if they knew that they might end up in the same position Kevin is in.